Second, the nature of the most relevant analytic input differs across sectors. For low-dispersion, high-correlation sectors, the most important decision is the sector call, not individual stock recommendations. The returns of the constituents of these sectors tend to cluster relatively tightly, so stock selection is of relatively little value. On the other hand, where correlations are high, it means that most stocks in the sector move up and down together. A correct sector call will be reflected more consistently across all sector components.
An analyst who follows utilities or energy would be well advised to spend most of his time and effort deciding whether to be in or out of the sector. An analyst who follows technology or healthcare may be better off trying to separate the sectoral wheat from the sectoral chaff. Dispersion and correlation not only provide insight into the volatility of sector returns, but offer guidance for active analysts as well.
This article was written by Craig Lazzara, global head of index investment strategy, S&P Dow Jones Indices.
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