Stock Sector Investing in the Era of Robo Trading, Index Funds

Despite what you might have read elsewhere, sector investing hasn’t necessarily gone out of style, and it can still potentially help bring a measure of diversification to your portfolio.

Over the last few years, the theory became popular that because so much investing is now done through index mutual funds and so-called “robo” programs, sectors have started to move more as a pack, and less based on individual differences. If that were indeed the case, sector investing might have lost some of its luster. However, that theory took a real hit in recent years as correlation between sectors fell to near-record lows.

“Can you still invest by sector? The answer is yes, you can,” said Lindsey Bell, investment strategist at CFRA. “They aren’t all moving in the same direction one way or the other.”

Understanding Sector Correlation

When sectors are more correlated, there’s typically less of a directional difference between how the 11 S&P 500 investment sectors perform in the market versus the S&P 500 Index (SPX). Strong correlation often happens in times of fear. For instance, in 2011, when concerns about eurozone debt dominated the market, inter-sector correlation climbed to nearly 90%, according to The Wall Street Journal. A reading of 100% would mean all sectors are moving perfectly in sync, and zero essentially means there’s no correlation between sectors.

During fearful times like 2011, and again in early 2018 when the SPX suffered a 10% correction based in part on U.S. inflation concerns, investors sometimes adopt a “herd” mentality that contributes to sectors moving together based on the main news of the day rather than on sector fundamentals, analysts say.

By late 2017, sector correlation had fallen to about 20%, and the uptick in early 2018 might have been a minor blip. When sectors move based more on their own fundamentals rather than as a pack, investors can sometimes attempt to take advantage of differences between the sectors, including how various ones respond differently to factors like interest rates, seasonality, mergers and acquisitions, tariffs, and geopolitics. The economic cycle can also influence sector performance.

Taking Advantage of Sector Performance Diversity

"In the context of modern investing, tilting toward and away from sectors can be additive to the risk-adjusted returns of a portfolio in up-markets and potentially provide durability and downside protection during bouts of market volatility," said Viraj Desai, Manager, Guidance Portfolio Development, TD Ameritrade. “That can help improve an investor’s probability of achieving his or her investment goals if done well."

"In normal market conditions, sector returns are not highly correlated in all cases, so modern investors can attempt to take advantage of potential opportunities that arise from diverging performance as themes in individual sectors play out and present potential opportunities for rotation," Desai added. 

As an example of how different sectors sometimes move in opposite directions, industrial stocks that potentially have more exposure to foreign markets suffered a hit in June 2018 as worries surfaced about the potential impact of U.S. and Chinese tariffs on sales and earnings for big exporters. During the same month, utilities stocks, which are potentially more shielded from the tariff issue, found some buyers. It’s this sort of ebb and flow between different sectors that can give a savvy investor the chance to improve his or her performance by weighting one sector over another at various times.

“Sector investing can be a good strategy because sectors can perform or outperform based on seasonality and different business cycles, which can allow investors to take advantage of abnormalities that take place in the market,” Bell said.

Seasonality can be one factor driving diversified investment sector performance. Looking at the time period since World War II, the SPX just posted its strongest six-month return from November through April and its weakest gain from May through October, CFRA’s research shows. On a sector basis, the cyclical sectors, such as consumer discretionary, industrials, materials, and tech outpaced the SPX during the “cyclical six” months of the year (November through April), while such defensive sectors as consumer staples and health care beat the market in the traditionally named “sell in May” period.

Bell acknowledged that the move toward “passive” mutual fund investing—a strategy in which funds are built to mirror specific market indices—coincided with so-called “active” investors not doing as well performance-wise. The temptation for some investors, seeing that, might be to adopt more of a “buy and hold” strategy like the one advocated famously by Warren Buffett. However, there are signs that active investing might have gained some traction in recent years, and that could be partly due to the lower correlations in sector performance.

Putting on Weight

Another thing sector investors might want to consider is the weight certain sectors have in the market versus one another. For instance, the sector weight percentage of info tech to the SPX is more than 26%, compared with just 2% for telecom. That means strength in the SPX might sometimes reflect in large part the outperformance of a handful of big tech stocks. Any shock to those shares that causes them to plunge could mean a rude awakening for those who think they’ve diversified by spreading funds among all 11 sectors, Bell noted. For those looking to take on a sector investing approach, there are various sector ETFs and sector mutual funds that allow investors to get set up. The 11 sectors in the SPX each focus on a different industry. Sector funds and sector ETFs often focus on just one of them.

It’s worth noting, however, that moving in and out of sectors can mean more transaction costs such as commissions and fees, which can affect your net return. Plus, depending on your trading frequency, you could be subject to wash sale rules. 

"Given that sector investing can be involved, investors should focus on fundamentals and valuations if they choose to rotate between sectors over a market cycle and maintain a long term diversified view consistent with their investment goal," Desai of TD Ameritrade said.

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