ETF Trends
ETF Trends

By WestEnd Advisors

For all the resources and effort investors pour into seeking an edge over the stock market, we believe those who focus on traditional stock selection and style factors often overlook one of the most useful potential tools for generating outperformance: sector allocation.

Companies are grouped within sector classifications explicitly because of the similarity of their economic activities. It follows that companies within a given sector are likely to have similar or correlated fundamental outcomes under a particular set of economic conditions. Conversely, companies in different sectors, which represent different types of economic activities, will typically have differing fundamental outcomes for a given economic environment. These divergent fundamental outcomes contribute to divergent equity sector performance, which, in turn, creates the opportunity for generating excess return through sector allocation.

If you subscribe to our belief that the economic environment is one of the key drivers of financial market returns, it doesn’t take much to imagine that sector allocation should offer better opportunities for generating outperformance than other types of allocation strategies.

To illustrate this, first consider two common equity style pairings investors seek to exploit: Large-cap versus Small-cap and Growth versus Value. Using the S&P 500 as a proxy for Large-cap and the Russell 2000 for Small-cap, the absolute calendar-year performance spread averaged 8.38% from 1990 through 2016. Similarly, for Growth versus Value, the absolute annual spread between the Russell 1000 Growth Index and Russell 1000 Value Index averaged 9.23%. Thus, tactically allocating between Growth and Value or between Large-cap and Small-cap allows the potential for an investor to capture some of that performance spread as excess return.

Now consider the potential from allocating among S&P 500 sectors over the same period. Comparing the average return of the five best-performing sectors versus the average return of the five worst-performing sectors each year, the performance spread averaged 19.98%. That is more than twice the spread of either the Growth/Value or Large-cap/Small-cap pairings. Additionally, there is consistency to the relative size of the sector performance spread. The sector performance spread was larger than either the Growth/Value or Large-cap/Small-cap spread in 25 of 27 calendar years since 1990. This combination of consistency and a large performance spread makes sector selection fertile ground to plant the seeds of active management in an effort to reap attractive risk-adjusted returns over time.

range-of-returns-by-sector

Of course, no investor is going to always pick what prove to be the best five sectors for a given period, just as no investor is going to perfectly time when to be in Growth stocks versus Value stocks or Large-cap versus Small Cap. However, if sectors tend to offer a larger performance spread than style factors, it seems intuitive that a skilled sector-allocator may be able to achieve greater excess return over time than an equally-skilled style-allocator.

What also seems intuitive, though perhaps underappreciated, is the potential for investors to take advantage of the opportunity in sector allocation through economic analysis. As previously mentioned, companies are explicitly grouped into sectors based on the similarity of their economic activities and drivers. More importantly, economic fundamentals shift with the progress of an economic cycle, and thus the relative attractiveness of the eleven sectors will change as the economic cycle evolves. Understanding how sector performance relates to the economic cycle provides a basis for making informed sector allocation decisions.

Some sectors are particularly economically sensitive.  We believe these sectors tend to perform best early in an economic cycle when economic growth is strong (and often after they have severely underperformed in an economic downturn). Other sectors have relatively stable demand for their goods or services throughout the economic cycle, and they tend to perform better on a relative basis at the end of a cycle (going into and during an economic downturn). Still other sectors fall somewhere in the middle. The following diagram illustrates the concept:

sectors-economic-cycle

No two economic cycles are the same, and sectors evolve over time. However, if an investor can formulate a reasonable view on where the economic cycle stands, and thus where the economic backdrop is headed, then allocating to sectors likely to enjoy relative tailwinds in the period ahead, while underweighting or avoiding sectors likely to face relative economic headwinds, may provide a path to exploit fundamentally-driven sector performance dispersion. Then, once an investor has determined desired sector weights, we believe ETFs are uniquely suited to implementing sector allocation, because they can provide a liquid, low cost means for gaining sector exposure.

Following the trail from economic outlook to sector allocation to portfolio implementation is simple in concept, but, of course, it is much more complex in practice. Formulating an appropriate economic outlook requires detailed analysis of economic history and the economic environment, as well as sound judgment. Translating an economic outlook into sector allocations requires understanding the fundamental linkages between the economy and sectors, as well as between the economy and the stock market. It also requires determining an appropriate time horizon for allocations—one short enough to allow confidence in the economic outlook, but long enough for fundamental drivers to overpower market noise. Finally, implementing a sector allocation strategy, even with ETFs, can require evaluating the costs, risks, and benefits of a wide range of available securities. Sector-based investing is by no means easy, but we believe active sector allocation offers the potential to capitalize on a significant opportunity to outperform the broad market.

This article was written by WestEnd Advisors, a participant in the ETF Strategist Channel.

Important Disclosures:

WestEnd Advisors is an SEC-registered investment adviser. Registration of an investment adviser does not imply any level of skill or training. The firm is an independent investment management firm, 100% owned by its active principals. WestEnd manages both equity and fixed-income assets for individuals and institutional clients.

The investment processes, research processes, or risk processes shown herein are for informational purposes to demonstrate an overview of the process. Such processes may differ by product, client mandate, or market conditions. Portfolios that are concentrated in a specific sector or industry may be subject to a higher degree of market risk than a portfolio whose investments are more diversified.

This report should not be relied upon as investment advice or recommendations, and is not intended to predict the performance of any investment. The information contained herein is not intended to be an offer to provide investment advisory services. Such an offer may only be made if accompanied by WestEnd Advisors’ SEC Form ADV Part 2. All investments carry a certain degree of risk including the possible loss of principal, and an investment should be made with an understanding of the risks involved with owning a particular security or asset class. Past performance is not indicative of future results. It should not be assumed that recommendations made in the future will be profitable. These opinions may change at any time without prior notice. While every effort has been made to verify the information contained herein, we make no representation as to its accuracy.

The Standard and Poor’s 500® Stock Index includes approximately 500 stocks and is a common measure of the performance of the overall U.S. stock market. The Russell 1000® Growth Index is an index composed of large- and mid-capitalization U.S. equities that exhibit growth style characteristics. The Russell 1000® Value Index is an index composed of large- and mid-capitalization U.S. equities that exhibit value style characteristics. The Russell 2000® Index measures the performance of the small-cap segment of the U.S. equity universe. It is a subset of the Russell 3000® Index and includes approximately 2000 of the smallest securities based on a combination of their market cap and current index membership. An index is unmanaged and is not available for direct investment.