Sector Funds Trump Value

TheStreet.com

NEW YORK ( TheStreet) -- In the 1990s, academic researchers showed that low-priced value stocks had outdone more expensive growth names over long periods. That encouraged many investors to emphasize value stocks.

Some of the most popular ETFs in recent years have been value choices, including iShares Russell 1000 Value IWD and Vanguard Value VTV .

But investors who put extra weight on value recently have had little to show for their efforts. During the past 10 years, the Russell 1000 Value index returned 6.7% annually, while the Russell 1000 Growth returned 6.8%.

"The difference between growth and value is not as great as many investors have been led to believe," says Paul Baiocchi, an analyst for IndexUniverse.com. "It didn't really matter whether you took growth or value because the patterns of returns have been so similar."

Instead of emphasizing a growth or value fund, investors might as well buy the whole market, says Baiocchi. If investors want to fine tune their portfolios, then they can get more distinctive results by using funds that specialize in a sector, such as energy or financials.

"If you are looking to make a call on the economy or lower the volatility of your portfolio, you should use sectors instead of growth or value funds," he says.

In a recent study, Baiocchi and Paul Britt looked at the past performance of the major sectors of the S&P 500 as well as growth and value segments. They found that the growth and value portfolios tended to act much like the S&P 500 -- and the correlations have been increasing in recent years.

The researchers found that each sector has delivered distinctive returns. During the past 10 years, financials lost money, while utilities more than doubled. During the financial crisis, all sectors dropped at once. But since then, the sectors have resumed following distinctive courses.

During 2011, the gaps in performance were especially wide. For the year, Consumer Staples Select Sector SPDR XLP returned 14.1%, while Energy SPDR XLE returned 2.8%, and Industrial SDPR XLI lost 1.1%.

This year the Utilities SPDR XLU returned 0.7%, while Technology SDPR XLK returned 15.4%.

The sectors have come with different levels of risk. While energy stocks are volatile, consumer staples deliver steady results.

Because the sectors vary so much, they can be used to implement precise strategies, says Baiocchi. Say you want to turn defensive and prepare for volatile times. You can overweight steady sectors, including telecom and health care.

Or suppose you believe that the economy is about to boom. You could overweight the sectors that do the best in good times, including technology, industrials and materials. An investor who wants broad diversification can include a pair of sectors with low correlations, such as technology and utilities.

What sector funds should you use? Baiocchi likes the choices from the major providers, including iShares, SPDR, and Vanguard. For financial exposure, he recommends iShares Dow Jones U.S. Financial Sector Index IYF , SPDR Financial Select Sector XLF and Vanguard Financials VFH . But he cautions against mixing funds from the different sector families in the same portfolio. Because the companies use a variety of selection systems, a group of funds from different families may not provide the diversification that investors expect.

So far Baiocchi's research has not caused many investors to abandon their value funds. This year iShares Russell 1000 Value and Vanguard Value have each reported inflows of more than $1 billion. But Baiocchi hopes that his study will start a conversation about the role that sector funds could play in portfolios.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

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