The Essence of Sector-Based Investment
A sector-based investment strategy refers to evaluating the investment potential of companies primarily based on their industries or sectors as opposed to focusing on individual stocks in a sector-neutral way. It involves allocating capital to companies that operate in a particular industry, such as technology, healthcare, or energy. This type of strategy allows fund managers and investors to target specific sectors with growth potential or build a diversified portfolio.
For instance, a fund manager may invest in the healthcare sector by selecting a group of companies that produce pharmaceuticals, medical devices, or provide healthcare services. This approach can provide investors with exposure to a specific area of the market and potentially generate higher returns than a “sector-agnostic” approach. The key idea, of course, is to identify the sectors with high growth potential in the medium- or long-term future.
While most other investment strategies use a specific stock/company as a unit of analysis, sector-based investment focuses on entire industries and niches.
The Key Advantages of Sector-Based Investment
Sector-based investment has a number of advantages over sector-agnostic strategies:
1. One obvious advantage is the potential for higher returns. By focusing on a specific high-growth sector, investors can gain exposure to companies that have the potential to outperform the broader market.
2. Across-sector diversification. Sector-based investment doesn’t imply focusing on one industry only. In most cases, fund managers and investors will look at a number of sectors. In addition to investing in potentially high-growth sectors, you may hedge risks by adding more stable and established sectors to your portfolio.
3. Within-sector diversification. A great approach when using sector-based investing is to allocate some funds towards the more stable niche leaders, while also not forgetting about high-potential smaller and newer players. By doing so, you are essentially diversifying within the sector itself.
4. Building expertise and unique insight within a sector. Having unique insight and expertise within a specific industry can be extremely valuable in the game of outperforming your competition. Sector-based investing allows you to acquire deeper knowledge of the chosen sector(s). This knowledge is often valuable when targeting the sector in subsequent cycles of portfolio rebalancing.
The deeper expert knowledge of the sector might come in particularly handy to hedge funds that go on to take a significant stake in a company involved in an innovative or emerging field.
Disadvantages and Risks of Sector-Based Investment
1. Concentration risk. A major risk with the sector-based approach is a potential heavy concentration on one or a number of correlated industries. This largely stems from using sector-based strategies that aim to maximise returns. As a result of chasing only or mostly the coveted high-growth sectors, fund managers might inadvertently concentrate investment in a small number of correlated or volatile fields.
The concentration risk is also present when you diversify only within a sector. Naturally, the best way to avoid the concentration risk is to employ across-sector diversification and balance high-growth industries with more stable ones.
2. Limited investment options in small or highly concentrated sectors. If your chosen sector has only a couple of viable players (at least by the minimum acceptable standards of your fund) to invest in, your options are naturally going to be limited. This might easily happen in young and emerging industries.
3. Poor applicability to short-term investment goals. Sector-based investment is largely a medium- and long-term investment game. You are betting on an entire sector doing well, not on one specific company shooting up, which might take some time to materialize. As such, shorter-term investments are probably bad candidates to be evaluated through the prism of the sector-based model.
4. Lack of necessary expertise. In the section on the sector-based strategy advantages, we noted that this investment strategy is great for deepening your knowledge of the chosen sector. However, some pre-requisite knowledge of the sector is, of course, required before you can even start assessing the niche. If no necessary expertise is present, investing in a specific sector, no matter how lucrative it looks, is best avoided. This is going to be particularly applicable to emerging industries, where the necessary body of knowledge is inherently limited.
Sector-based investment can work very well if there are promising sectors on the horizon or if a good, diversified mix of sectors is identified. It could be a refreshing alternative to other popular strategies, e.g., long/short investing, that normally take a sector-agnostic view of the market. Additionally, it is possible to combine the sector-based strategy with other investment strategies to optimise your market moves. Indeed, nothing prevents a fund manager from first selecting the right sectors and then using the long/short strategy to identify undervalued and overvalued stocks within that niche. Thus, you might use the sector-based approach as an add-on to your key investment strategy and have the best of both worlds.