Executive Summary
Sector-based index strategies are viewed by many investors as an effective way to express their views on macroeconomic, demographic and other trends while still achieving diversification. Meanwhile, investors are increasingly looking for ways to incorporate sustainability considerations and personal values into all aspects of investing, including index construction. Sector-based indices that factor in sustainability elements combine these two powerful trends and can help investors express their views on macroeconomic trends while applying a sustainability lens.
Sector indices need to account for the fact that sustainability elements don’t apply to each sector equally. The most prominent example of this is that climate-related financial risks affect energy companies quite differently than banking institutions or other service companies. This concept of materiality needs to be rigorously embedded throughout a sector index series.
In this paper, we explore why sector-based investing has become such a valuable tool for investors and how sustainability elements can be built into sector indices using consistent, materiality-based methodologies.
The Case for Sector Investing
Historically, a company’s sector has been shown to have a significant potential impact on the company’s stock performance, and the performance of specific sectors can vary dramatically, often reflecting broader economic conditions. Sector indices can give investors an efficient way to express views about how various segments of the economy will perform while maintaining diversification within each sector and mitigating single-stock risk.
Achieving Diversified Exposure within Sectors
Companies in a sector tend to have similar exposure to external forces such as interest rates, inflation, gross domestic product growth, demographic trends, unemployment, technological developments, geopolitical risk and legal or regulatory changes. For example, Consumer Discretionary companies tend to be sensitive to the strength of the economy, as well as consumer spending, sentiment and debt levels.
At the same time, each company in a sector also has a degree of idiosyncratic risk because of its business strategy, brand awareness, management team, supply chain and other factors that make up a company’s unique competitive positioning. Going back to the Consumer Discretionary example, a company that generates most of its sales in the U.S. would be more sensitive to a U.S. recession than a company with a more geographically diverse customer base. Similarly, a company that sources most of its products from offshore manufacturers would have more exposure to potential trade disruptions than a company that manufactures its goods locally.
By aggregating the performance of a representative subset of companies in a sector, sector indices provide insight into the performance of that sector while significantly reducing idiosyncratic risk of any one company.
Because all stocks in a sector share some level of macroeconomic risks, some investors use sector indices to express their view on the economic cycle. A well-known example is the use of sector indices to position among cyclical and defensive sectors. Cyclical sectors, such as Energy, Materials, Industrials, Consumer Discretionary, Financials and Information Technology, tend to be more sensitive to broader economic trends. Defensive sectors, such as Consumer Staples, Health Care, Communication Services and Utilities, tend to be less sensitive to how the economy is performing.
