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.
Here is an explanation of how the Global Industry Classification Standard divides sectors into sub-sectors and industries.
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
Another and potentially more illuminating way to look at these is to compare each sector ETF using the whole market ETF, i.e. SPX as a constant reference.
This is achieved mathematically by just dividing the price of each sector ETF by the price of the S & P 500 index ETF.
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. This explains how this index is calculated.
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 as a PDF.
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I get it! I am inclined to think that what happened after elections is that industries that lead the market before the election aren’t the same sectors and industries leading after the election. But I get it that it doesn’t matter what’s the motor of this, what matters is which sectors and industries will be leading.
Now, right now most of my investment is in consumer staples. What would you suggest me to do?
Yes, I think you have summed it up correctly. It looks as if some of the cyclical sectors are back in favor so Ferrous metals in materials are doing well. Also, the whole leisure and gaming area which is under consumer discretionary got a boost. It also seems that energy has been doing well since the election though that is likely to be because of green energy pulling the rest of that sector up with it. I think diversifying into more than one leading sector is a good idea especially as there is likely to be some repositioning. Best regards, Andy
Thank you so much for this highly informative article, Andy! I’m certainly not surprised that Information Technology is the best performing sector today; our world is becoming more digitized by the second (advanced electronics, A.I./robots, etc.), and as time goes on, this will only prove to be that much more true. I’m actually a bit surprised that Energy has performed so poorly; with so many people turning to solar energy and more environmentally-friendly/sustainable energy sources, I would think that its’ stock would be increasing exponentially, if not, at the very least, remaining steady. This all just proves that the stock market can be unpredictable at times. Haha. Great read! God bless you!
Hi and thanks for the comment. I think it is interesting to see how these sectors do not stay static in a leadership or “laggership” position forever. I think what we saw immediately after the election on the first full trading day was where the institutions decided the money should be invested. We actually saw that information technology got hammered and energy was pulled up probably because of green energy. Effectively everything changed. It is now more a question of how best to work with this new situation. Best regards, Andy
Thank you Andy, the pulling out of investors in some weeks to election is a common trend all over the world. They do this because of the uncertainty that comes after the polls. Like you mentioned our attention should be on where the big business are now focusing. What will happen and where will businesd turn to
Hi Ayodeji and thanks for the comment. Yes, I remember this is a very common phenomenon around the world. It is actually a very interesting thing to study the history of what happens in stock markets immediately after the national presidential elections. It would be interesting to look back and see whether common patterns emerge. Thank you for your insightful comment. Best regards, Andy
Thank you for this useful and informative article! I think the time of a big changes like we have now – pandemic and elections is not a good moment to make an investment, or maybe I’m wrong? Is it better to wait a few months until the situation is more stable and the trends become more clear? I’m agree that information technology probably will grow more and more over time. Could you recommend any books or articles how to make a good investment for a beginner?
Hi Alex and thanks for the comment. There are always going to be natural, political, social, and economic factors affecting the markets. One thing that can be said of the markets right now is that they seem to have decided there is a light at the end of the pandemic tunnel and they like the return to political stability now that the election is over. I think to be honest that the trends, certainly in terms of which sectors are now favored after the election are quite clear. I think also that the markets are likely to be strong for a while because of the liquidity that has been injected by central banks. I think one of the best all-around books for beginners in investing is The Intelligent Investor by Benjamin Graham. Here is a link to a review I did of it:
I also published an earlier post on books on different aspects of investing and trading, here.
I would be pleased to hear how you found any of these so please come back.
Thank you Andy, these post is very informative and useful, it is obvious that you have a lot of knowledge in the field of market and stock trading. I have a little Coca Cola stock, but honestly I am very concerned how the election and the corona virus situation will affect the market worldwide. What do you think, can there be a major crash and crisis?
Hi Danijela and thanks for the comment. There is always some risk of a market pull-back. But all the signs we see point to continuing confidence in the markets, particularly the US market. All the liquidity and essentially free money that the Fed and other central banks have been pumping into the economy means that much will inevitably flow into equities. As regards Coca Cola it is in the consumer staples sector. I see that the price took a major hit with the Coronavirus crash of March this year and it hasn’t recovered its previous highs yet. And that is in spite of seeing a major jump up in price on Monday 9 November. Speculation is maybe this is because there is a vaccine so bars and restaurants will be opening. I don’t know for sure but I could imagine that consumer staples and consumer discretionary will both benefit from an economy that is opening up, evening if that is only spring or early summer 2021. Even if we are in for a tough winter and higher infection rates etc. because there is now a vaccine light at the end of the tunnel. I would be reluctant to predict though whether or not there will be a crash. That is always possible. Best regards, Andy
Thanks for a comprehensive article.
There are obvious benefits to sector investing, but as you also point out, ‘ 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.’ So the real money is to be made in selecting those top-performing stocks and running with them.
For sure, sectors will change with time, due to government policies, resource availability, etc. The green energy sector should be booming, but it seems that the people in charge of the fossil fuel industries do not want to lose their ‘cash cow’ just yet. So what is beneficial for the people and the planet has not yet come to fruition because the lobbying power of the fossil fuels industries is still too powerful. Any sudden shift in attitude or government policies could have a quick and profound effect on the value of their stocks and therefore the ranking of this sector.
Thanks for sharing.
