Investors who are just beginning to fill out their investments may gravitate toward name brand stocks that they are familiar with, but a sector exchange traded fund may be a better option to diversify a portfolio.
“Investing in sectors can provide diversification benefits that, compared with single-stock ownership, may reduce portfolio volatility,” Fidelity Investments strategists, led by Scott O’Reilly, said in a research note.
Specifically, the Fidelity strategists argued that sector investments significantly diminish downside risk, which may could improve investor outcomes, especially among those less risk tolerant.
In a portfolio of stocks compared to a portfolio of sectors for the period between 1995 through 2015, Fidelity found that an investor’s risk profile significantly changed when moving from stock holdings to sector and to a diversified portfolio. Specifically, single stock exposure showed 35% idiosyncratic risk and 10% market risk when analyzing annualized volatility based on weekly returns, whereas a sector portfolio showed 7% idiosyncratic risk and 13% market risk.[related_stories]
Broad sector plays would allow investors to limit potential downsides relative to investing in individual stocks while helping investors gain exposure to any upside potential, essentially limiting the swings that may cause some to prematurely dump a holding. Fidelity research found that there is 55% less downside risk in sectors, compared to single stocks, when comparing 12 month excess returns for portfolios of skilled investors in the period 1995 through 2015.
“Reducing downside risk helps individuals weather bouts of volatility while staying invested, and it also reduces the subsequent gain required to catch up after a loss,” the Fidelity strategists said.
Additionally, investors would not have to go through the hassle of meticulously vetting each individual company stock to select the best picks.
“Sector investing still gives investors control of their portfolio construction, but without the challenge of trying to identify, analyze, and manage multiple individual stocks,” Fidelity said.
If professional stock pickers are having trouble beating the broad equities market, it is unlikely most people will be able to pick winners. Only 27% of large-cap core funds beat the S&P 500 over 2015, which was also below the 10-year average of 36%. Over the past decade, the likelihood of outperforming a sector by randomly picking individual stocks was lower 50% in nine of 10 sectors.
“Instead of trying to pick from the thousands of individual names in the equity universe, enhancing diversification via sector investing may be a better solution,” according to Fidelity. “It also allows investors to play an active role in their portfolio construction while reducing the volatility of their equity portfolio.”
For example, investors can utilize ETF options to gain cheap, efficient and easily accessible sector exposure, including:
- Fidelity MSCI Consumer Discretionary Index (NYSEArca: FDIS)
- Fidelity MSCI Consumer Staples Index ETF (NYSEArca: FSTA)
- Fidelity MSCI Energy Index ETF (NYSEArca: FENY)
- Fidelity MSCI Financials Index ETF (NYSEArca: FNCL)
- Fidelity MSCI Health Care Index ETF (NYSEArca: FHLC)
- Fidelity MSCI Industrials Index ETF (NYSEArca: FIDU)
- Fidelity MSCI Information Technology Index ETF (NYSEArca: FTEC)
- Fidelity MSCI Materials Index ETF (NYSEArca: FMAT)
- Fidelity MSCI Telecommunication Services Index ETF (NYSEArca: FCOM)
- Fidelity MSCI Utilities Index ETF (NYSEArca: FUTY)
- Fidelity MSCI Real Estate Index ETF (NYSEArca: FREL)
For more information on market sectors, visit our sector ETFs category.