LEADERSHIP SERIES

The Case for Using a Sector-Based Framework

in Equity Portfolio Construction
Sector exposure historically has been a major driver of stock returns and
can be an effective way to seek an objective and manage portfolio risk

Denise Chisholm l Sector Strategist

Scott O’Reilly, CFA l Head of Index, Sector, International, and Factor Products

Key Takeaways For most of the past two decades, equity allocations
within portfolios have primarily been determined using
• Using a sector-based framework to build traditional metrics such as market-capitalization size and
equity portfolios can help investors achieve a style (see “Equity classification systems in the modern
variety of investment objectives and greater era,” page 3). However, these metrics de-emphasize one
control in managing portfolio risk. of the most important determinants of equity volatility
and return variability: the sector and industry in which a
• Beyond company-specific factors, sector company operates. A sector-based framework can be an
exposure has been the most influential driver effective approach to equity portfolio construction for
of the variability in equity market returns over investors who are looking to generate positive returns and
time, yet sector-based portfolio construction maintain greater control over portfolio risk.
remains an underutilized strategy in the
Sector exposure has been a significant
marketplace.
determinant of equity returns
• Equity sectors have a variety of attributes, Diversification is a key element of any equity allocation
including stable classification, consistent approach.1 According to modern portfolio theory,
earnings drivers, high return dispersion, clear combining assets that are imperfectly correlated with

volatility patterns, and low correlations, which one another—meaning their performance does not move
in lockstep—lowers the risk (volatility) of a portfolio and
together can help investors generate an
opens the door to potentially higher risk-adjusted returns.2
efficient portfolio.
To construct a diversified equity portfolio, it is helpful to Our analysis of the various sources of historical return
understand the historical determinants of performance for variability in the U.S. equity market shows that sector
the asset class. One way to determine the most influential exposure (21%) was the second most important factor.
factors that have driven the performance of the equity The earnings of various companies within a given sector
markets is to perform an analysis of variance, which utilizes or industry often react similarly to the same economic,
statistical methods to attribute the variance of a variable regulatory, tax, and geopolitical factors. Yet these same
(in this case, stock returns in an index) to certain factors, factors may have little influence on earnings in other
such as sector, style, and market cap. After accounting for sectors. For example, the Federal Reserve’s monetary
these specific factors, the residual or remaining value can policies often have a significant impact on earnings for
be attributed to other company-specific factors. banks, but have far less impact on earnings for chemical

Looking at the various sources of historical stock returns manufacturers. Style (11%) and capitalization (11%)

in the U.S. equity market, we find that company-specific factors also have been important, albeit less powerful,

factors, such as earnings, sales, product innovation, determinants of equity returns.

free cash flow, and inventory levels, account for about

Six differentiating attributes of sector-based
57% of the variability of historical returns, on average
portfolio construction
(Exhibit 1). Due to the large influence of company-specific
Sector exposure has been a significant driver of equity
factors, individual stock investments tend to be highly
returns over time because of the distinct risk and
volatile, and this helps explain why many investors make it
performance characteristics of the 11 major sectors. It
a matter of policy to diversify their exposure to equities.
is these characteristics—or attributes—that also make
sectors compelling building blocks for creating an equity
EXHIBIT 1: Sector exposure is the second-largest
determinant in the variability of equity market returns. portfolio because they allow an investor to generate a
Average Source of Return Variability for U.S. Stocks (1990–2018) target return and manage the portfolio’s risk exposure.
(Note: Investing in a single sector can result in increased
 Company  Sector  Market Cap  Style
volatility because of its narrow concentration.)

11% 1. Intuitive, stable businesses

11%
78%
of the variability in equity
Sector classifications tend to be fairly intuitive, as most
investors are able to identify an energy or health care
57% company based on the nature of its business operations.
market returns has been
21% For instance, companies that manufacture products and
driven by sector and
company factors services that meet basic human needs—such as food or
detergent producers, electric utilities, and hospitals—
are fairly easy to identify as being in the consumer staples,
Based on rolling 12-month analysis of variance (ANOVA), which uses statistical
models to attribute the variance of a variable (stock returns in the Russell utilities, and health care sectors, respectively.
3000®) to certain factors (sector, style, and market cap). The residual is
attributed to other company-specific factors. Past performance is no guarantee As a result, sector components rarely, if ever, change.
of future results. It is not possible to invest directly in an index. All market Style box classifications, on the other hand, are based on
indices are unmanaged. Index performance is not meant to represent that of
any Fidelity mutual fund. Source: Fidelity Investments as of Dec. 31, 2018.

