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Is a Core or Sector Index the Superior Option for You?

02/13/2019

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Investors understand that indexes help monitor the performance of various equities and stocks. The next consideration for investors and speculators would be to ask which type of index provides the most accurate reflection of a given market, and will ultimately help people achieve better returns now and in the future.
This article will better explain the differences between sector and core indexes, each of which bring their own respective merits and drawbacks to the table. Read on to learn more.

What is a Core Index?

Otherwise known as a broad-market index or a total market index, a core index attempts to capture the entire equity market within a single index. While some indexes such as the Dow Jones or S&P500 focus on a select group of equities or securities, a core index tries to overview the entire market.

Examples of core indexes include the Russell 3000 and the Wilshire 5000 total market index, both of which cover over 95% of the U.S. market cap. The Russell 3000 follows over 98% of U.S. incorporated equities, Both of these indexes are capitalization-weighted indexes, meaning that mega-cap stocks such as Apple hold greater weight within the indexes than stocks with lower market caps.

Given that core indexes cover almost the entirety of the market, it’s also true that core indexes contain equities from all eleven sectors of the stock market.

Limitations of a Core Index

Core indexes run into the same problem as other cap-weighted indexes, in that mega-cap stocks still drive the index. While inexperienced investors may buy into a core index such as the Russell 3000 believing that they are investing across market caps of different sizes, the reality is that a core index such as the Russell 3000 moves in a corresponding fashion to a cap-weighted index such as the S&P500.

This isn’t to say that investing in a core index has no merit, or that listing most of the stocks within a given market is a bad idea. This is just to say that a core index has similar limitations to a cap-weighted index, and can be expected to behave and perform similarly.

In fact, some investors regard the S&P500 as a total market index, given that it includes the vast majority of market-moving stocks.

Alternatives to Core Indexes

Core indexes are widely used to interpret the performance of various markets, but as explained above, they are not without their shortcomings. As such, investors are always looking for new ways in which to analyze the market, and perhaps spot an equity with underappreciated value. A different way to analyze various markets is through the use of sector indexes. Sector-specific indices – such as the Nasdaq Health Care (IXHC) Index – were composed to measure the performance of equities within given sectors. This is another way to look at the market, and perhaps gain better overall insight.

What Exactly is a Sector?

Sectors are generally defined as areas of business or commerce in which similar goods or services are produced or rendered. This is a fairly-broad definition, and perhaps a better way to think of it would be to say that companies within a sector share a number of characteristics. Economies are typically divided into sectors so that they can be monitored and analyzed more closely. As it concerns equities and investing, the respective sectors each have unique attributes that would attract a particular type of investor, as well as the corresponding risk that an investor or group would need to manage. The U.S. stock market is currently divided into 11 different sectors, with Real Estate breaking off from the Financials sector in 2016. It’s quite typical for an investor or group to specialize in a certain sector, such as Financials or Healthcare.

Investment funds are also apt to focus on a single sector, though the investor pool might include contributions from experts in other sectors. The practice of creating a collective fund within a given sector is called sector investing.

Differences Between Industries and Sectors

While different industries are certainly represented by stock market sectors, industries in general are smaller and more specific than those represented by the 11 stock market sectors. There are a number of sector classification systems in place, with one of the most accepted being the Global Industry Classification Standard (GICS). This system recognizes the 11 sectors, 24 industry groups housing 68 total industries, and 157 sub-industries. Stock market sectors are often tracked by specific exchange-traded funds (ETFs) dedicated to the sectors themselves. For example, the Health Care Select Sector SPDR Fund (XLV) exclusively tracks changes within the Healthcare sector. Shares of the XLV can also be bought and sold like traditional stock shares.

What is a Sector Index?

As noted above, a sector such as the Nasdaq Health Care Index is an example of a sector index. As one would expect, the index was created to specifically monitor the Health Care sector, and there are indices across all sectors that mirror it.

Overview of Various Sectors

Below is a brief overview on the various sectors of the U.S. stock market:

Consumer Discretionary

As the name suggests, this sector is dictated by the discretionary income of consumers spending within the U.S. Discretionary purchases are considered non-essential, and this sector includes more indulgent purchases such as retail outlets, apparel companies, media companies, and other services in which discretionary income is the driver. An example of a consumer discretionary index would be the Consumer Discretionary Select Sector SPDR Fund, or XLY.

Consumer Staples

Standing in contrast to the consumer discretionary sector is the consumer staples sector, which focuses on essentials such as food, beverages, toiletries, and other items that are mostly recession-proof due to the unwillingness of consumers to trim them from their budgets.

Energy

Fossil fuel commodities such as gasoline and crude oil are the primary drivers of the energy sector. The sector also includes refineries and other companies directly tied to energy production.

The Vanguard Energy ETF is one of the largest and most popular sector-based indices for the energy sector.

Financials

Consisting of banks, mortgage firms, insurance companies – pretty much anything to do with money management – the financials sector is what many people picture when they think of Wall Street or equity investment. This sector generates revenue mainly via rising interest rates tied to housing loans and mortgages.

Real Estate

As noted above, the real estate sector become such an area of interest to investors that it split off from the financial sector entirely in 2016. The sector includes commercial, industrial, and residential real estate. Real estate generates the bulk of its income via rent payments and and real estate capital appreciation. As such, fluctuating interest rates on loans can affect the health and performance of this sector.

Health Care

Composed of all matter related to medical treatment, the health care sector is seen by investors as both a safe play and a growth opportunity. The need for medical care will persist, and as baby boomers continue to age, this need is anticipated to rise.

In addition to companies directly tied to medical treatment such as hospital groups, the sector also includes medical device companies, research groups, biotech divisions, and so on.

Industrials

As one would expect, the industrials sector mainly revolves around heavy machinery production. This can include aerospace, defense, large construction equipment, and fabrication facilities, as well as any companies that support those ventures.

Materials

The materials sector accounts for companies built on mining, refineries, and any other businesses that primarily focus on turning raw materials into coveted goods or services.

The VanEck Vectors Gold Miners ETF (GDX) is a large index that investors and speculators use to monitor the materials sector.

Technology

This sector is pretty straightforward, consisting of IT firms, software developers, and all other forms of electronics or tech. Many of the mega-cap stocks, such as Google, are categorized as technology sector equities. An examination of the XLK holdings also would show such heavy-hitters as Microsoft, Apple, Visa, and Cisco, just to name a few other big-name companies.

The health and performance of the technology sector obviously rises during cycles of innovation, and has grown consistently for the last 30-40 years.

Telecom

Telecom consists of all the wireless providers, internet service providers, and cable companies. As one would suspect, the sector is currently very healthy, as the sector generates significant revenue from recurring consumer billing.

Utilities

Lastly, the utilities sector is comprised of the gas, water, and electric companies, in addition to providers who are tied to those commodities.

Choosing Between a Core Index vs. a Sector Index

The limitations of a core index were explained above, with the main drawback being that a core index, like any cap-weighted index, is going to be driven by the performance of the mega-cap stocks.

This does not always give an accurate representation of a market on the whole. Sector indexes allow investors and speculators to examine markets through a different prism, and to thus get a new and sometimes clearer view on investment opportunities. And while diversification is always critical, a sharp investor could locate additional market opportunities in a sector that he or she understood particularly well. While a strict focus on a single sector index could give an analyst or investor tunnel-vision, monitoring select sector indexes in addition to a few cap-weighted or factor-based indexes could give an investor tremendous overall insight.

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