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Making the Most of Your Sector Plays

David Edwards

I've said on numerous occasions that 50% of investment returns come from the stock market, 30% from being invested in the right sectors and just 20% from being in the right stocks. So today let's see how we can boost that middle 30% by making the most of our sector choices.

Sectors Defined

Back in the dawn of modern stock investing, Dow Jones created three sector indexes, the industrials, transports and utilities. (This was back when power plants and railroads were high tech.) Today, there are many more sectors, and they're defined by a wide variety of financial services companies, including Standard & Poor's through its S&P 500 index, data provider Market Guide and Fidelity's Select sector mutual funds.

I prepared this chart to show that while sector definitions are broadly similar, there is some variation. For example, SPDRs, securities that track the S&P 500 index and its subsectors (it stands for Standard & Poor's Depositary Receipts), combine the transportation and cyclical sectors into one security. Fidelity's Select portfolios offer them as separate funds. MarketGuide separates consumer noncyclicals, health care and services into slightly different industry groups.

S&P publishes monthly statistics on the composition of the S&P 500. I find it very useful to see how the composition of my portfolios compares with the S&P 500. At the end of last year, 37.9% of the S&P 500 was in technology and communications, and my portfolios were about 40% in tech. I reduced the exposure to 25% in January, which at the time seemed risky, but now seems prescient. Even now, tech and communications remain about 30% of the S&P 500, whereas 10 years ago the allocation was more like 15%. When making historical comparisons about the S&P 500's price-to-earnings ratio, for example, it's instructive to consider how the composition of the S&P 500 has changed over time.

You can invest directly in sectors -- the chart includes information on SPDRs, which trade continuously like stocks, and on Fidelity's Select funds. Other sector-focused funds and securities include Barclay's iShares, based on Dow Jones' vastly expanded roster of sectors, and Merrill Lynch's HOLDRs, baskets of 20 stocks, grouped by sectors, that trade as a single security. You can learn quite a lot about sectors' risks and characteristics by reading the prospectuses on these products. And TSC has a handy guide to these securities.

One of the most useful tools I've found for tracking sectors is an interactive chart from StockCharts.com, which graphs the relative performance of SPDRS over the past two years. Set the number of days to 22 (the average number of trading days in a month) or 65 (the average for a quarter) and slide the start bar across the bottom. You will see, for example, utilities falling 18% relative to the S&P 500 in the first quarter of 1999 (as markets anticipated Fed rate increases) or technology rising 17% in the last quarter of 1999 as the Internet boom swelled out of control.

In my next column (Jan. 4), I'll discuss the risk factors in each sector and try to determine where the opportunities are most attractive.