Capturing the Opportunity of Sector Allocation

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:

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.

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