Many investors hold a portfolio of index funds designed to track the movements of the broad market. While this approach has benefits for cost-effectiveness and ease of management, it can be suboptimal when it comes to risk management and minimizing volatility. Often, investing passively means exposing your portfolio to the market's movements and its current composition.
For example, the S&P 500 index is currently weighted 26% towards the technology sector as of October 17th, 2022. This sector has historically delivered high growth but also incurred substantial volatility and drawdowns during unfavourable economic conditions. Thus, an index investor who holds an S&P 500 fund must accept the high weighting of technology stocks and their risk exposure if they seek to emulate the market.
This may not be desirable to investors who have objectives beyond growth at all costs, such as preserving of capital or reducing volatility. In this case, a sector-oriented investing strategy might be a better approach.
What is sector investing?
A stock market sector can be defined as a group of companies with similar characteristics to each other, commonly in terms of products and services. Currently, MSCI uses the Global Industry Classification Standard (GICS) of 11 sectors. They are:
7. Consumer Discretionary
8. Consumer Staples
9. Information Technology
10. Communication Services
11. Real Estate
Sector investing refers to the practice of over-weighting, or "tilting" certain market sectors in a proportion beyond what their natural market capitalization weights are.
For example, the real estate sector currently comprises 2.66% of the S&P 500 as of October 17th, 2022. An investor who wishes to overweight real estate companies in their portfolio can hold additional stocks to achieve exposure above and beyond this 2.66%. Thus, this investor has implemented a real estate sector tilt.
The importance and benefits of sector investing
Sector investing is a strategy that can help investors position their portfolios to take advantage of changes in the business cycle. This is because each sector is impacted in different ways by changes in macroeconomic variables.
In general, the business cycle can be characterized by four fairly predictable and consistent phases, each of which has historically benefited different sectors. As seen below, investors can tactically shift their allocations via a "sector rotation" strategy to optimally position their portfolio.
Sector rotation in the current market environment
The economic and market environment from 2021 to 2022 has been characterized by persistently high inflation, coupled with restrictive central bank monetary policy in the form of rising interest rates.
Under this regime, commodity prices have soared, while consumer discretionary spending has decreased. Housing demand and prices have fallen as mortgage rates increased. Fears of a "hard landing" for the economy are present as market participants price in the risk of a pending recession.
As a result, from January 2021 to September 30th, 2022certain sectors have significantly outperformed the S&P 500 index. In particular, the energy, utilities, and consumer staples sectors contained in the S&P 500 have significantly outperformed the overall index benchmark.
Total Annualized Returns
Year To Date*
Since January 2021*
S&P 500 ENERGY SECTOR
S&P 500 UTILITIES SECTOR
S&P 500 CONSUMER STAPLES SECTOR
S&P 500 INDEX
*YTD returns and returns since January 2021 are until September 30th, 2022 with all dividends reinvested. It is not possible to invest directly in market indices. Indices returns do not reflect trading costs, transaction fees, commissions, or actual taxes due on investment returns. Source: Portfolio Visualizer.
In the current market environment, investors can consider defensive sectors that are resilient when growth slows down and monetary policy tightens. This could include:
- The healthcare sector, which historically has lower elasticity thanks to its evergreen demand, thus reducing its sensitivity to economic fluctuations.
- The energy sector, which offers an inflation hedge given that it benefits from rising commodity prices and is less correlated with other assets, providing diversification benefits.
ETFs as a tool for sector exposure
Investors and advisors who attempt to implement a sector investing strategy via traditional stock-picking methods face some difficulties. Buying individual sector equities can be time-consuming, expensive in terms of trading costs, and subject to idiosyncratic, company specific risk. It is also capital intensive, as shares of certain companies can have a high price.
A solution here is using exchange-traded funds (ETFs) that track a "basket" of stocks from a particular sector. These funds can be actively managed to outperform a sector benchmark, or passively indexed to track one instead. Either way, sector ETFs provide access to an instantly diversified portfolio via a single ticker. They can be bought and sold on exchanges like any other security intra-day.
The benefit here is excellent liquidity, transparency, and ease of portfolio management. Thanks to the ETF creation/redemption mechanism, bid-ask spreads are minimized compared to trading dozens of different individual stocks. ETF holdings are reported frequently, which allows investors to see their underlying exposures on the fly. Finally, managing few sector funds leads to lower portfolio turnover.
For reasonable expense ratios, our lineup of sector ETFs provide investors and advisors with instant exposure to a variety of stock market sectors from various geographies and different management styles. For more information, see our full lineup of sector equity ETFs.