Regardless of your investing style, you may not realize that if you focus on a particular type of stock, you could be creating an undiversified portfolio and taking unintended sector risk.
We believe most investors should try to build a "sector-neutral" portfolio when implementing their favorite stock-selection strategy.
Our research finds that sector neutrality won't typically result in much of a hit to your overall average returns, and you can still pick stocks using your favorite style.
What type of stock picker are you? Do you look for growth stocks, value stocks or high-dividend-yielding stocks? Or perhaps you look for "story" stocks that trade more on future profit expectations than on current conditions. Regardless of your individual investing style, you may not realize that if you focus on one particular type of stock, you could be creating an undiversified portfolio and taking unintended sector risk.
Some investors may choose to make these thematic bets. However, we believe that most investors should try to build a "sector-neutral" portfolio when implementing their favorite stock-selection strategy. A sector-neutral portfolio seeks to match the sector weights of the portfolio with the sector weights of a benchmark. The benchmark chosen should reflect the strategy of the portfolio (i.e. a large capitalization portfolio might use a large capitalization benchmark like the S&P 500®).
To understand why sector neutrality is important to portfolio construction, let's start with a closer look at the sector composition of two common investment styles: growth and value.
A pure growth portfolio skews sector allocations ...
To find typical growth stocks, we used the Schwab Stock Screener to screen for the top 1,000 stocks by market capitalization that are also in the top 30% by three- to five-year forecasted growth rate and the top 30% by three-year sales growth.
We equal-weighted the 198 stocks that passed this screen to form a sample growth portfolio. As you can see in the chart below, this portfolio has close to 50% of its holdings in just three sectors: information technology (24%), energy (16%) and consumer discretionary (13%) —so it's not exactly sector-neutral. As a benchmark, the chart also shows the sector composition of the S&P 500.
Sample growth portfolio versus S&P 500 Index
Source: Schwab Center for Financial Research. Sample growth portfolio weights as of November 20, 2013; S&P Index weights as of November 20, 2013.
By comparing the sector weightings of a growth strategy to those of the S&P 500, you can see the inadvertent sector bets the growth strategy would make. For example, the sample growth portfolio has its largest overweight in the information technology sector, exceeding the S&P 500 weight by almost 6.5 percentage points and is underrepresented in consumer staples by almost 5.5 percentage points.
... As does a pure value portfolio
Moving on to a value strategy, we again used the Schwab Stock Screener to find typical value stocks. We screened the top 1,000 stocks by market capitalization for the 30% with the lowest P/E ratio, and equal-weighted the 91 stocks that resulted from this screen to form a value portfolio.
The chart below shows that our value portfolio has almost 30% of its weight in the financials sector. Compared to the S&P 500 sector weights, the sample portfolio is overweighted in financials by almost 14 percentage points, while greatly underweighted in information technology and health care. Again, this makes for a poorly diversified portfolio.
Sample value portfolio versus S&P 500 Index
Source: Schwab Center for Financial Research. Sample value portfolio weights as of November 20, 2013; S&P Index weights as of November 20, 2013.
Don't get burned
Why should you care about such mismatches in sector weights? Because they arose from a stock-selection process that had nothing to do with intentional bets on specific sectors. Although you could still get lucky with such sector bets, sector concentration increases the odds that a big drop in a particular sector that you're overloaded in could drag down your portfolio more than it would if you were properly balanced.
For example, many growth investors who inadvertently loaded up on tech stocks were badly burned when the sector plunged in 2000–2002. Many value investors were similarly burned when their financials-heavy portfolios collapsed during the 2008–2009 credit crisis. On the flip side, with a big run-up in a sector, such as tech in 1999, an unintentional underweight could keep your overall portfolio return below what it would be if you were sector-neutral.
Deep dive: Inside the model
To better appreciate how a sector-neutral portfolio helps reduce risk; let's look at performance characteristics of the Schwab Equity Ratings® model from both a sector-neutral and an unconstrained perspective. One metric we use to research model performance is an "information coefficient" (IC). First, the model ranks roughly 3,200 of the largest (by market cap) U.S. stocks from best to worst within each sector; then, we calculate the correlation of those rankings with how the stocks actually performed 12 months later after receiving their rating. The IC is this correlation, ranging from -1 to +1.
