Sector investing with ETFs

Sector investing can be helpful in pursuing a variety of investment objectives, regardless of where we are in the business cycle. In this article, we outline three common goals of sector investing and consider the advantages that sector ETFs may offer to investors.

Sector investing with ETFs

What are sectors?

Sectors are investable slices of the economy that represent groupings of similar companies. As a classification system, sectors give us a consistent way to think about cross sections of the global economy and a simple yardstick for understanding risk exposures.

There is more than one system used to define economic sectors. In the United States, one of the best-known methods was developed by Morgan Stanley Capital International (MSCI) and Standard & Poor’s (S&P) in 1999. Known as the Global Industry Classification Standard (GICS), this joint effort by MSCI and S&P yielded a robust hierarchy that today consists of 11 sectors, 24 industry groups, 68 industries, and 157 subindustries.

While GICS isn’t the only such system, it represents a common language for talking about all of the businesses that are involved in the manufacture or distribution of the same or similar types of products and services.

Why invest in sectors?

#1 Manage portfolio risk and return potential

One of the most common objectives of sector investing is to dedicate part of a stock portfolio to a single economic segment. Because sectors tend to show patterns of economic sensitivity, you can invest in certain sectors to reduce risk and other sectors to dial risk up in the pursuit of higher returns.

Utilities and consumer staples, for example, have historically exhibited low sensitivity to the cyclical rise and fall of the economy, while the consumer discretionary and materials sectors have historically tracked the fortunes of the business cycle. In an expanding economy, riskier sectors may tend to rise while more conservative sectors lag; conversely, in economic contractions or recessions, riskier sectors may struggle while more conservative sectors make gains.

Why use ETFs for sector investing?

Sector-focused exchange-traded funds (ETFs) can offer a lower-cost method of obtaining sector exposures—and the potential for certain tax advantages—relative to traditional mutual funds. Multifactor smart beta ETFs, moreover, can provide a systematic, rules-based approach to ensuring that the strategy stays focused on capturing the premiums inside each sector.      

Media and communications: sector change puts a growth spin on what was a value category

  • The development of internet technologies over the last 30 years has led to numerous economic transformations, including the rise of business models that straddle multiple sectors. This has prompted index providers to broaden the category formerly known as telecommunications.
  • In 2018, the communication services sector—called “media and communications” by some index providers —absorbed the traditional telecoms like Verizon and AT&T, along with a variety of companies from the information technology and consumer discretionary sectors. As a result, the typical value profile of telecom received a growth-biased makeover.
  • Some household names that migrated into the new media and communications sector: Alphabet, Facebook, Netflix, Nintendo

#2 Enhance your portfolio diversification

Because sectors can behave differently from each other under varying economic conditions, exposures to different sectors at the same time can carry diversification benefits. One thing to pay attention to in this regard is sector correlation.

When stocks tend to move in lockstep with each other—either up or down—they’re positively correlated. When they move in opposite directions, they’re negatively correlated. And when they move independently of each other, they’re said to be uncorrelated. By combining sector exposures with low or negative correlation, investors can build a measure of diversification into their portfolios, establishing a propensity for one part of the portfolio to outperform when another part may fall behind.

Sector (un)correlation offers a path to diversification

Why use sector ETFs for diversification?

Mutual funds used to offer the gold standard for diversification: They provided broad exposure to virtually any well-defined market segment, along with a method—whether it was active or passive—of maintaining exposure to that part of the market. But with the rise of ETFs in the 2000s, investors were given a rapidly expanding choice of diversified investments.

Today, ETFs can offer broad exposure to given sectors and can be particularly well suited to keep pace with sector changes. Multifactor ETFs, which tend to be based on customized indexes that include highly orchestrated rebalancing strategies, are a case in point. Sectors change from the bottom up, beginning with industries and subindustries that are growing, combining with other parts of the economy, or shrinking into obsolescence as the economy evolves. Investing in a systematic strategy that can keep pace with this ongoing economic transformation helps ensure a consistency in sector exposure.    

#3 Build a sector rotation strategy

Sector rotation is a term used to describe a strategy of investing according to perceptions of where we are in the business cycle. Dividing the cycle into four phases—the early, middle, late cycle, and recession phases—investors can own the whole market, but emphasize or deemphasize sectors according to how well they’ve performed historically in each phase.    

When investors suspect the business cycle is on the verge of changing, that may prompt them to rotate their sector emphasis. What’s more, sector rotation itself can be an early warning of a nearing shift in the economy. According to research from the National Bureau of Economic Research, “ … large-sized active orderflow into the material sector forecasts an expanding economy, while large-sized active orderflow into consumer discretionary, financials, and telecommunications forecasts a contracting economy."¹ Sector rotation, in other words, can be both a practice for getting out in front—and a predictive sign—of macroeconomic and market change.

Why use ETFs for sector rotation?

Sector-focused ETFs can be ideal building blocks for customizing a portfolio’s exposures in light of the business cycle. With their speed and ease of intraday trading, typically high liquidity, and frequently lower cost, ETFs allow for quick tactical moves and less resource-intensive structural repositioning.

 

1 “What Does Equity Sector Order Flow Tell Us about the Economy?” Alessandro Beber, Michael W. Brandt, and Kenneth A. Kavajecz, NBER Working Paper Series, November 2010.