Sector strategies are attractive because of their potential to add alpha1 and outperform the market. Tactically changing portfolio weights to capitalize on sector return differences can be a method of seeking better performance versus staying invested across the whole market during the same time period.
Sector investing provides attractive portfolio diversification when compared to investments in single stocks. The stocks with the largest weights in an index typically have a high correlation to the index itself, meaning a tendency to move together in the same direction. Using the sector, or subsector, rather than single stocks provides greater index diversification and reduces stock specific risk.
Sector strategies can offer enhanced portfolio risk management versus single stocks. When viewed individually, the majority of benchmark constituents generally tend to have higher levels of risk than the benchmark itself.
The Dow Jones U.S. Healthcare Index
|Top 3 Constituents||3-Year Correlations|
|Johnson & Johnson||0.77|
Source: Bloomberg, as of 6/30/11. Index constituents are subject to change. Correlation values range between +1 and –1. Assets that are perfectly correlated, or move together in the same direction, have a positive correlation of 1. Those that exhibit an inverse relationship (moving in opposite directions) have a correlation of –1. A correlation of zero implies that there is no relationship.
Looking at the three-year annualized risk and return of the Dow Jones U.S. Healthcare Index shows that compared to the index, 98% of the index constituents had greater risk, while only 60% had greater return2. Using the related sector or subsector instead of the stock can significantly reduce stock specific risk through greater diversification, while maintaining a balanced risk/return profile.
1 Alpha is the level of outperformance of a portfolio over and above its benchmark.
2 Source: Bloomberg, as of 6/30/11.