Watch Out for This Hidden Risk in Your Investment Portfolio in 2024

Key Takeaways

• Sector performance can be a significant driver of a portfolio’s overall returns. If you were underweight technology in 2023, that was a major hurdle to overcome. You probably underperformed the broad market. Sector allocation really matters.
• Investors who are holding a market portfolio, maybe an exchange-traded fund that’s tracking a broad market benchmark of U.S. equities, have outsize exposure to a single sector of the economy.

Susan Dziubinski: Hi, I’m Susan Dziubinski with Morningstar. When investors construct portfolios, they intentionally diversify by asset class, by investment style, and by market capitalization as a way to reduce risk. But investors concerned about risk shouldn’t forget to diversify by sector, too. Here today to discuss why sector considerations are important when portfolio-building is Dan Lefkovitz. Dan is a strategist with Morningstar Indexes.

Good to see you, Dan.

Dan Lefkovitz: Always great to be with you, Susan.

Sector Allocations and Sector Risk

Dziubinski: Dan, you recently wrote a new paper that viewers will be able to access through a link in the transcript of this video about sector allocations and sector risk. And your research illustrates that sector performance can be a significant driver of a portfolio’s overall returns. And that was especially true in 2022 and 2023. Let’s delve into that starting really with the performance of the technology sector in those two years and its impact on portfolio performance.

Lefkovitz: It was really a dramatic turnaround. In 2022, of course, the overall equity market was down, and tech stocks were hit especially hard compared to defensive sectors and the broader market. Our technology sector index lost over 30% in 2022. In 2023, there was a rebound and our sector index was actually up nearly 60% last year. The catalyst was artificial intelligence. We had the launch of ChatGPT in late 2022, and that really built a lot of investor enthusiasm for potentially transformative new technology. So, we had Nvidia NVDA and other semiconductor stocks soar in 2023. Microsoft MSFT was another perceived beneficiary. So, if you were underweight technology in 2023, if you had below-market exposure to tech stocks, that was a major hurdle to overcome. You probably underperformed the broad market. Sector allocation really matters.

Technology Sector Success

Dziubinski: Just building on what you said about technology, your research points out that the technology sector now represents the highest percentage in the Morningstar US Market Index that it’s represented since 2000. And I think the number was around 29%. What does that mean for investors?

Lefkovitz: Well, it means that investors who are holding a market portfolio, maybe an ETF that’s tracking a broad market benchmark of U.S. equities, have really outsize exposure to a single sector of the economy. We were saying that tech was a big part of the market in 2020 and 2021. It has now surpassed the level it was at in those years. And that’s not even including some tech stocks or techie-adjacent stocks like Meta META and Alphabet GOOGL that a lot of investors might think of as technology, those got reclassified a few years ago to the communication-services sector. Then you’ve got Amazon AMZN and Tesla TSLA in the consumer cyclical sector. Tech has been far and away the best-performing sector of the economy going back 10, 15 years even. We’ve seen a lot of the dreams of the 1990s realized in terms of e-commerce, mobile computing, and the cloud. More recently, of course, we’ve had AI and cybersecurity. There’s no doubt that these trends are real and there’s a lot of innovation in the technology sector. What there is doubt about, I think, is asset prices and how much is already being discounted.

Energy Sector Risk

Dziubinski: Let’s talk about the opposite scenario with energy in 2022 and then in 2023. And again, is there any sector risk there right now considering it probably doesn’t take up quite as much of a broad market index as tech does?

Lefkovitz: Right. So, energy flip-flopped the other way between 2022 and 2023. In 2022, of course, we had the Russian invasion of Ukraine. We had supply/demand imbalances in the energy sector that sent oil prices soaring. The energy sector was by far the best-performing section of the equity market in 2022. Our energy sector index was up over 60% that year, even as the broad market was down. In 2023, those effects moderated, and energy was basically flat. In terms of energy’s market share, it’s actually gone the opposite direction as technology. So, if you look, 2008, energy was about 15% of the U.S. equity market. Now it’s about 4%.

Leadership Change

Dziubinski: Wow. That’s quite a change. Let’s talk a little bit about sector leadership change. If it can change so much from year to year, as tech and energy just showed us for the past two years, how should investors then be thinking about sector allocations as they’re building or rebalancing a portfolio?

Lefkovitz: I think sector is a big driver of investment returns. You mentioned earlier investment style and market capitalization size, geographic exposure. It’s a risk factor that I think investors need to pay attention to as they’re building their portfolios. We said that if you have a market portfolio of U.S. equities, you’ve got about 30% in technology. If you have a growth bias to your portfolio, you have even more technology, most likely. Now, on the other side, if you have a value tilt, if you’re heavy on dividends, you have less technology. If you’re diversified internationally, you have more sector diversification there. So, it’s something to be aware of.

Which Sectors Look Attractive Today?

Dziubinski: Got it. Let’s say an investor would like to perhaps lean into a particular sector today or maybe an investor practices some sort of sector-rotation strategy. What sectors today look particularly attractive?

Lefkovitz: There are different ways to do this. There are sector-rotation strategies that try to align sector allocations with the business cycle and macroeconomic factors. So, if there’s a downturn, you’d want to be more defensive. If there’s going to be a recovery, you want to be in more economically sensitive sectors. Another way to do this, another approach is to use valuation. It’s going to be longer term in its orientation. We’ve got our Morningstar equity analysts who are assigning fair value estimates to hundreds of companies across economic sectors. If you roll those up to the sector level, get a view of where sector valuation is at the market level. In aggregate, we’re currently seeing at the beginning of 2024, financial services with upside, so trading at an aggregate discount to intrinsic value; the energy sector, utilities, healthcare—all with upside. Now, it might take years for that upside to be realized. That’s not necessarily a short-term signal for 2024, but if you’re patient, we’re seeing valuation opportunities there.

Which Sectors Should Investors Avoid?

Dziubinski: Got it. And then conversely, which sectors might have less appeal today? I’m assuming technology being one of them.

Lefkovitz: Given our conversation, you wouldn’t be surprised to hear that in aggregate, our analysts are seeing the technology sector as overvalued after its big rebound in 2023, after its big runup. We did see it as undervalued going into 2023, but at this point, we think at the sector level, the upside has been realized and there’s now overvaluation in the technology sector. But you can still drill down at the company level. There’s always going to be dispersion. You can still find undervalued opportunities with individual technology stocks.

Dziubinski: Got it. Well, Dan, thanks for your time today. This is one of those overlooked risks in a portfolio. You have some great research shedding light on what investors can be looking for with that.

Lefkovitz: Thanks so much for having me, Susan.

Dziubinski: I’m Susan Dziubinski with Morningstar. Thanks for tuning in.

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Watch “The Year in Dividend Stocks” for more from Dan Lefkovitz.