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 THE CASE FOR USING A SECTOR-BASED FRAMEWORK IN EQUITY PORTFOLIO CONSTRUCTION

ever-changing, backward-looking quantitative financial

data, meaning the classifications tend to shift over time
Equity classification systems in the
(Exhibit 2).
modern era
The straightforward equity classification of sectors may
Investment classification systems attempt to
allow investors to clearly understand what they own, group securities according to similar attributes or
which may give them more confidence in building an factors. Within the equity universe, the “style box”
equity portfolio suitable to their objectives. Meanwhile, classification and sector/industry classification are
the relative stability of a sector classification framework widely used.

may provide allocators with very precise—and potentially Style box classification generally relies on a
effective—exposure when constructing equity portfolios. combination of financial statistics and consensus
earnings-growth estimates to determine whether
2. Consistent performance drivers the stock of a company is classified as “value” (i.e.,
Although company-specific factors lead to stock undervalued based on the underlying financial health
of the company) or “growth” (i.e., high earnings
performance differentiation, companies within each sector
growth prospects). Sometimes a company’s stock
also can be influenced by similar macro drivers of revenue
may be categorized as having both value and growth
and profit growth; hence, the stocks often react similarly
characteristics, and part of its market capitalization is
to changes in the economic cycle. For example, consumer apportioned to both “styles” (i.e., blended category).
staples companies tend to have consistent demand for Market capitalization further divides the equity market
their products, which typically leads to stable revenues, based on the total value of outstanding shares of a
company, and divides the universe into three buckets:
small, mid, and large. This classification system results
EXHIBIT 2: Sector constituents rotate far less frequently
in a grid with nine individual boxes based on style
than style box constituents.
and market capitalization.
Month-to-Month Classification Changes for S&P 500®
Constituents (2008–2018) Sector and industry classifications generally rely on
a hierarchical approach that groups each company
Number of Companies that Switch Classification
into one of 11 sectors based on the nature of its
160 business—communication services, consumer
Style Box Changes Sector Changes
discretionary, consumer staples, energy, financials,
120 health care, industrials, information technology,
materials, real estate, and utilities. Beneath each
sector lies another layer, typically referred to as
80
industry groups, which consist of multiple industries,
and which subsequently can include multiple sub-
40 industries. The Global Industry Classification Standard
methodology assigns a stock to a sub-industry
based on its principal business activity, identified by
0
analyzing the relative importance of the sources of its
Dec-08

Dec-09

Dec-10

Dec-11

Dec-12

Dec-13

Dec-14

Dec-15

Dec-16

Dec-17

Dec-18

revenues and earnings.

Source: Fidelity Investments and Morningstar Inc., as of Dec. 31, 2018.

3
earnings, and stock performance relative to other sectors. their market capitalization assigned to each category.3 As a
A toothpaste producer is typically not going to see result of the diverse makeup of the style box components,
major swings in its earnings or stock price, whatever the there can be fewer consistent patterns of earnings results
trajectory of the economy, because few people in the and stock performance amid fluctuations in an economy.
developed world are likely to cut back on a basic need
3. High performance dispersion
such as toothpaste, even during tough times.
Equity sectors tend to have significant performance
At the same time, although some style box classifications dispersion relative to each other, which is a key attribute
tend to have higher exposure to certain sectors, there for any return-seeking equity allocation strategy.
are companies in all 11 sectors that are represented in Historical analysis shows that the dispersion of returns
each style category. This diverse style box composition between the best- and worst-performing sectors
can make the earnings and stock prices of style box (average = 11%) has been more than double that of style
components somewhat less uniformly influenced by certain box categories (average = 5%)—see Exhibit 3. By the
factors, such as shifts in the economy. Roughly one-third nature of their composition, style box-oriented strategies
of companies within the Russell 3000 Index are classified
®
are diversified across multiple sectors, leading to
as both value and growth companies, with portions of relatively lower performance dispersion.

