What can we learn by looking at the historical performance of sectors? Join S&P DJI’s Tim Edwards and Joe Nelesen for a closer look at how the distinct risk/return profiles of individual sectors may influence their performance during different market regimes.
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Tim Edwards:
The performance of individual sectors can vary greatly, which may make some sectors more attractive than others during different market regimes. So what can we learn from the historical record, performances, market sensitivities, risk levels and correlations among sectors and industries? Hello, I'm Tim Edwards of S&P Dow Jones Indices, and I'm joined today by my colleague, Joe Nelesen, to explore how sectors and industries have historically performed through different market cycles. Thanks for joining me, Joe.
Joseph Nelesen:
Thank you, Tim.
Tim Edwards:
So I guess first off, we said sectors behave differently, what sort of differences do they have?
Joseph Nelesen:
Sure, I think a lot of these differences are well understood as long as sectors have been used for quite some time, but we revisited that in the research, and the ways that these 11 sectors are different are really meaningful. If you think, for example, from a risk perspective, you have sort of low-beta sectors such as Utilities, Consumer Staples, with betas lower than one, because these are industries that people need through different parts of the market cycle, they’re less sensitive to the market. On the other end, you have things like Information Technology, Financials, that are much more sensitive, have a higher beta as a result, higher volatility at times as well, and so knowing these differences and starting to rank these sectors by their risk profile allows an investor to think about when they might be used in different parts of the cycle and to think about how certain sectors are very lowly correlated, or even inversely correlated, when you think of the excess returns, with each other, and that can allow for diversification in a portfolio.
Tim Edwards:
So I guess some that dampen market shocks, some that may accentuate market gains, and some people might think of Energy, which sometimes acts like the former and sometimes acts like the latter, and I guess that emphasizes the importance of understanding where you are. So these differences, how do they manifest in different economic cycles, market cycles, market regimes?
Joseph Nelesen:
We have a lot of history to look at this point with sectors. In the research that we've done, for example, we looked at every bull and bear period through this century, and you can go back further, but even looking at these periods, you'll find these consistent sort of performance profiles starting to play out. Even if we think more recently, for example 2022, when we had a sharp bear market, which was led on the downside by Information Technology. What did well during that time, as you mentioned, Energy stood out to a great degree. In fact, in 2022, we saw the largest spread between the best and worst sector, and so there are periods where you can look to the past to see how sectors have performed in different types of regimes and apply that to the present day.
Tim Edwards:
And are they persistent? I guess you mentioned Consumer Staples, Utilities, those are sort of persistently dampeners, and others like Information Technology are persistent and then some sort of swapping in between. Is it just bull and bear markets or would you add any more dimensions to that?
Joseph Nelesen:
I think there are bull and bear markets, that's a simple binary way to think about it. There are also different parts of the cycle, coming out of a downturn, slowdowns, you can think about different interest rate effects, all sort of different metrics that apply to how sectors behave.
Tim Edwards:
And you didn't just look at different sectors and industries, you also looked at actually how you build your sector index and took some time digging into the difference between capitalization-weighted industry and sector indices and equal-weighted sectors and industries. What were your take-aways from that study?
Joseph Nelesen:
That's right, and we did that kind of work because we realized people use and think about sectors not in a vacuum but in relation to each other, and weighting makes a difference, not only within the sector but amongst them. For example, we looked at equal weighting within a sector, equal weighting the stocks as well as equal weighting individual sectors in a compilation, and what we're finding is the equal-weight effect, which is something we've done a lot of research on as a team as well, is largely driven by some factors, for example, such as an anti-momentum bias is one, where you're moving away from the stocks that are generating the highest returns and naturally increasing their market cap. When you equal weight a portfolio, you're reducing those and bringing up the lesser weights in that portfolio or sector, which leads us to the second style bias, which is a small size, a small size tilt by bringing up those smaller names. It also introduces another factor effect into the performance of sectors and into a broader allocation of sectors as well. So equal weighting, market-cap weighting, both have their points of use. What we find these are approaches that are quite different and interesting to look at from a research perspective.
Tim Edwards:
Presumably, there's a time where both might have their time in the sun. If you have an industry where there's no clear leader, perhaps there's an opportunity for someone to take into the lead and perhaps you would want capitalization weighting I guess to follow that story on the way up. In other instances, maybe equal weighting would be a better tack, where you have an incumbent who is facing fierce competition, and so I imagine there's a time for each, and it's not like persistently one or the other is better.
Joseph Nelesen:
Indeed, and that's a great point to make around certain industries or sectors where an investor may not have a conviction around a single name, but has a general thesis around the industry itself, equal weighting can play a major role in allowing the diversification.
Tim Edwards:
But taking on perhaps a little bit more smaller company risk.
Joseph Nelesen:
Correct.
Tim Edwards:
Thank you, Joe, for joining us. And if you'd like to learn more, including the findings of our latest paper, Natural Selection: Tactics and Strategy with Equity Sectors, please visit us at the link below.
