Most investors buy sector-specific mutual funds or exchange-traded funds for investment reasons—because they think a sector has exceptional growth potential, attractive dividends, or low valuations. But do sector funds merit a place in investors’ portfolios for diversification reasons?
The short answer: not really. While energy stocks have recently exhibited low correlations with the broad US equity market, and utilities looked like good diversifiers before that, both sectors have underperformed the Morningstar US Market Index over the past 10- and 15-year periods. Moreover, the value of any specific sector as a diversifier will tend to wax and wane, and investors have done a poor job of timing their purchases of sector funds and ETFs.
Recent Performance Trends
The Morningstar US Market Index soared by 24% in 2024, but performance was widely dispersed. The technology and communications services sectors both notched gains of more than 35%, while the healthcare, basic materials, and real estate sectors posted only modest gains.
The Morningstar US Energy Index exhibited the lowest correlation with the Morningstar US Market Index over the past three years. The sector had a correlation of 0.79 with the US market at the end of 2021, but it dropped to just 0.37 by the end of 2023 and sat at a still-low 0.43 at the end of 2024. Meanwhile, the utilities sector—the diversification champ among sectors at the end of 2021—saw its correlation with the US market increase from 2022-24.
On the flip side, the technology sector has been a notably weak diversifier for investors who already have broad US market exposure. That’s not too surprising when you consider that tech stocks account for 30% of the Morningstar US Market Index. Moreover, tech sector indexes tend to be dominated by a handful of companies. Apple AAPL and Microsoft MSFT, for example, make up 35% of the Morningstar US Technology Index. Consumer cyclical stocks and industrials have also shown a tight correlation with the broad market.
Longer-Term Trends
Over the past few decades, utilities and energy have been the sectors that have performed most differently from the broad US market. From 2022 through 2024, energy stocks decoupled from the broad US market. The consumer defensive sector has also had a somewhat lower correlation with the US market than other sectors. Meanwhile, the tech sector’s performance movements have been consistently correlated with those of the broad US market about 90% of the time.
Some advisors recommend that investors carve out a separate allocation to real estate stocks with an eye toward boosting yield and diversification. The anticipated yield on the Morningstar US Real Estate Index is currently more than double the yield on the Morningstar US Market Index, but the Morningstar US Real Estate Index has been an underwhelming diversifier over long-term periods, with correlations typically hovering around 0.70 and nearly 0.90 recently.
Portfolio Implications
With the exception of utilities and energy, sector-specific indexes have generally exhibited performance that was closely aligned with the broad market. Thus, there doesn’t appear to be a strong portfolio construction case for layering on sector-specific exposure in a diversified equity portfolio that also includes exposure to that sector. Investors may wish to emphasize them for valuation or other factors, but that is a separate issue.
Utilities have exhibited the lowest correlation with the overall market of any of the sectors over longer time frames. More recently, however, energy stocks have been the best diversifier for a broad US stock portfolio. Both sectors have significantly underperformed the US market over the past 10- and 15-year periods, however. (The Morningstar US Energy Index’s 15-year return is the lowest of all sectors.)
Another caution—though beyond the scope of our Diversification Landscape research—is that investors have historically done a poor job with sector-fund timing. As noted in the 2024 “Mind the Gap” research paper on dollar-weighted returns, investors in sector-equity funds ceded nearly 30% of their funds’ total returns owing to poorly timed purchases and sales. That suggests that investors and advisors bring a healthy dose of humility when deciding whether and when to add sector funds or ETFs to a portfolio that’s already well diversified.
