How can a sectoral lens help to define equity markets? S&P DJI’s Tim Edwards and Joe Nelesen take a closer look at sectors’ strategic and tactical applications, as well as how sectors and sub-industry classifications have evolved over time.
[TRANSCRIPT]
Tim Edwards:
In recent years, S&P 500 sectors have exhibited elevated dispersion, including the widest-ever spread between best and worst performers in 2022, highlighting the potential impact of sector selection. As the global investment landscape continues to evolve, it's becoming more important for investors to understand why sectors matter. Hello, I'm Tim Edwards of S&P Dow Jones Indices, and I'm joined today by my colleague, Joe Nelesen, to explore the enduring power of sectors and industries in helping to define markets and serve as the foundation for a myriad of investing strategies. We'll also be uncovering the findings of our latest research, Natural Selection: Tactics and Strategy with Equity Sectors. Thank you for joining me, Joe.
Joseph Nelesen:
Thank you, Tim, good to be here.
Tim Edwards:
So first off, why did you call it Natural Selection?
Joseph Nelesen:
Sure, I think the analogy came to mind pretty quickly when you think about how we as human beings like to make order of our world. And you can look back in history with the classification of different animals and plants into a rigid system, a hierarchy, if you will. We find that same logic applied to the investment world through sectors. This is the beginning of what we call the GICS, the Global Industry Classification Standard, in 1999. We found a framework that can be applied across the investment universe around the world to classify companies by their principal business activities. That means looking at their revenue, their earnings, their public perception if you will, and deciding how each firm should be classified in a way that lets investors understand them better. And of course, that system is evolving, just as the hierarchy around the natural world does. For example, in 1999, there were 10 top-level sectors, 123 sub-industries that are nested beneath those sectors. Today we're at 11 sectors, 163 sub-industries, reflecting the changes in our world, and to give you an example of that, very recently we see for example, we all know in our neighborhoods, these department stores might be a species in decline, for example, and so, as these types of industries change, retail changes, the department store sub-industry that existed has merged into something called Broadline Retail, which now includes internet retailers that we're all very familiar with. And so these kinds of changes, these evolutions, are happening all the time within the GICS hierarchy and are still allowing companies to exist and move around into different classifications that make the most sense with their principal business activities.
Tim Edwards:
I think people might have a sense that yes, the tech sector is going to have shared properties that make it different from, for example, the railroads industry, but how do you actually measure the overall impact of where and how much sectors actually matter?
Joseph Nelesen:
Sure, I think we can look at this through some simple math. For example, if you look at a single stock, you may think it’s a unique story that has this idiosyncratic quality that it's like nothing else, and in many ways, that's true. But if you look at how a price of a stock performs, you can look at the correlation to its own sector, for example, and you'll find that, in fact, sector membership explains almost half of a single stock’s variation in price, and the market factor matters as well. But sectors play a big role in helping understand, it's kind of like the DNA of a company helping you understand how it will develop over time and how it will behave in different types of market regimes as well.
Tim Edwards:
So sectors are important in understanding what's driving risk in stocks and stock markets, but you actually look at tactical applications, i.e., essentially sector picking. Now we know from our SPIVA research that beating the market is hard. What's the difference in picking sectors versus picking stocks?
Joseph Nelesen:
Stock picking is hard. One of the reasons it's hard is because of positively skewed returns. There are a small handful of stocks that perform to such a high degree, they pull the average higher, meaning the majority of stocks underperform. For example, historically, we find around a quarter of the stocks in the market will outperform the average, which means from a probability perspective, it's difficult to find a winner. What we do find though is when you move up the chain into the hierarchy of industries and sectors, that proportion starts to flip around, you'll find that the majority of industries outperform the sector that they are a member of, and the majority of sectors outperform the average of the S&P 500. And so this means that you can still make tactical choices with instruments like industries and sectors with a little more of a forgiving margin around the likelihood of those strategies outperforming.
Tim Edwards:
So the odds in some sense are a little bit more in your favor, and it may also perhaps be a little bit easier to connect a macro view to a sector view, whereas it might be harder perhaps to connect it to individual company quality, and that sort of combination of the odds being in your favor and building a coherent story that reflects your overall view, do you see that as part of the value proposition there?
Joseph Nelesen:
Indeed, these are what the data suggests. If you look at a sector like Utilities, for example, you can look at any singular company in that space and have very different stories around management, regulation, whatever that single stock is subjected to, but at the sector level, you’re getting a diversification effect through companies that have a very similar business, and I bring up Utilities because in this case, there isn't as much dynamism in that sector in terms of variation between the firms. They're highly regulated, supply-and-demand dynamics for things like energy are fairly stable, things that we need that don't rise and fall with the winds of the economy. But you can look at the other end of the spectrum, something like Financials or Information Technology, where there's quite a lot of change, quite a lot of movement between firms and within firms, creating volatility and different beta situations as well, higher beta, lower beta.
Tim Edwards:
So you might look at the industries there perhaps.
Joseph Nelesen:
You might look at the industries, and they'll make a bigger difference, and the point of this is when you start to group these companies by their principal business activities, as the GICS does, you start to see similarities that align themselves around performance, and that performance can be then targeted to different points in the cycle by an astute investor.
Tim Edwards:
Thanks, Joe.
Joseph Nelesen:
Thank you, Tim.
Tim Edwards:
To learn more about sector indices, industries, and the findings of our latest paper, Natural Selection: Tactics and Strategy with Equity Sectors, please visit us at the link below.
