Style vs. Sector ETFs: Which Approach Best Manages Risk?

Facing interest rate uncertainty, increased market volatility and the potential for a slowdown in corporate profits, investors are questioning how to position portfolios. To get more from your core and help manage risk, it may be time to consider sector investing as an alternative to traditional stock picking and style boxes.

Picking sectors over stocks

One approach to building portfolios is stock picking, which proponents credit with helping a portfolio outperform. Investors can have greater success when they’re able to choose from a diverse number of securities with disparate returns and low correlations. However, consistently selecting the right stocks from such a broad universe, such as the S&P 500® Index, can be difficult and time-consuming. The level of effort and research required to select securities with the highest potential alpha or that allow investors to express a particular macro view can effectively involve making 500 different decisions.

Another approach is sector investing, as can be done using our family of Select Sector SPDR® ETFs. The number of decisions is essentially reduced to nine without sacrificing the potential to have better returns and/or lower volatility than a broad-based index. In addition, investing in sectors may help reduce the risk that the value of a portfolio with a concentrated stock position plummets, especially in a gyrating market.

Take energy stocks as an example. In the past year, the decline in the price of oil has roiled energy markets and sent the price of the S&P Energy Select Sector fund down some 35%.1Had an investor attempted to “play the energy sector” through a single stock, returns could have performed much worse than the broad sector. In fact, the chart “Energy Sector Price Returns” shows that in this case, the return on the sector was better than the average and median stock return, illustrating how a more broadly diversified sector can lower the potential for stock-specific risk and provide the desired exposure to macro-based themes in an efficient manner.

Source: State Street Global Advisors, Bloomberg, from 9/28/2014 to 9/28/2015.


Gaining a sharper focus with sectors than styles

Sectors have four distinct advantages over styles that allow investors to efficiently manage risk and express market themes in response to changes in the global economy.

1. Sectors are a key driver of risk

Sectors consistently account for a larger contribution to equity risk within the S&P 500 Index than do styles. As shown in the chart “S&P 500: Contribution to Risk” below, sectors—not style exposures—are the major determinant of risk within a core US equity exposure. Furthermore, over the last 17 years, the average contribution of risk from sectors within S&P 500 Growth and Value style indices is 18 percent. In comparison, style factors were near zero across Growth and Value indices. Even within style indices, it’s the sectors that drive more of the risk.

Source: State Street Global Advisors, FactSet, as of 8/31/2015.


2. Differentiated correlations to the broader market

Over the last 17 years, the S&P 500 Index’s average correlation to growth and value is 0.98 and 0.97, respectively. Meanwhile, average sector correlations to the broad market are much more diverse, ranging from 0.60 for Utilities to 0.92 for Industrials.

A lower average correlation means returns are more differentiated from each other which may positively impact asset selection strategies, such as rotating between sectors to manage risk and potentially improve diversification.

3. Wider dispersion of returns

As the “Sector Dispersion” and “Style Dispersion” charts demonstrate, sector returns differ greatly over time, while style returns vary less. A wider dispersion of returns is more attractive, as a low dispersion typically means the return of any particular stock is more similar to the average, which may adversely impact asset selection strategies.

Source: FactSet, State Street Global Advisors, as of 8/31/2014. FactSet based on estimates, actual portfolio level returns may vary.


Source: FactSet, State Street Global Advisors, as of 7/31/2014. FactSet based on estimates, actual portfolio level returns may vary.


4. Economic cycle dependency

Along the same lines as dispersion, sector performance from year to year is quite variable with some sectors going from worst to first. The reason for this is cycle dependency, as specific sectors may out- or under-perform during different phases, driven by cyclical factors such as corporate earnings, interest rates and inflation.

Cycle dependency allows investors to potentially generate alpha by overweighting certain sectors while underweighting others to harness macro trends, potentially with more precision and focus than styles. That’s why State Street Global Advisors’ family of SPDR ETFs also offers 19 Industry Funds that target various sub-industries of the US market.

When the bull market and economic recovery reach their next stage, a rising tide may no longer lift all boats and investing may require a more precise approach. For investors looking to harness the next stage of the US recovery cycle, we think it will prove beneficial to favor substance—by way of sectors and industries—over style.