A "sector" is defined as a group of companies that have similar behaviors, laws, and regulations. Not all sectors have the same performance during a particular time period or economic cycle. Picking the "optimal" sector is not easy but if you are successful, it is the one of the most powerful drivers of portfolio performance. Data from Fidelity Investments indicates that picking the "right" sector has significantly more impact than choosing the best style (value versus growth) or the best market cap (large versus small). It is therefore not surprising that investors have been moving toward sector funds over the past few years.
The performance of each sector is easy to find and is often advertised by fund companies. However, how much risk did you have to assume in order to obtain the sector performance? As a retiree who is risk adverse, the risk is just as important to me as the return.
Therefore, I decided to analyze the group of Select Sector SPDR Exchange Traded Funds (ETFs) is terms of risk-adjusted return. The Select Sector SPDRs partition the S&P 500 into 9 sectors and each stock in the S&P 500 is allocated to only one Select Sector ETF. All the funds are market-cap weighted with the proviso that no individual security can comprise more than 25% of a fund.
Please note that there are many other ETFs that I could have used instead of the Select SPDRs. Vanguard and other groups have excellent ETFs focused on the various sectors. I used the Select SPDRs for convenience and because they uniquely partition the S&P 500 into 9 non-overlapping funds. No claim is made that Select SPDR ETFs are better than other sector ETFs.
This analysis is divided into three parts:
- The first section is a tutorial on the definition of the different sectors. This data does not provide any fresh insights but is provided for investors that might need a refresher. If you are already familiar with the definition of sectors, you can skip to the second part.
- The second section provides the risk versus reward of each sector over multiple time frames and compares the risk-adjusted returns with those obtained by overall stock market.
- The last section draws some investment implications based on the sector data.
The characteristics of each sector are described below along with an overview of the corresponding Sector SPDR.
Consumer Discretionary. This sector is comprised of companies that sell non-essential goods and services. Some examples are retail stores, media firms, automotive companies, hotels, restaurants, leisure equipment, apparel, and luxury goods. This sector does well when the economy is strong and consumers have extra money to spend on non-essential items. The consumer discretionary sector plummeted in 2008, losing over 40%.
- Consumer Discretionary Select Sector SPDR (NYSEARCA:XLY). Consumer discretionary companies make up about 12.5% of the S&P 500. This ETF has 83 holdings, with the largest representation (30%) being media companies such as Comcast (CCV), Walt Disney (NYSE:DIS), and Twenty-First Century Fox (NASDAQ:FOX). Amazon.com (NASDAQ:AMZN) is the largest constituent at 7%. Other companies include McDonald's (NYSE:MCD) and Home Depot (NYSE:HD). This fund has an expense ratio of 0.18% and yields about 1.2%.
Consumer Staples. This sector consists of companies that sell essential products such as food, beverages, household items, and tobacco. The products of these companies are always in demand, regardless of economic conditions. Companies within this sector often have slow but steady growth. This sector is normally considered to be "defensive" and was the best performing sector in 2008, losing only 16%.
- Consumer Staples Select Spider (NYSEARCA:XLP). Consumer staples companies make up about 9.6% of the S&P 500. This ETF holds 40 companies, with food retailers making up 25% of this fund followed by 21% for household product firms. Other major areas include beverages (19%), food producers (17%), and tobacco companies (16%). Proctor & Gamble (NYSE:PG) is the largest holding accounting for 14% of the fund. Other holdings include Wal-Mart Stores (NYSE:WMT) and Phillip Morris International (NYSE:PM). This fund has an expense ratio of 0.18% and yields 2.4%.
Energy. This sector consists of integrated oil companies as well as companies that specialize in exploration, oil services, and drilling. The performance of the sector is based on supply and demand and as you would expect, companies do well when oil and gas prices are high. This sector is also sensitive to political events, especially those that might disrupt the flow of oil. Energy was hit relatively hard in 2008, losing 39%.
- Energy Select SPDR (NYSEARCA:XLE). Energy companies make up about 10.2% of the S&P 500. This ETF consists of 44 oil, gas, and energy services companies. Most (90%) of the companies are large-caps. The integrated oil companies make up about half the fund followed by exploration and production companies. Two companies, Exxon Mobil (NYSE:XOM) and Chevron (NYSE:CVX), make up about a third of the total assets. Other holdings include Schlumberger Limited (NYSE:SLB), Occidental Petroleum (NYSE:OXY), and ConocoPhillips (NYSE:COP). The fund has an expense ratio of 0.18% and yields 1.7%.
Financial. This sector consists of commercial banks, brokerage houses, insurance companies, consumer finance firms, and Real Estate Investment Trusts (REITs). The financial sector performs best in a low interest rate environment and when the economy is on the upswing. As the economy improves, businesses make more investments and consumers spend more, which bode well for the financial sector. As you might expect, financials were devastated in 2008, losing a whopping 47%.
