The Role of Sectors in Risk, Pricing, and Active Returns
Sometimes, the sector composition of an equity portfolio is of primary importance. At other times, single-stock risks are more prominent. In this paper, we shall:
- Assess the relative importance of sectors in determining the performance of the S&P 500 and its constituents;
- Compare the potential of active strategies based on sectors to those based on single stocks;
- Discuss the role that sector-based products can play in generating active returns; and
- Identify periods when sector selection was particularly important.
This perspective is particularly timely; Exhibit 1 illustrates the increasing strength of sector-level effects in the S&P 500 over the past five years.
1. INTRODUCTION
Consider an active manager who has identified a certain stock in the Utilities sector1 as relatively attractive. He anticipates an excess return from a concentrated position in that stock, compared to a diversified position in the sector. However, a concentrated position in any stock is exposed not only to the specific prospects of that company, but to a sector and to the market. Which exposure is more important?
To illustrate the relative importance of sectoral and stock-level return drivers, consider that the average annualized dispersion of constituent returns in the S&P 500 Utilities sector over the 10 years ending in December 2018 was 10%. Thus, a better-performing stock in the Utilities sector might be expected to offer a one-year excess return over its sector of around 10%. However, over the same 10-year period, the average difference between the one-year return of the S&P 500 Utilities and S&P 500 indices was also 10%. In other words, a stock being one of the best Utilities stocks may be less important than being a Utilities stock.
Of course, even if a chosen stock outperforms its sector, and even if that sector doesn’t significantly underperform the market, the risk of a loss remains. (The S&P 500 Utilities outperformed the S&P 500 by 18% in 2008, but even the best-performing Utilities stock still had a negative total return for the year.) A manager selecting which securities to avoid faces equal and opposite difficulties; an Energy stock with poor prospects relative to its competitors might soar in price if there were a sudden shortage of crude oil.
The extent to which sector-level effects can drive stock returns is the subject of Exhibit 2. It shows the average statistical coefficient of determination (R-squared) between the daily price changes in S&P 500 constituents and their respective sectoral index, based on capitalizationweighted averages of monthly calculations over the 15-year period from January 2004 to December 2018.
