The importance of sector constraints

Abstract

History provides plenty of examples of individual sectors reaching unsustainable market capitalizations relative to the total value of the market. When these sector weights fall back, it can be catastrophic for investors. Examples include energy in the early 1980s, the post millennium tech bust and the recent crisis in the financial sector. Getting in and out of the right sectors at the right times is difficult for several reasons, including the nature of the economy and the limitations of models that rely on macroeconomic variables as inputs. Previous studies suggest that putting a cap on sector weightings allows investors to avoid the most serious damage from these 'sector corrections'. We find support for this at the broad MSCI Global Industrial Classification Standard sector level using 20 years of data. © 2014 Macmillan Publishers Ltd.