EXHIBIT 3: Equity sectors have had more than twice the performance dispersion of style box indexes, providing investors with
more opportunity to seek returns and manage risk.
Dispersion Between Best- and Worst-Performing Sectors & Style Box Indices (1999–2018)

Return Dispersion % (Max–Min)

35
Sector Dispersion Style Box Dispersion
Sector Average Style Box Average
30

25

20

15

10

0
Dec-99

Dec-00

Dec-01

Dec-11
Dec-02

Dec-03

Dec-04

Dec-05

Dec-06

Dec-07

Dec-08

Dec-09

Dec-10

Dec-12

Dec-13

Dec-14

Dec-15

Dec-16

Dec-17

Dec-18

U.S. equity market is represented by the top 3,000 U.S. stocks as measured by market capitalization and sectors are defined by the GICS. Style box categories are
represented by the following indices: large cap growth: Russell Top 200® Growth; large cap value: Russell Top 200 Value; mid cap growth: Russell Midcap® Growth;
mid cap value: Russell Midcap Value; small cap growth: Russell 2000® Growth; and small cap value: Russell 2000 Value. Past performance is no guarantee of future
results. It is not possible to invest directly in an index. All market indices are unmanaged. Index performance is not meant to represent that of any Fidelity mutual fund.
Source: Fidelity Investments, as of Dec. 31, 2018.

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 THE CASE FOR USING A SECTOR-BASED FRAMEWORK IN EQUITY PORTFOLIO CONSTRUCTION

The wider return dispersion of individual sectors relative 4. Clear patterns of volatility
to style box components suggests that sectors tend to Equity sectors historically have demonstrated some
be more volatile, but this dispersion also allows investors clear patterns of volatility. Exhibit 4 shows the historical
the opportunity to have greater control in managing average standard deviation of returns for each sector.
a portfolio’s risk exposure and greater opportunity to Although the volatility of sectors can change from year
generate alpha. As with any strategy that deviates from
4
to year, some sectors have historically been more volatile
a market-cap-weighted benchmark, it’s also important for than others, and there has been some consistency
investors to recognize that active sector allocations can among sectors.
potentially lead to increased return variance over short-
In general, more economically sensitive sectors, such as
term periods. For this reason, making effective equity
energy, materials, and information technology, tend to
sector allocations to achieve an investment objective may
show more volatility than the average level of volatility for
be most suitable for investors who have the appropriate
the broader U.S. equity market in any given year, while
experience, investment tools, and research capabilities.
defensive-oriented sectors, such as consumer staples
and utilities, tend to show less volatility than the market
average. Information technology has tended to be the
EXHIBIT 4: Historically, some sectors have been more volatile most volatile sector, while consumer staples has tended to
than others.
be the least volatile sector.
Average Sector Standard Deviation (1999–2018)

Higher
5. Low performance correlations
Volatility
Information Technology 25%
To achieve an adequately diversified equity portfolio,
Materials 21% investors need to evaluate not only the dispersion of
Financials 21% returns, but also the correlations of those returns. Equity
sectors have exhibited low return correlations over
Energy 20%
extended time periods.5 From 1999 through 2018, all 11
Communication Services 19%
sectors showed performance correlations of 0.5 or lower
Real Estate 19% versus at least one other sector (Exhibit 5).

Consumer Discretionary 18% The most dramatic examples of low correlations among
individual sectors tend to be between the most and
Industrials 18%
least economically sensitive sectors. For example, the
U.S. Equity Market 15%
consumer staples sector historically has been one of the
Utilities 15% least economically sensitive sectors; consumers tend to

Health Care 14%

be more willing to curtail spending on discretionary items
before failing to buy shampoo. Thus, since 1999, consumer
Lower
Cons. Staples 12%
Volatility
staples have had a very low correlation to information
U.S. equity market sector volatility is represented by the standard deviation of technology, one of the more economically sensitive
the top 3,000 U.S. stocks as measured by market capitalization, and as defined
by the GICS, from Feb. 1, 1999 to Dec. 31, 2018. Standard deviation measures sectors. Further, sectors have shown generally lower
the historical volatility of a fund. The greater the standard deviation, the greater
the fund’s volatility. Source: Fidelity Investments, as of Dec. 31, 2018. return correlations compared with style box categories.

