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Navigating the S&P500 - some strategies to consider

Writer's picture: Royce AdvisoryRoyce Advisory

In an era of global interconnectedness, the S&P 500 stands as a beacon of opportunity for Australian investors seeking to diversify their portfolios and tap into the world's largest economy.


Much of the sector exposures available in the US is diverse to our own domestic market, i.e. Tech versus Resources, Defence versus overweight financials and so on. Therefore consideration of the world's largest market is important for all investors seeking a truly diversified portfolio approach.


Sector Dynamics and Performance


The S&P 500 is composed of 11 sectors, each with its unique characteristics and performance drivers. As recent divergence in sector performance has shown us, the US market is not a single monolithic entity, but a diverse ecosystem of sectors, each with its own unique characteristics and performance patterns.


As shown in the exhibit below, different sectors like Information Technology and Energy can exhibit high volatility yet inverse correlations, outperforming at different periods in the market cycle. A nuanced understanding of sector performance can help investors make more informed decisions about their S&P 500 exposure.



The Power of Sector Correlation


Sector membership statistically accounts for roughly half of the average S&P 500 constituent's daily returns. This highlights the importance of sector trends, especially during periods of market stress.


It is for this reason that we consider using sector ETFs or sector-focused strategies to gain more targeted exposure within the S&P 500 where we feel it warranted. For example, sectors such as Consumer Staples and Utilities often move together, while others like Information Technology and Consumer Staples are inversely correlated.


This knowledge can be used to construct a more resilient portfolio.



The Skew Factor


When investing in individual stocks within the S&P 500, it's crucial to understand the concept of return skew. As illustrated in the exhibit below, 76% of stocks appearing within the S&P 500 underperformed the average stock between December 1999 and December 2023.


This data suggests that a broad-based approach to S&P 500 investing, such as through index funds or ETFs, may be more prudent for many investors than trying to pick individual winners.



Sector Outperformance


Contrary to individual stock performance, sector-level data paints a different picture. Since December 1999, 8 out of 11 S&P 500 sectors have outperformed the S&P 500 itself.


This suggests that tactical sector allocation within the S&P 500 could potentially enhance returns.


This also introduces the idea of sector rotation which involves shifting investments from one sector to another based on economic cycles and market conditions. This strategy can enhance returns by capitalizing on the varying performance of sectors during different market phases.


Some active investors implement a sector rotation strategy by periodically reviewing sector performance and economic indicators. For instance, during economic expansions, cyclicals like Industrials and Consumer Discretionary may outperform, while defensives like Utilities and Consumer Staples may fare better during downturns.



Defensive vs. Cyclical Sectors


Understanding the behaviour of defensive and cyclical sectors during different market conditions can be a powerful tool for portfolio construction. As shown in exhibit below, certain sectors tend to outperform in rising or falling markets.


For this reason, some active investors may consider overweighting defensive sectors during market downturns and cyclical sectors during upswings.



The Equal Weight Alternative


There are potential benefits of equal-weighted sector approaches, especially in industries with high concentration risk. As illustrated in the exhibit below, equal weighting can significantly alter sector exposures compared to market-cap weighting.


There are ETF products available to investors that take this equal weighted approach as this alternative strategy is becoming increasingly appealing to some investors.



Global Economic Factors


Macroeconomic factors such as interest rates, inflation, and GDP growth play a crucial role in shaping the performance of the S&P 500. For instance, rising interest rates can negatively impact high-growth sectors like Technology, while benefiting financial stocks.


While the S&P 500 is a U.S. index, as it is heavily influenced by global economic factors. Australian investors generally should pay attention to:


  • U.S. Federal Reserve policy decisions

  • Global trade tensions, particularly between the U.S. and China

  • Currency fluctuations between the AUD and USD


Conclusion


Constructing an S&P 500 investment strategy for Australian investors involves more than simply buying a broad-based index fund. By understanding sector dynamics, leveraging the power of diversification, and tactically adjusting exposures based on market conditions, investors can potentially enhance their returns and manage risk more effectively.


The S&P 500 is not just a single investment, but a rich tapestry of opportunities. By applying the insights we've discussed – from sector correlations to equal-weight strategies – we can attempt to navigate the US market with greater confidence and precision.


Royce Advisory Pty Ltd (ABN 43 622 402 706) is a Corporate Authorised Representative (CAR) of MB Capital Partners Pty Ltd (AFSL 536053). This article, commentary and discussion is general information only and is not intended to provide you with financial advice as it does not consider your investment objectives, financial situation or particular needs. You should consider whether the information is suitable for your circumstances and where uncertain seek further professional advice.


This communication is based on information from sources believed to be reliable at the time of its preparation (July 2024). However, despite our best efforts, no guarantee can be given that all information is accurate, reliable and complete. Any opinions expressed in this email are subject to change without notice and neither Royce Advisory or MB Capital Partners is not under any obligation to notify you with changes or updates to these opinions. To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information.

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