Source: Morgan Stanley Quantitative Research

• A sector-based investment discipline allocates a client's assets among these 10 areas based on a broad diversification strategy, while often seeking to overweight or underweight specific sectors relative to the index.
• A sector rotation strategy seeks to increase returns by varying these weightings as an economic cycle progresses.

Source: Wilshire

Shunned in the 90s

During the 1990s, most financial advisors shunned sector-based investing and rotation, for valid reasons. During sustained bull markets, these strategies do not work as well as buy-and-hold investing or style-based asset allocation. Also, the U.S. experienced a record post-war expansion, 120 months in duration, that "upset the applecart" of how sector rotation is supposed to work. Finally, it wasn't easy to implement sector strategies during the 90s using either mutual funds or individual securities. Due to these drawbacks, many financial advisors still disparage sector strategies as an exercise in trying to outguess trends that are notoriously fickle.

But is that "prisoner-of-the-past" thinking? Our answer will focus on three key changes that have enhanced sector-based investing.

What has changed?

1. Financial markets and economic cycles – There have now been 10 U.S. economic cycles since 1945. The average expansion phase has lasted 57 months and the average contraction phase 11 months. On average, stock market peaks and valleys have occurred seven months prior to the corresponding points in economic cycles. (Historically, the stock market has been a reliable predictor of market cycles.) Now, many analysts are projecting that average stock market returns over the next decade will be in the mid to high single digits. In such a slow-growth environment, one opportunity to outperform the market average may lie in shifting assets among sectors as economic cycles progress. This technique could become relatively more attractive if cycles return to their traditional duration, instead of repeating the "extended expansion" pattern of the 90s.
2. Better instruments with more cost efficiency – Over the past 3-4 years, sector investing has been enhanced with the introduction of sector-based mutual funds and exchange-traded funds (ETFs). If single-digit stock market returns dominate the next decade, cost-efficiency could become a critical factor in any strategy's ability to outperform. Thanks to economical sector ETFs, a sector-based strategy can be among the most cost-effective of all investment disciplines to implement. This gives fee-based advisors flexibility to set their own earnings at profitable levels, without creating an impediment to performance.
3. Discipline and risk control – In the bear market's aftermath, many investors want a structured discipline that emphasizes risk control. In style-based asset allocation, it's hard to shield equity investors from the stock market's overall risk, because all style categories correlate somewhat strongly with the S&P 500 Index and each other. (The lowest correlation between styles, .65, is between large-cap growth and mid-cap value.) In sector-based investing, three of the 10 GICS sectors have correlations with the S&P 500 of .40 or below, and a number of sector pairs have correlations of .25 or below, according to the research firm FactSet. This increases the advisor's ability to combine sectors into attractive "efficient frontiers" for risk-control purposes. Research coverage of sectors also has greatly expanded in recent years. For example, Morgan Stanley publishes a quantitative model, updated monthly, which ranks all 10 GICS sectors on the basis of six numerical factors. By applying such a model to help investors select or weight sectors, advisors can create a consistent investment discipline that is very efficient to monitor and manage.

Style-Based vs. Sector-Based Correlations

The table below compares correlations of the S&P 500 paired with both style-based asset classes and GICS sectors. It also shows the lowest correlations between pairs of styles and sectors.

Source: FactSet for the 3-year period ending 1/03.

Sector-Based Strategies

Below are specific ideas for implementing sector-based investing and rotation into your investment strategies.

