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(Tibor Kolley)
(Tibor Kolley)

Market Lab

Why you should diversify by sector, not region Add to ...

Common investor thinking says look abroad for portfolio diversification. In Canada, that maxim carries particular weight given the country's small place in the global economy.

A new study from S&P Indices, however, finds that regional variety offers less of a benefit from diversification than investing based on economic sectors.

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S&P researchers took the organization's Broad Market Index (BMI), a unique gauge on global stock markets that covers about 10,000 companies in 45 countries, and sliced it up by region, countries and sectors. They compared the historical performance of the subgroups with the BMI itself and discovered some interesting patterns.

The great convergence

The correlation of market performance in developed regions with the BMI has converged substantially recently. The five-year correlation increased to 0.95, compared with 0.91 over 10 years and 0.87 over 20 years.

S&P also found that the five-year correlation between the BMI for emerging markets and the BMI for developed markets has increased significantly. The five-year correlation of the S&P Emerging BMI to the S&P Developed BMI is 0.91, compared with a 0.82 15-year correlation.

The convergence is a result of increasing global economic and financial market interdependence, according to the study's authors. "In the last couple of decades, investing has become global," says Alka Banerjee, vice-president at S&P Indices. "The same story is playing out in emerging markets. It's the same flow of funds and the same sentiment."





The sector advantage

In contrast to the regional alignment of markets, some individual sector indexes of the S&P Developed BMI show wide varying correlations to the parent index. Specifically, energy, health care, utilities and consumer staples have 20-year correlations of less than 0.75. Several sectors, however, move closely with the broader BMI. The industrials, consumer discretionary and financials sectors all show 20-year correlations above 0.90.

A lot of the economy today is powered by multinational corporations that conduct their business worldwide. "Sectors are really what's driving the markets today rather than the domicile of the companies," says Michael Orzano, an associate director at S&P and the other co-author of the study.

"The capacity to over- and under-weight individual sectors potentially offers the ability to outperform broad regional indices in both up and down markets," the report says, adding that cyclical sectors (industrials, IT, consumer discretionary) have historically outperformed defensive sectors (consumer staples, health care, utilities).

One of the technical risk ratios most commonly referred to by professionals is alpha, a statistical measurement of the risk-reward profile of an investment. Essentially, alpha marks the level of outperformance, or underperformance, compared with a benchmark index. Market sectors will continue to deliver highly divergent performances on both an absolute and risk-adjusted basis, the S&P report concludes: "sector investing provides significant opportunities for alpha generation in both up and down markets."

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