Sector picking

Sector picking or sector investing is a top-down investment strategy that involves identifying specific economic sectors and subsectors (industries) that are expected to outperform and investing in strong companies within them. It’s a way of capitalizing on market shifts caused by changing business conditions and investor focus. Fundamental to sector picking is the fact that different sectors and industries perform differently in different phases of the business cycle. Typically, growth sectors, such as information technology, do best during an expansion, while defensive sectors, such as food products and tobacco, fare better during a contraction. At any given time, some sectors will perform better than others, creating opportunities for investors.

The ideal way to invest in a sector may be to hold a diversified mix of stocks considered representative of that sector. For most investors, the easiest way to do this is to buy shares of a sector mutual fund or ETF. Momentum in stocks and book to market value strategies are well-documented examples of factor outperformance of individual stocks compared to the market. However, these are often hard to implement due to high trading costs, low liquidity and a large number of stocks needed. Sector indices and ETFs could solve this problem, but do they still contain price momentum?

Chen et al. (2012) examine momentum effects among sector ETFs and show that a dynamic momentum strategy can further enhance the performance of style investment even after adjusting for transaction costs. Sectors are also impacted differently by trends or specific events. Rising interest rates, for example, may have a negative impact on the financial services sector, but very little effect on the health care sector. Consumer discretionary industries such as construction, automobiles, or household durables tend to be particularly sensitive to business cycles, while consumer staples and other “defensive” sectors tend to be better insulated from changes in economic activity.

Style and sector picking strategies have been widely employed in the industry and extensively researched by academic studies (see, e.g., Brown and Goetzmann, 1997, 2001; Chan, Chen, and Lakonishok, 2002; Levis and Liodakis, 1999; and Lucas, van Dijk and Kloek, 2002). Sorensen and Burke
(1986) use relative strength analysis for 43 industries and find that an industry momentum rotation strategy produces abnormal profits. Using macroeconomic variables such as the default premium, maturity premium, and aggregate dividend yield, Beller, Kling, and Levinson (1998) create an
industry trading strategy that earned economically significant profits. Chen (2001) uses the maturity premium as a rotation indicator in strategies that switch between value/growth stocks, small/large stocks, defensive/cyclical stocks, and international stocks. He finds excess returns in the latter two cases. Finally, Cavaglia and Moroz (2002) show that a strategy that invests in industries that are profitable, attractively priced, and have positive momentum generates excess returns.

Most professional investors seem to agree that sector momentum rotation strategies can be extremely profitable, with good market timing skills. However, sector choice is highly dependent on the choice of indicators. Such analysis can suffer from reverse causation and omitted variable bias. Hence such strategies could imperfectly capture the true underlying dynamics of time-varying sector performances.

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