What’s sector investing and why is it important? Though this is always a very important consideration, some would say the most important consideration in investing, it so happens that this is also a very timely question.
Those of us with portfolios strong in technology stocks and healthcare might have been wondering what was going on with the markets in the week immediately after the November 2020 US presidential election.
We all sat and stared while the Dow Jones Industrial Index and the Standard and Poor’s 500 Index jumped 3, 4, 5 percent last week while the value of our portfolios may have dropped, even precipitously depending on what you were holding.
So what happened we could ask ourselves?
It’s actually quite simple. Many investors pulled out of the market in the weeks leading up to the election, not knowing what would happen and not wanting to be caught. After the election, the big institutions decided that the sectors and industries that lead the market before the election will be replaced by other sectors and industries after the election. They may also have had an eye or two on the likelihood of a coronavirus vaccine being distributed and being effective and that driving changes in which industries and sectors would benefit.
Market pundits and commentators came up with other suggestions that the market was shifting away from – stay at home stocks – and moving into – back to work stocks. Other ideas were that with a Democrat in the White House, the likelihood of regulation of big tech came a step closer. Alternative energy would also see a boost etc.
All that is very interesting, but an argument could be made, however, that it doesn’t really matter what the big institutions are deciding and basing their rationale on. It only matters what they are doing. In other words, it only matters which sectors and industries they are divesting from – and here is a hint – you don’t want to be in those…
The other side of the same coin is that it also only matters which sectors and industries they are investing in – and here is another hint – those are the sectors and industries that you do want to be in.
What are sectors and industries?
Let’s not get ahead of ourselves. Most investors these days adopt the 11 sectors defined by both the Global Industry Classification Standard which was created by Standard and Poor’s and Morgan Stanley Capital International and by the Industry Classification Benchmark which is maintained by FTSE Russel.
To see the detail of how the Global Industry Classification Standard divides sectors into sub-sectors and industries, check here.
The 11 sectors in approximately descending order of size are:
- Information Technology
- Financial Services
- Consumer Discretionary
- Communications Services
- Consumer Staples
- Real Estate
As I said above, this is an approximate order in terms of size and by size, I mean market capitalization. However, as we will see, in each bull market certain sectors tend to grow more than others, and over time the relative weighting of the sectors changes. Also, sub-sectors and new industries emerge and become more important so how we call the main sectors and the sub-sectors and industries that make them up will also change over time.
Now that we’ve identified the sectors, the important point is that bull markets tend to be led by one or more sectors, other sectors sit somewhere in the middle while yet other sectors lag behind or even decline.
So one way to look at this is that during most bull markets, that last a few years, by the way, the sectors that start off leading tend to continue leading and the sectors that drag their feet tend to continue dragging their feet.
Every so often there will be a shift in the ranking. For whatever reason, one sector will fall out of favor and drop behind while others will move up the ranking. Let’s look at this by examining the relative performance of some sector ETFs compared with the Standard and Poor’s 500 index over the last five years to 14 November 2020. The sector ETFs we will use, all from SPDR.
Here is how the Standard & Poor’s 500 index and each sector performed going back from 14 November 2020, 1-day, 1-week, 1-month, 1-year, and 5-years in table format.
Data source: SPDR
OK, that isn’t so easy to see what’s going on. But just look at the last column.
If you had been invested in just the Index itself, you would have seen a 77.22 percent gain. If you had only been invested in the information technology sector you would have seen a 186.05 percent gain. White if you had been invested only in the energy sector you would have seen a 48.65 percent loss. Let’s look at that same data this time in a bar chart format.
Data source: SPDR
What jumps out to me is that there is some consistency in which sectors performed well over all time periods and some inconsistencies. Some sectors have patterns that match the index as shown by SPX and some are very different.
Here is another way to look at the comparative performance of sector ETFs plotted against the S & P 500 index this time over a 200-day period from 4 February to 16 November 2020.
There are too many lines to see what’s going on. To make it easier, here are the best performing sector ETF, Information Technology, and the worst-performing sector ETF, Energy compared with the S & P 500 index for the same 200-day period.
Over this specific 200-day period, the S & P 500 returned around 12 percent, the Information Technology sector returned 25 percent and the Energy sector lost around 29 percent.
Looking at the comparative performance, there can be no doubt if you had a choice you would rather have been invested in the better performing sector, Information Technology, than in the market index and you certainly would not want to have been invested in the worst-performing sector, Energy.
Flatten out the index – relative performance
Of course, this way of looking at these ETFs isn’t going to tell you how they perform if you were to just buy and hold each one. But the relative performance view gives a clearer picture of which sectors are the strongest at any point in time.
Here is what each of these looks like.
Source – Stockcharts
I’ve included the S & P 500 index ETF, SPX in the bottom right-hand corner for reference. The way to look at each of these is to imagine that in each of the 11 ETF sector charts, the S & P 500 ETF would plot as a horizontal line starting from a point on the left-hand side of each chart.