- Financial Select Sector SPDR (NYSEARCA:XLF). Financial companies make up a relatively large 16.4% of the S&P 500 index. XLF is the most liquid financial ETF, trading over 50 million shares per day. The fund is comprised of 81 firms, with the top 10 holdings making up about 50% of the total assets. Some of the companies represented are JPMorgan Chase (NYSE:JPM), Wells Fargo (NYSE:WFC), Bank of America (NYSE:BAC) and Citigroup (NYSE:C), with each company comprising about 6% to 8% of the total assets. The expense ratio is 0.18% and the yield in 1.5%.
Healthcare. This sector consists of companies that provide healthcare and medical services. This sector is typically considered defensive since healthcare is not discretionary. Having a steady demand for goods makes this sector less sensitive to the economic cycle. The healthcare sector held up relatively well in 2008, losing only 23%.
- Health Care Select SPDR (XLV). Healthcare companies make up about 13.2% of the S&P 500. This EFT consists of 55 companies with big pharma consuming almost 50% of the assets. In addition to pharmaceuticals, the fund also contains biotech companies, health care providers, and health equipment makers. Johnson & Johnson (NYSE:JNJ) is the largest constituent at 12% of total assets, followed by Pfizer (NYSE:PFE) at 9% and Merck (NYSE:MRK) at 7%. The fund has an expense ratio of 0.18% and yields 1.5%.
Industrial. This sector consists of companies providing goods used in construction and manufacturing. This sector includes aerospace and defense, construction companies, machinery companies, transportation firms, and industrial conglomerates. The sector does best when the economy is booming and companies are expanding. The Industrial sector lost about 40% in 2008.
- Industrial Select Sector SPDR (NYSEARCA:XLI). Industrial companies make up 10.9% of the S&P 500. This ETF holds 64 companies, with the largest sub-sectors consisting of aerospace and defense (26%) followed by industrial conglomerates (19%) and machinery (18%). General Electric (NYSE:GE) is the largest holding at 11% of total assets. Other large constituents are Boeing (NYSE:BA), United Technologies (NYSE:UTX), and 3M (NYSE:MMM), each comprising about 5% of total assets. The fund has an expense ratio of 0.18% and yields 1.7%.
Materials. This sector is comprised of companies that are involved the discovery, development, and processing of raw materials. This sector includes chemical, mining, paper, forestry products, and construction material companies. This sector is sensitive to the economic cycle. If the economy is strong, the demand for more raw materials typically increases. The materials sector was one of the worst performing sectors in 2008, losing 45%.
- Materials Select Sector SPDR (NYSEARCA:XLB). Materials companies make up a relatively small part (3.5%) of the S&P 500. This ETF holds 31 companies, with the vast majority of the holdings being chemical companies (73%) with metals and mining a distant second at 16%. E.I. du Pont de Nemours (NYSE:DD) and Monsanto (NYSE:MON) are the largest constituent at 10% each, followed by Dow Chemicals (NYSE:DOW) at 9%. The fund has an expense ratio of 0.18% and yields 2.1%.
Technology. Technology companies are involved in the development or distribution of technology products such as computers, electronics, software, and information technology. Technology is a fast evolving sector and offers products to the Government, businesses, and the consumer. Technology fads tend to come and go with breath-taking advances followed by equally impressive drops. Technology was devastated in 2008, losing around 44%. However, the worst performance of the technology sector was during the 2000 to 2002 bear market where the sector fell over 80%.
- SPDR Technology Select (NYSEARCA:XLK). Technology companies make up the largest sector of the S&P 500, weighing in at 20.7%. This ETF has 71 holdings, with the top constituents coming from the computer and peripherals subsector (25%) followed by IT services (17%) and software (15%). The top 5 holdings are Apple (NASDAQ:AAPL) at 14%, Google (NASDAQ:GOOG) at 9%, Microsoft (NASDAQ:MSFT) at 8%, International Business Machine (NYSE:IBM) at 6%, and AT&T (NYSE:T) at 5%. The fund has an expense ratio of 0.18% and yields 1.7%.
Utilities. The utility sector consists of large firms that operate facilities for the generation and transmission of electricity, gas, or water to the general public. These firms usually require substantial infrastructure, like power distribution lines, and they have to assume large amounts of debt to finance expansion and improvements. This makes utility companies sensitive to interest rates. However, once the infrastructure is in place, it becomes cost prohibitive for other companies to compete. Therefore, utilities often enjoy a "natural monopoly" in the region they serve. The Government also views utilities as providing essential services for the wellbeing of society. For these reasons, many of the utilities companies are regulated. The regulators set retail rates that are designed to provide each company with a "fair" rate of return. This provides a stable income for the regulated companies but decreases their ability to grow profits. The utilities sector was the third best sector in 2008, losing only 28%.
- Utilities Select Sector SPDR (NYSEARCA:XLU). Utilities are the smallest sector of the S&P 500, making up only 2.9% of the index. This ETF consists of 31 holdings, with electric utilities making up 56% of the index and diversified utilities 36%. Gas utilities and independent power producers represent the other 8%. The largest constituent is Duke Energy (NYSE:DUK) at 9% followed by Dominion Resources (NYSE:DOM), NextEra Energy (NYSE:NEE), and Southern Company (NYSE:SO), each representing about 8% of the total assets. The expense ratio is 0.18% and the yield is a relatively high 3.8%.
