The volatility of individual stocks? Too hot! Following the entire market? Too cold!
For investors looking for alpha, what strategies are just right? S&P Dow Jones Indices’ Joseph Nelesen and Tim Edwards analyzed more than 20 years of returns to determine how bets on sectors and industries can outperform major market indexes that blend industries. VettaFi contributor Dan Mika spoke with Nelesen about his latest research.
The following interview has been edited for clarity and brevity.
Dan Mika, VettaFi: You posit that during downturns, accurately picking the right sectors for investment is more likely to generate outperformance than actively picking individual stocks. But, at the same time, eight out of the 11 sectors in the S&P 500 have outperformed the entire index since 1999. So maybe start by explaining why the research shows picking sectors might be the Goldilocks for investors between actively picking individual stocks, but also versus sticking with a large sector-blended index.
Joseph Nelesen, S&P Dow Jones Indices: It’s hard to pick anything over the long term, right? Whether it’s stocks, sectors, or asset managers. We show year after year that the broad benchmark in the U.S., for example, the S&P 500, is really challenging to outperform. You’re talking about over 80%, 90% of managers falling below over a 15- or 20-year period. This really is a testament to how hard it is not only to pick managers but for those managers themselves to pick stocks. We show another way in various reports: a phenomenon called skew, [which is]a positive view of markets.
I’m still talking about single stocks, but over that period from 1999 to the end of 2023, around 25% of stocks in the S&P 500 outperformed the average stock. What that’s telling you is there’s a small number of these that are driving that index average upward. We know what they are, we’ve been talking about things like FAANG and Magnificent Seven for years now. That’s a side of the equation around the difficulty of picking stocks.
When we write about sectors being relatively more forgiving than stocks, we have a line in there about the power of diversification inside those sectors. As you pointed out, eight out of 11 outperformed the broad S&P 500 over that period of time. There are interspersed periods in between where individual ones do better in any given calendar year, or during certain parts of the market cycle.
VettaFi: Statistically speaking, picking from those sectors is a little more forgiving than trying to pick from amongst the 500-plus stocks that a manager might have at their disposal.
Nelesen: It’s still challenging. It’s still hard to be active. But I think the whole point of bringing this paper out. Others we’ve done before on the topic of sectors is that we know a large element of the investing populace is using sectors in a very active way with their passive instruments. Still, they’re toggling or rotating between them actively around the cycle.
VettaFi: How does rebalancing factor into the patterns of certain sectors outperforming the whole S&P 500 over time? Is that because the sector indexes have smaller-cap companies with more room to grow, but aren’t big enough to be in the S&P 500?
Nelesen: I think the diversification benefit comes from a breadth of holdings as well as rebalancing. It’s hard to talk specifically about rebalancing without considering certain periods and different methodologies. Within the paper, we use cap-weighted sectors, we also use equal-weighted sectors, and we find similar outcomes.
I really think it’s not so much that there’s magic in the rebalancing — although you could argue that holding a broad array of securities when something is reverting from a high position, it’s very likely it’s something else in that index is gaining at the other side. As money might fall out of one stock, it might come into another. You’re still at this collective higher average.
The difference between cap-weighted and equal-weighted is a part of it. We’ve recently seen a lot of interest in equal-weight strategies among investors who want to move away from concentration in market cap. The flip side is that as certain stocks grow faster than others, that’s where performance comes from for people who already have index exposure, whether it’s a broad market or a sector.
In a year like last year, we saw a very large rebound in the market. There were certain sectors, like consumer discretionary, information technology, or communications services, that individually held some of those major stocks that drove the overall index upward. You’re getting that diversification without knowing ahead of time which single stocks will be the winners.
VettaFi: You brought up equal weighting. Doing some comparison, I found the Invesco S&P 500 Equal Weight ETF (RSP) over the time period of this study returned 746%, while SPY returned just over 500% But at the same time, the cap-weighted sector ETFs have all outperformed their equal-weighted counterpart ETFs during that same period. Why are the cap-weighted sector ETFs generating more outperformance over the long-term than equal weight, while an equal-weighted sector-blended ETF is not just beating the S&P 500, but beating it by 200%?
Nelesen: I can’t comment specifically on any ETF; I’m talking about indices. Even in that case, I’d have to go back and look a little closer at some attribution and see what’s going on.
Research would show us that the two different approaches… are kind of explained by factors and cyclicality. In other words, with cap weighting, you’re getting the large size effect and the momentum factor to a certain degree. The large size (effect) when mega caps are outperforming… and momentum is building up those stocks. That cycle continues for some period of time. Equal weighting is more around small-size bias or small caps; you’re going to get more of that effect.
VettaFi: Is that a reason for sectors to outperform?
Nelesen: Some of that is coming in more so in the equal weight. There’s an anti-momentum tilt when you’re trying to capture that mean reversion, when the highest flying, fastest growing stocks start to come back to Earth with the average.
On an individual sector basis, it’s hard to say what an equal weight or cap weight has up from the other. But you can probably imagine how those dynamics play out in something like tech, for example, where there may be a few standouts in the cap-weighted version. And because they’re not constrained, they’re going to make an outsized contribution.
The flip side of that is if you look at equal-weight tech sector exposure, you’re giving a lot more consideration to the much smaller stocks. From a starting point, say, some of the newly emerging semiconductor companies really grew very fast when they started out. (If you consider) equal weight versus a cap weight, that equal weight for that stock was higher and would have a greater contribution.
It really is time-dependent. That’s not a single answer that explains the performance disparities. But I think we certainly want to empower people through the data to take a look at different time periods and when certain equal-weight or cap-weighted exposures have done better than their counterparts.
VettaFi: If you were an individual investor or if you were a financial advisor who’s positioning a client’s portfolio for a long-term time horizon, what are the key takeaways from this research when thinking about how to position portfolios? What are the strategic takeaways that you think investors can use right away from this research?
Nelesen: I think there are two things that come immediately to mind.
One, which we touched on at the beginning of this conversation, is that it’s very hard to pick stocks. It is also hard to pick anything that will outperform. However, sectors — because you’re getting a little broader exposure than just a single name, and you have some thematics and factors among them — have proven to be pretty valuable tools for those kinds of investors.
VettaFi: That said, an individual could look at their portfolio, or an advisor could look at their client’s portfolio, through the lens of factors and try to evaluate the kinds of risks they’re taking.
Nelesen: We think about sectors in this paper in two buckets. The cyclical bucket is where sectors like consumer discretionary and tech move much more upward on average when the market is rising. Then, there’s defensive sectors such as utilities, consumer staples, these lower-beta sectors that tend to have less volatility and therefore perform relatively better when the market’s going down.
The first step for an advisor would be looking at the portfolio you’re creating or managing for your clients and seeing what those sector risks are. Something we haven’t talked about is that sectors explain a lot of stock performance. A data point we bring up in the paper shows that around 50% of a stock’s performance can be explained by the sector. The rest of it is market risk, but it matters.
Lastly, I’d say that it matters all the time what sector a stock is in, but interestingly, it seems to matter even more during certain periods, such as downturns. And during years when there’s an election — specifically presidential elections, which we’re in right now — these are the times that historically, we see sectors explain much more of the dispersion in the market than they do on average.
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