Sector Weightings: What Is The Right Benchmark For You?

|
Includes: SPY, VT
by: Common Cents

For many individual investors, the end of the year often provides the catalyst to adjust their portfolio via tax loss harvesting and general rebalancing. While performing these activities, one key element of consideration for an equity portfolio is sector allocation. This seems especially true in today's world, where multinational corporations reach across country borders and the speed of communications is faster than ever seen in the history of the world. S&P provides a good overview of historic sector returns and weightings over the past 10 years here. A key quote from the top of that chart brings the importance of sector allocation to the forefront.

"Sector returns can vary widely – over the last 10+ years the average difference between the best performing and worst performing sectors has been more than 40% per year."

Clearly, sector allocation is a critical component of an equity portfolio's performance. Hence, many investors think of purposely being overweight or underweight a specific sector based on their view of global macro events, economic cycles or current market momentum. However, sector over/under weighting is only relevant when compared to a benchmark. Most of the time sector allocation is discussed in relationship to the current composition of the S&P500. That makes a lot of sense if you are a U.S. based large-cap fund manager trying to attract capital by beating the market. However, an individual investor most likely has a portfolio that is diversified across countries, market cap sizes, etc. Hence, comparing the weighting of your overall portfolio's sector allocation against the S&P 500 may not be the right comparison for an individual investor. Perhaps an individual investor should be benchmarking against total U.S. or world markets.

The chart below shows the weightings of sectors shown on Yahoo finance as of the end of the third quarter of 2011 for the

  • S&P500 (NYSEARCA:SPY)
  • Total US market (VTSMX)
  • Total world market (NYSEARCA:VT)
Sector

SPY

VTSMX VT
Consumer Cyclical 11.9% 10.3% 9.3%
Consumer Defensive 9.3% 11.0% 10.9%
Energy 12.4% 10.6% 10.7%
FInancials- non Reits 12.4% 12.0% 17.0%
FInancials - Reits 1.8% 3.0% 2.3%
Health Care 11.4% 11.8% 9.1%
Industrial Products 11.7% 12.1% 11.8%
Information Technology 17.9% 17.4% 11.4%
Materials 3.3% 3.6% 7.9%
Telecom 4.2% 4.3% 5.9%
Utilities 3.7% 4.0% 3.9%

Another point to consider about sector allocation is that they change rather significantly over time. For example, until the mid 90's the financial sector comprised well less than 10% of the overall market, while materials were more than double their current weighting until the start of this century. The chart linked to above provides information about how the weighting of sectors has changed over the years.

An investor may want to consider that these sector weightings might revert to the mean. Hockey great Wayne Gretzky is claimed to have said "don't skate to where the puck is, but skate to where it is going to be" . Since sector weightings change over time, perhaps it is best to use more of a historical average for a benchmark as opposed to the current number.

CONCLUSION

With sector allocations arguably become more a important element of a diversified equity portfolio, it is important for an investor to consciously decide their sector weighting. At the simplest level, an investor could just equal weight each sector. This could have the natural effect of overweighting underperforming sectors and underweighting recent high flyers. Interestingly, the same S&P chart linked to above indicates that an equal weighting by sector has almost doubled the performance of the actual index over the past decade.

Taking into account a more global and historical perspective of sector allocations, here are the approximate target sector allocations this investor plans to use for 2012.

  • Consumer Cyclical/Discretionary - 7.5% Underweight. Place an emphasis on global markets in this sector as the emerging market consumers start to acquire more than just staples;
  • Consumer Defensive/Staples - 10% Equal Weight. Mostly through big multinationals;
  • Energy - 15.0% Overweight. The energy sector has often been a much large percentage of the total market. It seems there are many potential global macro events that could change the world's view of oil and also many potential technology breakthroughs that could make this a growing area. I will likely get exposure through industry specific ETFs and funds.
  • Financials - 10% Underweight. It seems like many of these companies are destined to be pushed by governments and populist movements to return to a more basic, less speculative industry and hence, profits may be challenged for a long time. De-emphasize the big banks and focus on other aspects of the industry, including apartment REITS.
  • Health Care - 10% Equal Weight - Aging populations would seem to be driving demand for this sector, but the demand created may end up being for basic low margin services that won't improve earnings for the sector;
  • Industrial Products - 12.5% Overweight. Try to emphasize trends such as infrastructure, water, agriculture, etc;
  • Information Technology - 17.5% Equal Weight. Often it seems this sector can grow forever, but it likely has to hits limits at some time. Also what is often thought of as technology may increasingly be embedded in products. For example, is Apple (NASDAQ:AAPL) a technology company or a consumer products company? Are companies like Google (NASDAQ:GOOG), Facebook, etc. technology companies or media companies? Investments in this space might best be focused on the companies that provide the IT infrastructure that support new products and services.
  • Materials - 10% Overweight - The world population continues to grow, and that could drive demand for basic materials;
  • Telecom - 2.5% Equal Weight - This sector has been the most consistent percentage of the total over the years. No reason for that to change now. Plan to focus investments on both dividend yield and emerging market growth.
  • Utilities - 5% - Equal weight - This has been perhaps the best performing sector of the past year. It might continue to perform well for awhile-- or then again, maybe not.

Disclosure: I am long SPY.

Additional disclosure: This posting is for informational, educational and entertainment purposes only and should not be considered investment advice.