5
Historically, the average correlation of sectors versus one to equities and, at the same time, lower his or her equity
another was 0.54, while the average correlation among risk profile, might be more confident in tilting allocations
style box benchmarks over the same period was 0.78. 6
toward sectors with historically lower volatility. Historically,

Consistent volatility patterns and low correlations are 3 of the 11 sectors (consumer staples, utilities, health

attractive features that can enhance the ability to manage care) have displayed lower volatility than the very broadly

portfolio risk and reap diversification benefits. While an diversified U.S. equity market (Exhibit 4).

investment in any single sector may not be an appropriate 6. Sources of portfolio efficiency
level of diversification for an equity portfolio, diversified
The attributes of equity sectors make them effective
exposure across sectors may allow an investor to achieve
building blocks for investors looking to create an efficient
a desired level of portfolio diversification and volatility. For
equity portfolio—one that maximizes risk-adjusted
example, an investor looking to maintain some exposure
returns for any given level of risk. The efficient frontier, a

EXHIBIT 5: Return correlations historically have been lower among sectors than style boxes.

Performance Correlations of U.S. Sector Monthly Returns (1999–2018)

Comm Health
Srvcs Cons Disc Cons Stpls Energy Financials Care Industrials Info Tech Materials Real Estate Utilities
Comm Srvcs 1.00
Cons Disc 0.73 1.00
Cons Stpls 0.51 0.53 1.00
Energy 0.45 0.45 0.36 1.00
Financials 0.62 0.75 0.57 0.49 1.00
Health Care 0.54 0.53 0.62 0.39 0.60 1.00
Industrials 0.70 0.82 0.59 0.62 0.81 0.60 1.00
Info Tech 0.75 0.69 0.31 0.38 0.51 0.47 0.65 1.00
Materials 0.64 0.74 0.52 0.69 0.70 0.50 0.86 0.57 1.00
Real Estate 0.52 0.68 0.51 0.40 0.66 0.50 0.69 0.45 0.64 1.00
Utilities 0.31 0.28 0.45 0.45 0.34 0.40 0.39 0.20 0.34 0.47 1.00

Performance Correlations of U.S. Style Box Monthly Returns (1999–2018)

U.S. equity market is represented by the top 3,000 U.S. stocks as

Small- Small- Mid- Mid- Large- Large- measured by market capitalization and sectors are defined by the
Cap Cap Cap Cap Cap Cap GICS. Style box categories are represented by the following indices:
Growth Value Growth Value Growth Value large cap growth: Russell Top 200 Growth; large cap value: Russell
Top 200 Value; mid cap growth: Russell Midcap Growth; mid cap
Small-Cap Growth 1.00 value: Russell Midcap Value; small cap growth: Russell 2000 Growth;
Small-Cap Value 0.84 1.00 and small cap value: Russell 2000 Value. Past performance is no
guarantee of future results. It is not possible to invest directly in an
Mid-Cap Growth 0.95 0.74 1.00 index. All market indices are unmanaged. Index performance is not
Mid-Cap Value 0.73 0.91 0.73 1.00 meant to represent that of any Fidelity mutual fund. Correlation
coefficient is the interdependence of two random variables that range
Large-Cap Growth 0.79 0.64 0.88 0.72 1.00 in value from −1 to +1, indicating perfect negative correlation at −1,
absence of correlation at 0, and perfect positive correlation at +1.
Large-Cap Value 0.64 0.79 0.68 0.91 0.77 1.00
Source: Morningstar, as of Dec. 31, 2018.

