The case for the tactical use of sectors not only makes intuitive sense, it is supported by the data. Top-down investors attempt to distill the macroeconomic environment into projections about how that will impact the economy. In doing so, they break the market out into sectors in an attempt to focus on how changes in the economic, political or technological landscape will affect every pocket of the economy.
Since each segment of the economy reacts to these dynamics in different ways, sectors serve as the perfect outlet for these views. By all typical measures of risk and return, sectors have recently done a better job of parsing the market than size and style strategies. They also do a better job reflecting the cyclicality of a firm's operations and their leverage to economic growth. What constitutes a growth or value firm is not always clear without a deep dive into financial statements, whereas determining which sector a company operates in is a relatively simple task. There are always exceptions, as we highlighted above, but the differences between different sectors are much clearer than the difference between growth and value.
As the data illustrate, the correlations between utilities firms and most sectors, especially technology and consumer discretionary, have been extremely low over all time frames. With this in mind, holding a growth or value portfolio that has companies operating in both the utilities and technology sectors doesn't allow investors to position themselves according to their economic expectations. While it could be argued that it is precisely this combination of low-correlated sectors in the same portfolio that allows investors to lower overall market risk, it also prevents them from realizing the full potential of either strategy.
If you look at sectors as different pieces of the total market puzzle, then it stands to reason that each sector's influence on the market is limited to its relative weighting in the market composite. As such, each sector will have a different correlation to the broad market. It stands to reason that each sector's correlation to the market is therefore fluid, changing as the economy evolves and changes.
Of course, modifications to the market portfolio will impact correlations as well. An equal-weighted portfolio increases the weighting of the utilities and telecom sectors—two sectors that carry the lowest weight in the cap-weighted S&P 500. They are also two of the sectors with the lowest correlations to the market. As their influence on the market portfolio increases, so will their correlation to it.
None of this is to say that timing sectors is easy. Being able to absorb all available information and effectively project its impact on each sector of the economy is an extremely challenging endeavor. The rolling correlation data that we discussed earlier highlights just how volatile intersector correlations were over the past 15 years. In times of stress they converge, and during some periods negative correlations pop up. Sector strategies must hit a moving target.
What we can say is that sectors do a much better job than style groups of deconstructing the market's risk. At no point over the past five years has the difference in volatility between growth and value exceeded 10 percent, and in all but one of the periods of study it has been less than 6 percent. In fact, both growth and value strategies were more volatile than the broad market over the past 15 years. Style indexes have therefore proven to be a poor tool for portfolio risk management.
On the other hand, sectors have shown a wide range of volatilities over time, which allows investors to more finely tune their portfolio to fit their risk profile. Over all of the periods of study, the volatility differences between the most and least volatile sectors were amazingly consistent over time, remaining above 15 percent and even spiking as high as 28 percent over the past 10 years. Once again, the big volatility differences follow logical patterns. Defensive sectors like consumer staples, utilities and health care have been significantly less volatile than pro-cyclical sectors like industrials, energy and consumer discretionary.