Overall stock market. For reference I will compare the sector performance with the S&P 500. As we all know, the stock market, as measured by the S&P 500, peaked in October, 2007 at 1576 and then plummeted to a bear market low of 666 in March 2009, a drop of about 58%. The worst year of this bear market was 2008 when the S&P 500 had its third worst year in history, dropping 38% (the worst year was 1931 with a 47% loss followed by 1937 with a drop of almost 39%). However, since the low in 2009, the market has been in a rip-roaring bull market, romping to an all-time high near 1850 in January, 2014. No one knows the future but it is likely that the market still has more upside before a major correction.
- SPDR S&P 500 (NYSEARCA:SPY). This cap weighted ETF contains all 500 stocks in the S&P 500. It has and expense ratio of only 0.09% and yields 1.8%.
Sector Risk versus Reward
To assess the sector funds over a complete market cycle, I plotted the annualized rate of return in excess of the risk free rate (called Excess Mu in the charts) versus the volatility of each of the Sector SPDRs. To capture the entire bear-bull cycle, I used data from October 12, 2007 (the market high before the collapse) until today. The Smartfolio 3 program was used to generate this plot. The data is shown in Figure 1.
Figure 1. Risk vs. reward for Sector SPDRs over the bear-bull cycle
As is evident from the figure, there was a relatively large range of returns and volatilities. For example, XLY had a high rate of return but also had a high volatility. Was the increased return worth the increased volatility? To answer this question, I calculated the Sharpe Ratio.
The Sharpe Ratio is a metric, developed by Nobel laureate William Sharpe that measures risk-adjusted performance. It is calculated as the ratio of the excess return over the volatility. This reward-to-risk ratio (assuming that risk is measured by volatility) is a good way to compare peers to assess if higher returns are due to superior investment performance or from taking additional risk. In Figure 1, I plotted a red line that represents the Sharpe Ratio associated with SPY. If an asset is above the line, it has a higher Sharpe Ratio than the S&P 500. Conversely, if an asset is below the line, the reward-to-risk is worse than the S&P 500.
Some interesting observations are apparent from Figure 1. First off, over the entire market cycle, 5 of the 9 Sector SPDRs had risk-adjusted returns better than the overall market (as measured by SPY). The consumer staple sector had the lowest volatility and also the best risk-adjusted return. The consumer discretionary sector had the best absolute return coupled with an excellent risk-adjusted performance. The healthcare sector also put in superior results.
Likely because of the poor performance in the 2008 bear market, the financial sector had the largest volatility and the lowest absolute return, resulting in the worst risk-adjusted return of all the sectors. Somewhat surprisingly, the utility sector also had inferior performance, lagging all the other sectors except for financials. The rest of the sectors had risk-adjusted performance relatively close to the overall market.
Over the more recent past, the S&P 500 has been in a rip-roaring bull market. To see which sectors perform best in a bull environment, I re-ran the analysis over the past three years and the results are shown in Figure 2.
Figure 2. Risk vs. reward for Sector SPDRs over the past 3 years
Over the past 3 years, consumer staples, consumer discretionary, and the healthcare sectors continued their outperformance. The utility sector did live up to its representation of lower volatility but again underperformed the overall market. During this period, the materials, energy, and financials sectors had the highest volatilities and they also lagged in risk-adjusted performances.
As a final stress test, I re-ran the analysis over the past 12 months, when the S&P experienced a truly impressive bull run. The results are shown in Figure 3.
Figure 3. Risk vs. Reward for Sector SPDRs during previous 12 months
During this period, consumer staples did lag slightly (as you might expect) but consumer discretionary and healthcare continued their outstanding performance. The financial sector made a good comeback but still had a lower risk-adjusted performance than the overall market. In this extraordinary bull environment, utilities could not keep up and not only had the lowest return but also had volatility similar to the other sectors.
- Consumer Discretionary: This sector provided excellent risk-adjusted returns in all time frames. The sector was highly volatile but generated commensurate returns.
- Consumer Staples: This was the lowest volatility sector. The sector had superior risk-adjusted returns over the bear-bull market cycle but did not maintain performance in the strong bull market.
- Energy: This sector had high volatility with good, but not excellent risk-adjusted returns over a complete bear-bull cycle. The sector lagged during the recent bull market.
- Financial: This sector experienced the highest volatility with generally poor risk-adjusted returns. During the past year, this sector showed improved performance.
- Healthcare: This sector was relatively volatile sector but generated commensurate returns to provide the investor with excellent risk-adjusted returns over all cycles.
- Industrials: This sector was in the middle of the pack in both volatility and risk-adjusted returns. It did better in a strong bull market.
- Materials: This was a high volatility sector and the returns were not commensurate with the increased risk. Risk-adjusted returns have lagged over all time frames.
- Technology: Surprisingly (at least to me), this sector had relatively low to medium volatility. The risk adjusted returns were in the middle of the pack in all time frames.
- Utilities: This sector experienced low to medium volatility but did not generate commensurate returns. The sector lagged most of the other sectors in all time frames.
No one knows which sectors will outperform in the future but judging from the past, the consumer discretionary and healthcare had by far the most consistent risk-adjusted performance.