Look At Overseas Sectors, Too

09/22/2009 11:30 am EST

Focus: MARKETS

Alexander Young

Equity Market Strategist, S&P Capital IQ

Alec Young, equity strategist for Standard & Poor’s, says investors need to factor sectors into their international as well as their domestic investing strategy. 

While US investors have been investing in domestic, sector-specific investment vehicles for years, in the international arena, Americans remain largely focused on regional and/or country-level exposure at the expense of targeted overseas sector-level allocations.

Standard & Poor’s Equity Research believes the inclusion of dedicated foreign sector exposure [can] increase overall international equity portfolio performance.

S&P Index Services, which operates independently of S&P Equity Research, maintains the S&P BMI Developed ex-US index, which is [composed] of 24 developed foreign markets dating back to 1989. State Street Global Advisors licensed the index data and created a line-up of international sector ETFs that track all ten sectors of this index.

Over the past 20 years, six of the ten Global Industry Classification Standard (GICS) sectors that comprise the index have outperformed it on a risk-adjusted basis—several by a very wide margin.

Our analysis revealed a wide dispersion of sector-level, risk-adjusted returns relative to that of the broader index, demonstrating the alpha-generation potential of targeting specific sectors to overweight and underweight rather than simply passively investing in the broader index.

Of course, the same sectors are unlikely to outperform indefinitely, but we do know there will always be sector leaders and laggards, thereby validating, in our opinion, the alpha- generation potential of targeted sector investing.

S&P Equity Research believes the more metrics exist that meaningfully differentiate sector performance from that of the broader index, the more compelling the case for sector investing.

Dividend yields are a case in point. Four sectors sport higher yields than the broader BMI Developed ex-US index’s recent 2.86%, making this metric another way to add value with targeted overseas sector investing.

It is also worth noting that nine of the ten international sectors recently yielded more than the S&P 500’s 2.1%, as dividend yields for foreign stocks are generally much higher than those for US shares.

In addition, the relatively low correlation of certain sectors with the index allows investors to boost international equity portfolio diversification by including targeted sector positions. Lastly, the fact that each sector has a different geographic mix than the index is yet another reason to explore targeted sector exposure.

The ability to overweight and underweight individual international sectors offers US investors the potential to outperform broad regional indexes during both bull and bear markets, in our view. As in the US, [international sectors] can be divided into two categories: economically sensitive cyclical sectors that have historically outperformed during economic expansions and countercyclical defensives that have traditionally outperformed during recessions.

This historical pattern has held true in the current cycle, with defensives largely outperforming the S&P BMI Developed ex-US index during the October 2007 through February 2009 bear market, while cyclical sectors have largely outperformed since the early March low.

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