Since what seems like the dawn of time, investors have been dividing the market, picking sides and leaving it up to index providers or active managers to define which half of the market represents growth and which represents value.
Meanwhile, a more intuitive breakdown of the market based on economic sectors sat and watched as style indexes grabbed the headlines.
In fact, sector strategies, as many financial advisers know, have proved to be a more powerful way to access the market. Over the past 15 years, sectors have shown consistently lower correlations and a wider range of performance results when compared with their style counterparts.
In particular, sectors have done a superior job of accessing the market from a business cycle perspective, better arming advisers and their clients with the tools to implement macroeconomic views.
In the past 10 years, leading and lagging sectors have varied remarkably over successive 12-month periods.
For example, over the most recent 12-month period, the best-performing sector was telecommunications and the worst was energy. Prior to that, energy led the way while financials fell behind.
Looking back even longer — 15 years — the difference between the best- and worst-performing sectors was 278%. But the difference between growth and value over that same period was just 4%.
Even more interesting is the correlation between sectors compared with growth and value. The lower the correlations between sectors, the more effective they are for rotation strategies.
Whereas sectors such as telecom and financials have had a correlation of just 0.48 to each other over the past five years, growth and value showed a correlation of 0.9.
Correlations among the 10 sectors, especially the defensive/offensive combinations, represent the heart of the case for sector strategies. Utilities, telecom and health care firms — all defensive sectors — showed low correlations to offensive sectors such as industrials, consumer discretionary and technology, which in turn showed high correlations to one another.
Performance and correlations allow tactically minded advisers to rotate among the 10 sectors based on their view of the business cycle. Regardless of whether you look at the past 10 years in aggregate or individually, sectors have done a much better job of providing distinct returns.
Of course, returns are only part of the investment equation, and the other half — risk — also must be managed effectively by advisers.
It is in this phase that sectors enjoy perhaps their greatest advantage over style strategies. Over the past 10 years, sectors have done a much better job of parsing volatility than style indexes.
STANDARD DEVIATION
Since about 2002, growth and value indexes have had an average annual standard deviation of 29% and 22%, respectively, which is higher than the S&P 500's 17.8%. This left advisers with nowhere to turn when looking to decrease volatility.
Style indexes showed higher returns than the broad market during this time, and this trend of higher volatility and mostly higher returns for the style indexes generally holds true over other time periods.
Meanwhile, sectors, mostly in line with their economic sensitivities, have shown a much wider range of volatility over the same 10-year period.
Financials, the most volatile sector in the past decade, had an annual standard deviation of 27%. Compare that with consumer staples, which showed just 13%.
These historical volatilities are consistent with the concept of defensive sectors, such as health care and consumer staples, and more cyclical sectors, such as financials, materials and energy.
This view of sectors along business cycle lines offers advisers another advantage over style investing — namely, that it is easier to grasp. The business cycle offers a more compelling and real-world framework to view the market than the financial statement ratios that define individual value and growth stocks.
The firm-level, bottom-up approach of style investing makes more sense for picking a handful of stocks than it does for choosing large swaths of the market.
Advisers should note that style indexes that split the market in half are too blunt of an instrument in today's dynamic markets. Ultimately, sectors provide much more granularity and performance differences.
For advisers, this makes them an indispensable tool for managing client equity allocations.
Paul Baiocchi and Paul Britt are exchange-traded-fund analysts at IndexUniverse LLC.