Hi and thanks for the comment. Perhaps one of the main points I was trying to get across in this piece was that all investors want to know what is going on in the market and why. And it is easy to get wound up in understanding the why and there is an assumption there that if we can just understand why then we will be able to predict what is likely to happen next. I guess that is human nature and as rational beings, we like to be led by our reason. But the point for the individual retail investor is that it is much more important to know what is happening in the market right now. That information alone will help us to invest and trade more profitably. Thanks again for your comment and best regards, Andy
At first I was amazed that energy performed so poorly, but I guess this is including all sorts of energy, also the fossile one?
I do invest in sectors. Just never actually looked at what performs well and what doesn’t. I choose on what sectors please me. Not too smart, from an investor’s point of view, I know. 🙂
Anyway, your article is very informative and I will have a better look at what I have in my portfolio. After all, it must be possible to invest in a good sector and still choose the green and sustainable ones, shouldn’t it?
Hi Hannie, Yes, the poor performance of the whole energy sector – up until October this year – has probably been because of the fossil fuels part and that has also been reflected in the oil and gas prices as well. Actually, green energy is probably what has dragged up the whole energy sector. If you look at green energy ETFs many of them to a massive leap up in price on Monday 9 November which was the first full trading day after the election results were clear – to the market at least – and they have continued doing well since then. So yes it should be possible to invest in sustainable energy, follow your values, and be profitable at the same time. Best regards, Andy
I was relieved when I got to the end of your article and learned that if one has an approach to buy and hold positions for the long-term, one needs to be investing in the strongest sectors that lead the bull market. It was indeed a big relief, because although that was my strategy, I was essentially a “hit-or-miss” investor, not fully understanding what I was doing. Thanks for providing me with the clarity I needed.
Thanks for the comment. I think an important point to check is whether the stock positions you have are still in sectors that are leading the market now. It looks very much as if the big institutional investors have rotated out of some sectors and into others immediately after the election outcome was clear – to most of us that is. Good luck and I hope you come back.
I must say this was a very interesting read. It also proves you have to watch the markets with a close eye and have a good understanding of the markets to play it. For me, albeit I enjoyed the read, I prefer to leave my investing to a professional who spends the time keeping abreast of the markets. Unless one is willing to spend the time to learn and understand I believe they are taking a bigger risk by guessing albeit even most professionals are merely guessing themselves. The difference is that they are using an educated guess which to me can make the world of difference especially with so many fake claims and reports going on today.
It is still great to read up on various articles especially quality ones like yours. Thanks for sharing your wisdom, it was very informative.
Hi and thanks for your comment. I agree with you that not everyone has the time and application to invest for themselves and often the best course is to let a professional manage your investments. You will be well advised to check that the incremental return that the professional advisor delivers over and above what the market regularly returns is greater than the advisor fees you will need to pay. Best regards, Andy
Thanks for this well written, detailed and informative article, which I consider to be an expose on Sector Investing. There are a lot of investment opportunities out there, and it is best one gets to know all the basics before taking any step. Haven read so much about sector investing, I would like to ask for a range of what it would cost to go into sector investing?
Hi and thanks for the comment and question. Today there is no reason why investing in sectors needs to be more or less expensive than many other styles of investing. For example, you could take a simple and steady approach and invest regular monthly sums in a few of the strongest sectors through ETFs in those sectors. Many large brokerage firms these days allow you to invest in fractional shares with no minimums
Here is a review that considers some of the major brokers. If you refer to the quick comparison table right at the beginning and look for Fractional Shares you will see that all but one of these firms offer customers this feature.
So you could even invest $50 or $100 a month regularly in a few of the strongest sectors, watch their relative strength, and then rotate out of them into the new leading sectors when that happens. With this style of investing I would not rotate too often. Probably once every six months or so should be sufficient.
I hope this helps and best regards
I get it! I honestly believe that what happened after the election is that industries that lead the market before the election don’t have as much influence as they did before the election. But what matters really are which industries will be leading in the future and which ones will be going to the back of the line. I currently invest in index funds, do you recommend me moving into individual stocks?
Hi Misael and thanks for the comment. If you are comfortable investing in index funds I would stick with that. You can check which sectors your funds invest in. Depending on which indexes your funds track you should find that they will ride with the bull market. As with all of this information is useful and good to understand what is going on and investing in a way that you are comfortable with is another and very important side to the equation. If you push yourself into investing in areas that you are not comfortable with then the chances are high that you will get shaken out and bail at the worst possible time when those investments suffer a setback. Good luck and best regards, Andy
A good portfolio strategy with sector funds is to add them as satellites to diversified core holdings. This way, you’re not putting all of your eggs in one basket, so to speak; you’re simply putting a few more eggs in a few select baskets. Before choosing a sector or stock, investors should identify a trend using multiple time frames within charts.
Hi and thanks for the comment. I agree that it makes sense to add sector funds as a means of diversification. One of the main points of this article was that it is important to assess the relative strength and performance of one sector against the market and against other sectors and you will tend to find that the leading sectors stay in leading positions for some considerable time. So while I agree it is important to check the trend of a stock or sector fund against different time frames, you will gain a better understanding if you make the comparison with a market benchmark and with other sectors. An example could be you check the performance of a sector and see it has gained 10 percent, but then when you check the rest of the market gained 15 percent in the same time frame, that 10 percent is not such a positive indicator. Thanks for the comment and best regards, Andy
This is really amazing to read through, it has been a really long time that I read through a sensible and educative article like this. I am sure this is a of great benefit to everyone. Investing is something that we all should always try to consider at a point or another which brings us down to sector investing. Thanks for sharing
Hi and thank you for your comment. I am glad you found the article interesting and useful. Best regards, Andy