When the sector ETF line is rising then over that period that sector ETF was outperforming the S & P 500 index. When the sector ETF line is falling, then over that period that sector ETF was underperforming the S & P 500 index.
To illustrate this point here is the SPX plotted on the Financial Services ETF XLF.
Source – Stockcharts
What this shows is that taking November 2015 as the reference point, from then on ignoring short-term blips, the Financial Services sector, XLF underperformed the S & P 500 until around the beginning of July 2016 when it started to trend upwards and was outperforming the S & P 500 until around December 2016 when it started underperforming the index again. Yes, there were some irregular blips that often lasted a month or so. Whether as an investor you pay attention to those shorter-term movements would be a question of your investing or trading style.
It is important to remember that all 11 charts are showing relative performance. It will always be important to know what the general market is doing. If a particular sector outperforms the market by say 10 percent over a 6-month period, but the market itself dropped 15 percent in that time, then that sector will still have lost 5 percent.
Here we get to an important consideration. The best way to ride a bull market up is to be in the strongest sectors. The investing method known as sector rotation involves monitoring the relative performance of market sectors and periodically switching out of the weaker sectors and into the stronger sectors.
That is a simplified way of looking at it. Sector rotation can be used in many ways but the same principle holds.
You can adapt sector rotation for a slow and steady buy and hold approach. In such a case you might hold the top four sector ETFs and every six months, or even every year just rotate your holdings into whichever are the new top four sectors assuming there has been a change. For example, if three of them are the same and only one has changed then you will only need to swap out your holdings in that one sector fund and keep the others. You would probably want to rebalance your holdings between the four funds as well periodically.
At the other end of the scale, you can use sector analysis to find the strongest stocks in the strongest performing sectors and hold those positions until they lose their leadership position and move on to the next set of strong stocks.
Somewhere in the middle of these approaches you could look for the strongest industries in the strongest sectors and hold ETFs of those strongest industries.
Bull and bear markets
Something else to notice.
If we look again at the S & P 500 index plotted from 4 February to 16 November 2020, we will remember the dramatic bear market pullback of the month of March.
As we will recall and as we can read on the chart, the S & P 500 dropped by around 30 percent from its peak around 19 February. The Information Technology sector also dropped by about 30 percent from its peak. However, the Energy sector, as measured by the ETF XLE dropped around 55 percent, i.e. nearly twice as much again.
If you were a nimble trader you would have made more money trading the downside of the Energy sector during the bear market than if you had stayed in the strong sectors or in the general market.
Other considerations – equal or cap-weighted
Are all sector funds equal? Probably not. One of the big drawbacks of the large headline market indexes is that a few big, or rather mega-cap stocks dominate the indexes. This is more the case for the Dow Jones Industrial Average which just sums the stock prices of 30 large stalwarts, adjusting the mathematical result for stock splits. To see how this index is calculated, check here.
The same issue is really also the case for the Standard and Poor’s 500 index. Because it is cap-weighted, the top ten companies account for 28 percent of the total index. So that is only 10 out of 500 stocks that account for 28 percent of the index.
You have to ask yourself when you follow the S & P 500 index, is this really what the overall market is doing? There are good reasons for saying no it isn’t.
If you hold a portfolio of stocks the chances are you have a system that involves using a constant or near-constant position size in order to manage your risks. There are good reasons for this and this is what the large majority of investors do. Given that this is the case, you have to ask whether watching the main market indexes is really giving you a good idea of what the overall market is doing. The simple answer is that no they don’t and not in a way that is comparable with your portfolio.
More valid comparators for most investors’ portfolios are equally weighted indexes rather than market cap-weighted indexes. The same rationale applies to sector ETFs.
So when you are looking for a sector or specific industry ETF you should check whether the stocks composing the fund are market-cap or equally weighted. Most funds have some weighting whereby the larger cap stocks are held in larger proportion, so you will find this isn’t a precise science. But you can still look for a fund where the weighting is less pronounced. This way you will be investing with eyes wide open and understanding the implications and how you should evaluate performance against other holdings or benchmarks going forward.
Answers to questions
Q. What sectors are the best to invest in?
A. If your approach is to buy and hold positions for the long-term, you want to be investing in the strongest sectors that lead the bull market. The strongest sectors also tend to stay strong in bear markets unless they are knocked off of their leadership positions.
Q. Are sector funds a good investment?
A. Yes, sector funds are a good investment as you can then select the funds of the strongest sectors.
Q. Why are sectors important?
A. Sectors are important because the stocks that belong to a specific sector tend to perform in tandem. If a particular sector is favored by investors then that favor tends to be shared by all stocks in that sector to a greater or lesser extent. The reverse is also true. If a particular sector is out of favor then all stocks in that sector are likely to suffer the same fate.
Here is a single-page summary of sector investing. You can download a PDF here.
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