An IC of 1 means a stock's ranking perfectly correlates with its subsequent return ranking—the model is doing an excellent job of forecasting which stocks will outperform others in each sector. An IC of zero means the model has no forecasting ability. An IC of -1 means a stock's ranking is perfectly negatively correlated with its subsequent return ranking—the model is doing a poor job of forecasting which stocks will outperform others. In our research, we look for an IC greater than 0.08 to indicate the model is doing well differentiating between well- and poorly performing stocks.
The chart below shows the time series of ICs associated with simulated scores for both the unconstrained and sector-neutral Schwab Equity Ratings models. You can see that the IC variability of the unconstrained model is much greater (almost double) than that of the sector-neutral model. Note how the unconstrained ratings have higher highs in 1992, 1997 and 2001 and lower lows in 1991, 1999 and 2002. But this extra variability doesn't mean higher returns, as both models have similar average IC performance numbers over the full time period. What these results show us is that a stock-selection strategy implemented in a sector-neutral portfolio provides the same level of predictive power (i.e., return) at substantially less variability (i.e. volatility), or risk.
Source: Schwab Center for Financial Research.
Results from tests using Schwab Equity Ratings are based on the use of historical model performance results that have certain inherent limitations. Unlike an actual performance record, simulated results do not represent actual investment performance or trading. No representation is being made that any investor will or is likely to achieve profits or losses similar to those shown. The results presented are for illustrative purposes only and should not and cannot be viewed as an indicator of how individual stocks with a particular Schwab Equity Rating are performing or will perform in the future.
Eliminate inadvertent sector bets
To help avoid unintentional sector concentration, we suggest picking stocks in a sector-neutral manner. Our research finds that sector neutrality won’t typically result in much of a hit to your overall average returns, and you can still pick stocks using your favorite style.
However, by establishing a sector-neutral portfolio, you may enjoy similar returns with less risk because you've eliminated unwitting sector bets. To implement this technique, the portfolio's sector weightings are constrained to match those of a benchmark—the stock picking is done within each sector. So whatever style you choose to pick your stocks, you'll still be taking action so that you don't get over- or underweighted in any sector(s). We provide an example of how to construct a sector-neutral portfolio using some of the Schwab tools below.
Putting it to work for you
Let's look at two ways that you can implement this sector-neutral technique in your own portfolio—first with individual stocks, then with mutual funds.
Screening for individual stocks
If you prefer to pick all of your stocks yourself, we suggest that you build a portfolio of at least 40 highly rated stocks—20 large-cap and 20 small-cap. Weight the dollars that you invest in both large- and small-caps to match your individual asset allocation plan, and make sure each of the 10 sectors is represented in proportion to its benchmark weight.
For example, let’s say you have $10,000 to invest, equally allocated to large and small cap stocks. Owning 40 stocks equally weighted means that you would hold $250 in each position ($10,000 divided by 40). If a sector's weight is 10% of the benchmark, then 10% of your portfolio, or $1,000, would be invested in that sector. Because you’re investing $250 in each stock, you would hold 4 stocks in this sector ($1,000 divided by $250). Since you have equally allocated your capital to large and small cap stocks, you would own 2 large and 2 small cap stocks.
You can find current sector weights for the S&P 500 (for large-cap stocks) within Schwab Sector Views. To find sector weights for the Russell 2000 (for small-cap stocks), you can use the weights in the iShares Russell 2000 ETF as a proxy. Log into your Schwab account and type the ticker “IWM” into the Research box. Click on the Portfolio tab and go to the Equity Sectors section.
Keep in mind that if you have less than $100,000 for your stock investments, you'll have smaller positions in each stock and higher transaction costs relative to the size of each position, so mutual funds may be a better alternative.
Sector-neutral mutual funds
If it's not feasible for you to invest in 40 different stocks, or if you'd simply prefer not to have to build and maintain your stock portfolio yourself, you can always outsource the job to full-time professionals via mutual funds. Schwab's actively managed equity funds use Schwab Equity Ratings to employ a sector-neutral stock selection technique.
For a list of the seven funds that utilize Schwab Equity Ratings, clients can log in to the mutual funds page, click Schwab Funds, and from there, find the link to the Active Equity Funds.
Regardless of how you choose to invest in stocks, we suggest that you try to sector-neutralize your stock portfolio. You get the best of both worlds—maintaining your personal stock-selection edge while potentially reducing your portfolio's overall risk. Taking this course of action can help you keep your investment portfolio on track.