Some of the biggest challenges currently faced by investors include how to position portfolios for potential rises in interest rates, higher volatility and any slowdown in corporate profits. In this environment, sector investing is an attractive strategy that can augment traditional stock-picking and asset allocation strategies.
Sector investing provides more targeted exposure than growth and style investing, without the risk level of single stocks. This is because companies grouped together in the same sector exhibit more similar performance behaviour compared to those grouped by growth or value characteristics.
The economy moves in cycles. While a rising economic tide lifts all sectors to some extent, specific sectors benefit to different degrees and at different points in the recovery. For instance, interest-rate sensitive sectors, such as consumer discretionary and financials, will likely benefit most in the early stages of recovery as more confident buyers increase their borrowing to buy cars, houses and so on while interest rates remain low.
As the recovery picks up steam, economically sensitive sectors such as industrials, information technology and materials will generally experience gains as their sales begin to increase.
In the contractionary phase of the business cycle, less economically-sensitive sectors that provide the necessities of life — health care and consumer staples, for example — tend to perform well. In contrast, cyclical sectors like energy, industrials and information technology tend to underperform since their growth is closely tied to the ups and downs of the economy.
Fed lift-off: Sector performance during monetary tightening
As a rule, the Federal Reserve’s policy tightening has coincided with the recovery phase of the economic cycle. The Fed usually only starts to tighten when it feels an economic recovery has become strong enough to withstand being reined in.
Each time the Fed has tightened in the recent past has been for different reasons. When the Fed started tightening in June 1999, it was focused on the equity bubble, whereas in June 2004 the housing market was its key concern. The Fed’s current goal is to get the unprecedented low interest rates and high market liquidity to more normal levels now that the economy appears to be on a healthier footing.
Given the different circumstances surrounding the Fed’s recent tightening cycles, it is no surprise that the impact of rate hikes on sector performance has not been entirely consistent.
Yet some trends have emerged. For example, during the Fed’s two most recent periods of monetary tightening, June 1999 to May 2000 and June 2004 to June 2006, the consumer discretionary sector underperformed the S&P 500 by 7.06% and 4.29%1, respectively, as one would tend to expect since, when interest rates rise, consumers cut back on major discretionary purchases.
At the other end of the spectrum, energy outperformed by 7.48% and then a staggering 30.49%1; in both periods, the economy was still expanding robustly and energy consumption was rising.
Style returns, in contrast, exhibited almost no consistent pattern from one tightening cycle to the next, other than remaining close to the performance of the overall market. The style segments appear to react to Fed monetary tightening homogenously, creating even less opportunity for investors to express their investment views and generate positive active returns.
Sector investing through ETFs
In today’s economic environment, investors remain concerned about the impact increasing interest rates may have on their portfolios, with a hike in US interest rates looking likely in the near term. Particularly in periods of rising interest rates, sector strategies have recorded more diverse returns and lower correlations than style strategies across economic cycles.
Sector performance has shown some clear patterns over time and monetary tightening offers investors an opportunity to use sector-rotation strategies to harness the impact of changes in interest rates — a key variable of stock returns.
Exchange traded funds (ETFs) are a cost-effective, efficient and straightforward way of benefiting from precise sector investing and sector-rotation strategies, enabling investors to gain exposure to multiple sectors of the market without having to manage the risk of trading multiple positions.
In recent years, the number of ETFs available to investors has burgeoned, with increasingly sophisticated products offering access to ever-more specific segments of the market. Some of the most innovative of these ETFs provide investors with exposure to the various sectors of the US economy.
Ray Chan is vice president and head of ETF business development for Asia ex-Japan at State Street Global Advisors.
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1 Source: FactSet, State Street Global Advisors, as of 20 June 2014.
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