• Asset allocation – Sector-based asset allocation can be a viable alternative to style-based allocation. For example, you could create a model consisting of ten asset classes by deleting the three smallest GICS sectors by market weight-Telecom, Utilities and Materials-and adding bonds, cash and international equities. (The seven remaining GICS sectors cover 92% of the U.S. stock market by weight.) A growth or value focus could be added by emphasizing specific sectors. For example, overweighting Financials and Energy would create a value focus, while overweighting Health Care, Consumer Staples and Information Tech would create a growth focus.
• Indexing and tax managing – As shown in the table below, Sector SPDRs are currently available in all GICS sectors except Telecom. So, it's possible to create an index-like fund by combining sector ETFs. For example, buying Sector SPDRs in amounts that correspond to their market weightings would approximate the performance of the S&P 500 Index. (Sector SPDRs correlate to GICS sectors at a near-perfect level.) Several large NYSE firms are now advocating this strategy for tax-optimization. At the end of each year, they suggest that sectors with negative performance be sold to harvest tax losses. The same positions can be bought back after 30 days (the "wash sale period") or else similar ETFs can be substituted. iShares Dow Jones sector ETFS correspond to GICS sectors closely enough to make them viable alternatives to Sector SPDRs, and also the best choice for Telecom exposure.
• Actively-managed funds – Several fund groups such as Fidelity, Rydex, Morgan Stanley, MFS and Invesco now offer series of actively-managed sector funds, but there are two problems with them. First, their expense ratios typically run 1.5% -2.5%, compared to .28% for Sector SPDRs. So, they tend to be relatively high-cost implementation tools, especially for fee-based advisors who layer an asset-based charge on top of fund expenses. Secondly, few actively managed sector funds correspond closely to the 10 GICS sectors. For example, many of Fidelity's popular sector funds actually track industry groups, not GICS sectors. One actively-managed approach that can make sense is to offer a "sector rotation asset class" implemented through one mutual fund whose manager makes allocation and rotation decisions among sectors. Several choices include Rydex Sector Rotation, T.O. Richardson Sector Rotation, MFS Managed Sectors Fund, and Oppenheimer Multi-Sector.
• Specific sectors and pairs – One of the 10 GICS sectors stands out for meeting the needs of today's cautious equity investors, and that is Consumer Staples. While it is fundamentally a large-cap growth sector, Consumer Staples has the lowest correlation with S&P 500 Index performance: 0.11. It also correlates very low with Consumer Discretionary, Energy and Financials and negatively with Information Tech. That means an overweight in Consumer Staples could offset some of the volatility inherent in these sectors. Combining Consumer Staples with any grouping of these other sectors produces a more attractive historic risk-adjusted return than the S&P 500 Index as a whole. Consumer Staples was one of the two GICS sectors (along with Materials) to finish the three-year bear market period 2000-2002 with positive performance.
• Passive rotation – A sector rotation strategy need not be aggressive to pay off. The most passive rotation strategy is simply to rebalance each sector back to a model weighting at the end of each period. During the bear market of 2000-2002, this would have preserved assets better than rebalancing a style-based allocation, because it would have specifically whittled back exposure to Information Tech and Telecom. Another relatively passive strategy overweights the best performing sectors on a lagging basis, perhaps quarterly, on the assumption that the momentum of an economic cycle will continue for at least several more quarters.
• Active rotation – Smart financial advisors who pursue active rotation strategies combine common sense with proven expertise in identifying sector trends. This expertise may be obtained from a few Registered Investment Advisors who have produced credible track records in calling sector moves, and also from quantitative models that avoid guesswork. Even if an active rotation strategy is not always on target, it can give clients the discipline they need to maintain their investment commitment, along with the confidence that professionals are taking action to anticipate and adjust portfolios based on current trends.

During the booming 90s, buy-and-hold strategies built around passive asset allocation made sense and were rarely questioned by profit-happy investors. However, it may be "prisoner-of-the-past" psychology to assume that in the more difficult markets ahead, investors will pay hefty fees to advisors who do little or nothing to adjust portfolios. At the least, a sector-based strategy with some rotation can demonstrate professional service that responds to today's market dynamics.

Sector-Based ETFs

The table below lists the 10 GICS sectors along with their corresponding Sector SPDR Exchange-Traded Funds (ETFs). Alternative ETFS also are shown.

Source: Morgan Stanley