Whilst investing in the S&P 500, might be a solid strategy for many novice investors, for those who would like to learn more about improving their returns over the long term it may be beneficial to look at investing in different sectors. A sector, put simply, is a collection of companies according to their business activities. For example, in the US market, sectors are generally split using their SIC and NAICS codes. You can get great data on “sectors” or “industry” portfolios in the US from Kenneth French’s data library (See Here).
The idea behind sectors is that in particular economic periods, certain industry sectors may perform better or worse depending on their business activities. For example, let’s take a look at the coronavirus pandemic, investing in “DRUGS” i.e., the Pharmaceutical Products industry, maybe a smarter move compared to investing in the Airline industry which has been heavily impacted by the pandemic.
Why does investing in sectors make sense? The correlation and the correlation matrix
Without getting too technical, a correlation between two things is when they are linked. For example, something with a high correlation would be the sale of left and right shoes. A slightly lesser correlation, but still applicable, may be between the sale of hotdogs and hotdog buns, sure, some people may eat hot dogs without the bun, but we would generally form some association between the two. This is the same with companies, there are economic links, across the financial world, so if one industry is doing well, related industries could do well too, we would see these as having a high business correlation.
Correlation is measured between -1 and 1. Perfect correlation is when something moves in the exact same direction, the closest we can think of is the left and right shoe example. A negative correlation would be between say, speed and travel time. When one goes up the other goes down.
Now let’s think about industries or sectors. Using data from the library in the above link, we can see the correlation between 12 sectors. From this, you can start to paint a picture of which industries are correlated with each other.
So, what is the best industry sector for investment?
Generally, the best sector will change at specific time frames, many banks, mutual funds, and large financial institutions will spend hours of research in deciding which is the best sector at a particular time period. What sector investing does, offers exposure to certain companies whilst keeping some of the diversification benefits that we have mentioned about investing in stock indices such as the S&P 500.
In our opinion, the best sector to invest in is the one that you have found an angle in through doing research. Encouraging signals from a particular sector may be a reason to buy. Can you see earnings trends increasing in the electric car market, can you see that a particular sector is undervalued through fundamental analysis of some of the top earners in that sector? Understanding what is going on in the sector gives you the best understanding of why you should put your money into it.
It is important to understand the correlation between sectors as if you are investing in sectors that are highly correlated, it is likely that if one falls in the future, then both will, leaving you with losses in your portfolio. Investors often try to overcome this by diversifying across sectors that are not highly correlated. This can be difficult when trying to find “winning sectors” however.
What is the SPDR and are sectors included?
The SPDR is an ETF that tracks the S&P 500. The S&P 500 is also split into sectors. You can invest in particular sectors of the SPDR, for example XLY the Consumer Staples Select SPDR.
If you’re looking to become a savvy investor, our previous post on the history of ETFs is a must-read. Gain valuable insights and tips by following the link to access it.
