Today, advisors have a diverse array of investment solutions that allow them to access virtually every market segment to construct well-diversified portfolios for their clients. They can develop broad-based asset allocation strategies to own the market or break it into smaller pieces of the pie. By dividing the market into finer slices, they may be able to efficiently make tactical decisions. In other words, based on their view, advisors can overweight sectors of the market they find attractive and underweight those they believe are overvalued. By investing in a specific sector, or a group of securities within the same industry, advisors may be able to help their clients take advantage of a market segment that is well positioned for growth.
Allocating across sectors helps in reducing company-specific risk. It also enables advisors to create a pure play to focus on an investment theme that is expected to perform in a particular sector, but not necessarily in the market at large. Specifically, sectors allow for the deconstruction of the market and the ability of advisors to build portfolios as they see fit. Sector allocations provide the opportunity to respond to the market in more of a real-time basis, rather than waiting for a broad market investment to reconstitute or rebalance. Sectors can also be used as complements to core exposures. In general, sector exposures provide flexibility to respond to the market.
Equal Weight or Cap-Weighted
The traditional way to construct sector indices is through cap-weighting, which weights the constituents of each sector based on the market capitalization. With cap-weighting, the largest stocks are overweighted and can dominate a particular sector index, potentially leading to some large security and sector bets. Smaller securities comprise a lesser percentage of an index and have less chance to impact overall sector index performance that could mean a missed opportunity.
Advisors have questioned the merits of cap-weighting for many years, which has led to alternative weightings such as equal-weight indices. By investing in a specific sector or a group of securities within the same industry, investors may be able to take advantage of a part of the market that is positioned for growth.
Equal-weight indices are comprised of the same constituents as their cap-weighted equivalents. But, as the name suggests, each component in the index has an equal weight. This may be thought of as a rational allocation among components, rather than making concentrated bets on the largest companies based merely on capitalization.
Cap-weighted indices will likely outperform in an environment that rewards the largest companies within a sector. More advisors are considering sector allocations as a means of overweighting the least desirable ones and underweighting the least favorite sectors. In their asset allocation processes, they have the option to own either cap-weighted or equal-weight sector strategies. The investment results for your clients can be dramatically different depending on the manner in which they gain exposure.
Tony Davidow, who has more than 25 years in the business,
is the managing director and portfolio strategist
at Rydex SGI. He can be reached at www.rydex-sgi.com.