Sector checkup can reveal weakness in your portfolio

Risk management is always an interesting topic, especially when it comes to the stock market.  There are many things an investor can do to help manage stock market risk.  Diversifying your investments by sector should be about lowering portfolio risk, and directing your funds to areas you feel will outperform.  Individual equities are typically classified under one of the following ten sectors:  financials, energy, materials, industrial, consumer discretionary, telecommunications, technology, consumer staples, utilities, and health care.

The S&P/TSX Composite Index (S&P/TSX) is one of the most commonly referred benchmarks for Canadian stocks.  In the United States, a popular index is the S&P 500.  The following chart compares both of these indices as of June 30, 2010.

 Weight By Sector

S&P/TSX (Canada)

S&P 500 (U.S.A.)

Financials

30.1%

16.3%

Energy

26.5%

10.7%

Materials

20.7%

3.4%

Industrial

5.7%

10.4%

Consumer Discretionary

4.8%

10.1%

Telecommunications

4.6%

3.0%

Technology

2.8%

18.7%

Consumer Staples

2.6%

11.5%

Utilities

1.7%

3.8%

Health Care

0.5%

12.1%

100.0%

100.0%

 

The following are five steps to complete your sector check-up:

Step 1)  Obtain a consolidated statement of your investments sorted by the above ten sectors.   This list should be done at one point in time, such as quarter end or year end. This is a relatively straight forward exercise if you hold individual stocks.  This step becomes more difficult if you hold multiple mutual funds, exchange traded funds (ETFs), and other holdings.  Every fund has a sector break down disclosed on a monthly basis.  If you have a sector ETF then this is easy.  If the ETF is more broadly based then it is possible to obtain the above subsector breakdown.

Step 2)  From the above step compare your sector exposure percentages to both your desired goal and the indices above.  Your goals may be largely driven by both economic and financial conditions.  It is important to note that investors should not necessarily use the percentages of the indices to equal their own portfolio weighting.  As the S&P/TSX is a “weighted” index, there can be specific stocks that distort the numbers.  One example of this is when Nortel hit $124.50 on July 26, 2000, it represented 34.2 per cent of the TSE 300. During economic uncertainty, sectors such as telecommunications, consumer staples, and utilities are considered more defensive.  During periods of growth, an investor may choose to shift more towards cyclical sectors such as materials, energy and consumer discretionary.

Step 3)  Advisors should be able to provide you with their financial firm’s recommendation for each sector, along with their own opinion.  Most financial firms provide guidance on a sector basis by stating whether you should underweight, market weight, or overweight a sector.   As an example, if a sector represents 20 per cent of an index and a firm is recommending to market weight the sector then 20 per cent of your total equities should be invested in this sector.  If the guidance is to underweight the sector then less than 20 per cent should be within the sector, and vice-versa for overweight.

Step 4)  Once the three steps above have been completed this should reveal any necessary sector adjustments.  If you are over exposed to a sector then you should determine the weakest holdings in that sector.  Rebalancing sector weightings may take some time.  Limit sell orders work well to establish a sell discipline at the right price.

Step 5)  If you need to increase exposure to a sector then the process should be integrated into your geographic diversification.  The main reason for putting the S&P 500 in the above chart is to demonstrate how some countries dominate sectors where Canada has less representation.  Canada is strong in financials, energy, and materials.  The United States market is strong in technology, health care, and consumer staples.

Regular sector check ups will enable you to rebalance sectors.  If one sector has done particularly well during the year then this should be revealed in the above exercise.  Just as an investor should trim or sell a successful stock, the same applies to a sector.  Each check-up should focus first on the macro sector decision.  Making correct sector decisions are often more important than the individual stocks you select.