A Primer on Sector Investing

Passive investors often opt for a portfolio of index funds that mirror the broader market's movements. While this strategy is straightforward and cost-effective, it might not always be the best approach for mitigating risk and controlling volatility.

Investing passively implies an acceptance of market movements and its composition at any given moment, including downside risk and possible underperformance. In addition, it means giving up the possibility of ever outperforming the benchmark index.

Consider an instance where a notable index like the S&P 500 has a strong bias toward a specific sector, such as technology. Despite its propensity for high growth, this sector has also been known to experience considerable volatility and steep declines in unfavorable economic climates.

A passive investor emulating the market via an S&P 500 index fund would thus inherently accept a higher exposure to tech stocks and the associated risk. This strategy's upside potential would also be capped at the returns of the index, minus fees and costs.

This approach might not be the most appealing to those investors prioritizing capital preservation or volatility reduction over unbridled growth, or for those seeking to outperform a benchmark. For these individuals, a sector-specific investment strategy could serve as a more effective solution.

Here's all you need to know about the basics of a sector investing strategy, and how sector-specific ETFs can help you implement it.

What is sector investing?

A sector in the stock market can be defined as a cluster of companies that share similar attributes in relation to the products and services they offer. As per the Global Industry Classification Standard (GICS) used by MSCI, there are 11 recognized sectors at present:

1. Energy
2. Materials
3. Industrials
4. Utilities
5. Healthcare
6. Financials
7. Consumer Discretionary
8. Consumer Staples
9. Information Technology
10. Communication Services
11. Real Estate

These sectors are weighted in different proportions in various market indexes based on the market capitalization of their constituent companies. However, investors are free to depart from this weighting scheme based on their own investment thesis.

By over or under-weighting, a particular sector relative to its original index weight, an investor is said to have implemented a sector investing strategy. By doing so, the investor is trying to achieve a meaningful increase or reduction in exposure to one or more sectors. But why?

Why consider sector investing?

In a nutshell, the basis for sector investing stems from how diverse sectors react differently to varying stages of the business cycle and economic states. By tactically shifting their portfolio's sector representation and/or allocation, investors can either:

1. Take advantage of phases in the business cycle by overweighting advantageous sectors; or
2. Minimize volatility and drawdown by underweighting risky sectors during a particular phase.

Overall, the business cycle consists of four phases: expansion, slowdown, recession, and recovery. During each phase, certain sectors have historically demonstrated a persistent pattern of either outperformance or underperformance, as seen below.

By tactically shifting allocations between these sectors, investors can "rotate" their portfolio to optimally position it for success at any point throughout the business cycle. For example, an investor may overweight growth-oriented technology stocks during the expansion phase, while emphasizing more defensive consumer staples stocks during the recession phase.

CI GAM ETFs for Sector Investing

Trying to follow a sector investing strategy by picking individual stocks can be tough. It takes a lot of time, can be expensive due to trading costs, and comes with company-specific risks. Some company shares are also costly to buy.

A better, more diversified way is to use exchange-traded funds (ETFs), which can be tailored to provide sector specific exposure by tracking a benchmark sector index or be actively selecting a portfolio of sector-specific stocks according to its own proprietary strategy.

As a sector investing tool, ETFs are easier to manage, are transparent, and have good liquidity. You won't have to worry about large bid-ask spreads as you would if trading many individual stocks. You can also check your ETF holdings regularly as they are updated daily. Lastly, managing just a few sector ETFs means fewer transactions and lower costs.

CI GAM's sector ETFs let you instantly invest in various stock market sectors from around the world. You can view the entire lineup of sector ETFs here.