A multifactor ETF approach to sector investing

U.S. stock indexes are rising to new highs, and there’s a lot going on under the surface in terms of sector rotation. For investing in individual sectors, a multifactor approach may make sense for long holding periods and for those who want to avoid overconcentration in individual stocks.

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Different sectors passing the leadership baton back and forth isn’t uncommon during a bull market, which is why some investors employ sector rotation strategies. For example, in the third quarter of 2019, it was defensive and yield-oriented sectors such as utilities, consumer staples, and real estate that led the market. More recently, growth sectors such as technology and healthcare have taken back leadership.

Yet, for investors who want to take a longer-term mindset to sector investing, a multifactor approach that seeks to overweight stocks with characteristics that have historically outperformed may make sense. These investors might have long-term views on particular sectors that may benefit from secular trends in the economy. Examples may include the technology sector benefiting from the rise of digitization and artificial intelligence, or consumer sectors profiting as the huge millennial generation enters its prime earning years.

Combining sector and multifactor investing

Factor-based investing is backed up by reams of academic research and the live historical performance of strategies that use this approach. It’s typically applied to broad swaths of the market such as U.S. large-cap stocks and emerging markets as a group.

However, there’s evidence that multifactor investing also works in sectors; still, multifactor investing requires a disciplined and patient approach, and sectors are no exception. It requires a long-term view to capture the historical performance premiums that have been associated with factors such as size, value, and profitability.

Dimensional Fund Advisors, the subadvisor for John Hancock Multifactor ETFs, has found that within U.S. sectors such as financials and healthcare during the 1975 to 2017 period, value stocks generally outperformed growth stocks, and stocks with higher profitability generally outperformed those with low profitability.¹

Avoiding overconcentration

Some investors use passive approaches to sector investing, with vehicles such as exchange-traded funds (ETFs) that track market-capitalization-weighted strategies that weight stocks by their size. Some sectors are dominated by a handful of stocks, which can result in these ETFs become quite top-heavy.

For example, a popular sector ETF for technology stocks has nearly 40% of its assets in just the two largest stocks in the tracking index: Microsoft and Apple.

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Conversely, a multifactor approach can employ disciplined, rules-based strategies to limit concentration within sector portfolios, with rules to reduce stock-specific risk while seeking to outperform market-cap-weighted indexes. That’s why multifactor sector strategies could make sense for investors who are in it for the long haul, rather than trying to profit from quick sector trades.

 

1 “Value and Profitability Premiums Across Sectors,” Dimensional Fund Advisors, September 2018. Past performance does not guarantee future results.