6
 THE CASE FOR USING A SECTOR-BASED FRAMEWORK IN EQUITY PORTFOLIO CONSTRUCTION

hallmark of mean-variance optimization, depicts optimal Investment implications

portfolios that maximize investor return for a given level of Our analysis shows that after company-specific factors,
volatility (or minimize volatility for a given level of return). sector exposure has been the most significant driver
Efficient frontiers created using U.S. equity sectors as of the variability in equity market returns over time—
portfolio building blocks provided potential asset mixes even more so than style and market capitalization. The
that offer significantly different volatility exposure than attributes of equity sectors, and their distinct risk
those created using style box components, and superior and return characteristics, provide investors with the
return potential at similar levels of volatility (Exhibit 6). On opportunity to create an equity portfolio with favorable
the other hand, style box frontiers show a tighter range risk-adjusted performance. For its part, style box portfolio
of volatility levels, reflecting less differentiation among construction provides investors with a framework to create
style box components. The optimal portfolio mixes an equity portfolio, and continues to remain a viable way
shown in Exhibit 6 have the benefit of 20/20 hindsight, as to achieve a level of diversification. At a minimum, though,
an investor would need to pick the right mix of sectors putting greater emphasis on sector exposure—along with
to achieve a portfolio on the efficient frontier. But the style and market cap—can enhance an investor’s ability
opportunity to create more efficient portfolios using a to evaluate and manage risk. The potential to generate
sector framework has held consistent over the time period alpha and have greater control in managing a portfolio’s
shown, and throughout other time periods analyzed. risk exposure should motivate more investors to give
increased consideration to sectors when constructing an
allocation to equities.
EXHIBIT 6: Portfolios created with equity sectors as building
blocks were consistently more efficient—providing higher
return and lower risk—than those created using style box
components from 2000 to 2018.
Efficient Frontiers: U.S. Equity Sectors and Styles (2000–2018)

12% Authors
Sectors Styles
Denise Chisholm l Sector Strategist
Annualized Total Return

Denise Chisholm is a portfolio manager for Fidelity Investments.

10%
She is instrumental in delivering innovative sector-based pack-
aged solutions using a combination of sector mutual funds and
exchange-traded funds.
8%
Scott O’Reilly, CFA l Head of Index, Sector, International, and
Factor Products
6%
Scott O’Reilly is the head of index, sector, international, and
factor products at Fidelity Investments. In his current role, Mr.
O’Reilly oversees a team of product managers focused on the
4%
10% 12% 14% 16% 18% 20% product strategy, development, management and positioning
Annualized Volatility of Fidelity investment products to retail, intermediary, and insti-
tutional clients.
Sector benchmark: 11 sectors as defined by GICS for the top 3,000 U.S. stocks
according to market capitalization. Style box components reflect Russell style Fidelity quantitative analyst Zhitong Zhang, investment product
indexes.6 Volatility measured by standard deviation, which reflects the historical
annualized volatility of a portfolio. The greater the standard deviation, the greater the director Michael Mulcahy, and sector and ETF specialist John
portfolio’s volatility. Source: Fidelity Investments, as of Dec. 31, 2018. Gagliano also contributed to this article.

