By Matthew J. Bartolini, Head of SPDR Americas Research.

Sector investing: A powerful portfolio construction tool

Sector investing can be a powerful portfolio construction tool. As economic variables and business cycles impact segments of the economy differently, sector-based investment strategies can help investors align and adjust portfolios based on a variety of objectives.

Here we explore how investors can use sector strategies to accomplish four important goals:

1. Pursue alpha
2. Position for business cycles
3. Capture secular or cyclical industry trends
4. Harness diversification benefits

1) Pursue alpha: Wide dispersion and changing leaders create opportunities

As shown below, sectors have historically exhibited wider dispersion than styles. In fact, the return dispersions among sectors have been wider than among styles every year for the past two decades as shown in the chart below, and more than twice as wide on average, even when we account for style-based strategies in the small-cap universe.

For investors, wide dispersion and changes atop the leader board provide opportunities to deliver alpha by overweighting winners and underweighting losers.

Source: SPDR ETFs.

2) Position for business cycles: Invest according to the current economic phase

The economy moves in cycles. Each phase typically exhibits characteristics that impact sectors or industries differently, meaning specific sectors may outperform or underperform during different phases. With sector-based strategies, investors can align portfolios with shifts in business cycles by increasing allocations to sectors that are favored by the current economic phase and reducing allocations to sectors facing macro headwinds.

3) Capture secular or cyclical industry trends: Put high-conviction views to work

Because sectors are closely aligned with specific economic variables, sector-based strategies can help investors capture secular or cyclical industry trends based on macro relationships (interest rates, inflation, oil, and the dollar).

Consider, for example, that US regional banks have higher beta sensitivity to 10-year Treasury yields than the broader market, as represented by the S&P 500 Index (0.48 vs. 0.10). Utilities, on the other hand, have negative beta (-0.25). Investors with high conviction about the direction of long-term yield movement can use sector-based ETFs focused on regional banks or utilities to enhance the positive or negative beta exposure of their portfolios.

Investors can also use sector-based strategies to capture long-term growth opportunities created by secular shifts or technological trends. For example, the pharmaceutical industry has witnessed a boom in drug innovation over the past decade, particularly in biotechnology. And right now, in terms of the market share for prescription drug sales, biotech-based products have increased from 17% in 2010 to 27% in 2018. Driven by this secular shift, biotech stocks have outperformed the broader health care segment by 136% and the S&P 500 Index by 186% on a cumulative basis over the same time period, as shown below.

Source: SPDR ETFs.

4) Harness diversification benefits: Take advantage of thematic trends without shouldering too much stock-specific risk

Stock picking is not an easy job. An investor may get the sector call right, but the stock call wrong: Historically, over the past 15 years, more stocks (34%) have underperformed their respective sector averages by more than 10% than having outperformed (28%) by more than 10%, as shown below.

Source: SPDR ETFs.

Compared to holding a small group of stocks designed to capture thematic trends, sector investing can help investors achieve the desired exposure without shouldering too much stock-specific risk. For example, rather than select three or four companies focused on driverless cars to capture the boom in autonomous vehicles, seek a thematic, diversified—but targeted—sector exposure focused on many of the firms innovating within that space: the core players and the supply chain providers. This approach seeks to provide targeted exposure to a theme, but mitigate stock-specific risk, in case a stock call was wrong even if the theme was right.

Consider ETFs for precise implementation of sector-based strategies

From a total portfolio perspective, with the attributes mentioned above, the potential role a sector-based strategy could play is to strive to do more for the core by capturing alpha opportunities. And carving out a piece of core US equity exposure is a part of the tactical asset allocation strategy run within the SPDR SSGA Global Allocation ETF (GAL US) where approximately 20% of the US exposure (6% of the entire portfolio) is dedicated to a sector rotation strategy.

There are many different ways to construct sector rotation strategies (technical, fundamental, macro-based), and the transparency of sector-based ETFs means investors can implement either simple or sophisticated strategies with greater precision. Our SPDR family covers 11 GICS sectors and 22 industries, as well as thematic sectors focused on firms driving technological innovations within certain areas such as smart transportation, clean power, and intelligent infrastructure.

(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)