The Value of a Sector-Based Perspective

After years in the shadows, value stocks have emerged into the light this year, amid higher inflation and rising interest rates. Throughout this volatile year, some sectors have also experienced a change of fortune, led by energy’s 56% return through the end of May (as measured by energy stocks in the MSCI USA Index).

The long-term impact of sectors on value

For illustrative purposes, we constructed three distinct hypothetical versions of a value strategy. The first (“sector-agnostic”) holds “cheap” firms regardless of sector. The second (“sector-relative”) holds firms that are cheap when compared to their own sector. And the third (“sector-relative and -neutral”) holds firms that are cheap relative to their sector, while preserving the sector weights of the broad market.¹

The sector-agnostic approach resulted in a large overweight to financials and energy. This year’s surge in oil prices drove high short-term performance, but over the longer term this approach underperformed in part due to its sector (and industry) makeup. Concentration within sectors resulted in higher tracking error, more severe drawdowns and a higher share of lower-quality “value traps.”

The sector-relative approach mitigated many of these effects, but still resulted in sizable sector tilts. In contrast, we found that applying sector neutrality and relativity (as was done in the sector-relative and -neutral approach), derived the value premium without taking on the outsized risks present in the other approaches.