7
Endnotes market capitalization of the Russell 1000 Index. Russell Midcap® Growth Index
1. Diversification does not ensure a profit or guarantee against loss. 2. Source: is an unmanaged index that measures the performance of those Russell Midcap
Fisher, L., and J.H. Lorie. “Some Studies of Variability of Returns on Investments Index companies with higher price-to-book ratios and higher forecasted growth
in Common Stocks.” The Journal of Business. April 1970. The article showed that values. Russell Midcap® Value Index is an unmanaged index that measures the
a portfolio of 32 stocks could capture 95% of the volatility reduction. 3. Source: performance of those Russell Midcap Index companies with lower price-to-book
Fidelity Investments, as of Dec. 31, 2018. 4. Alpha: the excess return over a ratios and lower forecasted growth values. Russell 3000® Index is constructed to
benchmark, taking into account the risk taken to obtain that return. 5. Return provide a comprehensive, unbiased, and stable barometer of the broad market and
correlations can converge over shorter time periods. 6. Sectors defined by GICS for is completely reconstituted annually to ensure that new and growing equities are
the top 3,000 U.S. stocks according to market capitalization. Style box categories reflected. Russell Top 200® Index measures the performance of the largest-cap
are represented by: large-cap growth—Russell Top 200 Growth Index; large-cap segment of the U.S. equity universe; a subset of the Russell 3000 Index. Russell
value—Russell Top 200 Value Index; mid-cap growth—Russell Midcap Growth Top 200 includes approximately 200 of the largest securities based on a combina-
Index; mid-cap value—Russell Midcap Value Index; small-cap growth—Russell tion of their market cap and current index membership, and represents approxi-
2000 Growth Index; small-cap value—Russell 2000 Value Index. Source: Fidelity mately 68% of the U.S. market. Russell Top 200® Growth Index is an unmanaged
Investments, as of Dec. 31, 2018. index that measures the performance of those Russell Top 200 Index companies
with higher price-to-book ratios and higher forecasted growth values. Russell Top
Definitions
200® Value Index is an unmanaged index that measures the performance of
Mean-variance optimization mathematically accounts for expected return (mean)
those Russell Top 200 Index companies with lower price-to-book ratios and lower
and risk (variance) in an attempt to find optimal portfolios along the so-called effi-
forecasted growth values. S&P 500® Index, a market capitalization-weighted index
cient frontier with the maximum return for the minimum risk. • Standard deviation
of common stocks, is a registered service mark of The McGraw-Hill Companies,
shows how much variation there is from the average (mean or expected value). A
Inc., and has been licensed for use by Fidelity Distributors Corporation.
low standard deviation indicates that the data points tend to be very close to the
mean, whereas a high standard deviation indicates that the data points are spread All indices are unmanaged. You cannot invest directly in an index.
out over a large range of values. • Correlation coefficient measures the interde- Stock markets, especially non-U.S. markets, are volatile and can decline
pendencies of two random variables that range in value from −1 to +1, indicating significantly in response to adverse issuer, political, regulatory, market, or economic
perfect negative correlation at −1, absence of correlation at 0, and perfect positive developments. Foreign securities are subject to interest-rate, currency-exchange-
correlation at +1. rate, economic, and political risks, all of which are magnified in emerging markets.
Sectors are defined as follows: Sector investing can be volatile because of its narrow concentration in a specific
Communication services: companies that facilitate communication or provide industry. Investing involves risk, including risk of loss. Investment decisions should
access to entertainment content and other information through various types of be based on an individual’s own goals, time horizon, and tolerance for risk. The
media. • Consumer discretionary: companies that manufacture goods or provide securities of smaller, less well known companies can be more volatile than those
services that people want but don’t necessarily need, such as high-definition tele- of larger companies. Growth stocks can perform differently from the market as a
visions, new cars, and family vacations; businesses tend to be the most sensitive to whole and from other types of stocks, and can be more volatile than other types
economic cycles. • Consumer staples: companies that provide goods and services of stocks. Value stocks can perform differently from other types of stocks and can
that people use on a daily basis, like food, clothing, and other personal products; continue to be undervalued by the market for long periods of time.
businesses tend to be less sensitive to economic cycles. • Energy: companies
whose businesses are dominated by either of the following activities: the construc- Information provided in this document is for informational and educational purposes
tion or provision of oil rigs, drilling equipment, and other energy-related services only. To the extent any investment information in this material is deemed to be a
and equipment, including seismic data collection; or the exploration, production, recommendation, it is not meant to be impartial investment advice or advice in a
marketing, refining, and/or transportation of oil and gas products, coal, and fiduciary capacity and is not intended to be used as a primary basis for you or your
consumable fuels. • Financials: companies involved in activities such as banking, client’s investment decisions. Fidelity and its representatives may have a conflict of
consumer finance, investment banking and brokerage, asset management, insur- interest in the products or services mentioned in this material because they have
ance and investments, and real estate, including REITs. • Health care: companies a financial interest in them, and receive compensation, directly or indirectly, in
in two main industry groups: health care equipment suppliers, manufacturers, connection with the management, distribution, and/or servicing of these products
and providers of health care services; and companies involved in research, or services, including Fidelity funds, certain third-party funds and products, and
development, production, and marketing of pharmaceuticals and biotechnology certain investment services.
products. • Industrials: companies whose businesses manufacture and distribute The Chartered Financial Analyst (CFA) designation is offered by the CFA Institute.
capital goods, provide commercial services and supplies, or provide transporta- To obtain the CFA charter, candidates must pass three exams demonstrating
tion services. • Information technology: companies in technology software and their competence, integrity, and extensive knowledge in accounting, ethical and
services and technology hardware and equipment. • Materials: companies that professional standards, economics, portfolio management, and security analysis,
are engaged in a wide range of commodity-related manufacturing. • Real estate: and must also have at least four years of qualifying work experience, among other
companies in two main industry groups—real estate investment trusts (REITs), requirements.
and real estate management and development companies. • Utilities: companies
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Russell Midcap® Index measures the performance of the 800 smallest compa-
nies in the Russell 1000 Index, which represent approximately 26% of the total