Sector neutral portfolio

A sector neutral portfolio is a portfolio that is constructed in such a way that it does not take any active positions or ‘active risk’. This means that the portfolio does not deviate from the benchmark weights to which the portfolio is compared. This is the most common definition of a sector neutral portfolio.

Alternatively, a sector neutral approach to portfolio construction can also mean that the signals used by the manager to pick securities are sector neutral. In this case, the signals are standardised (i.e. turned into z-scores) at the level of the sector or industry group such that they are comparable across different industries or sectors.

On this page, we discuss both types of sector neutrality and provide an example of how to make a portfolio sector neutral.

Sector neutral investing

The easiest way to perform sector neutral investing is to impose constraints in the portfolio optimization on the sector or industry-group weights. This means that, when we pick securities, we only pick within securities within each sector but do not change the overall weight of each industry group or sector. In other words, we do not allocate more or less to a particular sector compared to the benchmark. This kind of sector-neutrality is easy to apply and easy to understand.

The second type of a sector neutral strategy is somewhat more involved, but is commonly used by quantitative fund managers.

A sector neutral strategy

The second sector neutral approach works as follows. We calculate different signals for the universe of securities we wish to invest in. This can be stocks’ company fundamentals or security characteristics. Next, we standardize the signals (i.e. calculate a z-score) of the signals.

We do not calculate the z-score across all stocks, but instead calculate the score within each group of companies within every sector or industry group. This makes the signals sector neutral.

Sector neutral example

To understand why this works, let’s discuss a simple example. Suppose we have two sectors, banks and utilities. Let’s calculate the leverage of companies in both sectors. We know that banks are more heavily leveraged than utilities. If we would now calculate the z-score across all stocks, the banks would have high z-scores and the utilities companies would have low z-scores. As a consequence, our signal is not sector neutral. If we were to allocate more to the less leveraged companies, we would in fact be buying utilities, and selling banks.

Now, instead of calculating the z-score across all stocks, let’s calculate a z-score across all banks, and then separately a z-score across all utilities. Then, high z-scores will be assigned to the utilities with the highest leverage within utilities and the most leverage banks within the banking sector. This results in a measure of leverage that is said to be ‘sector neutral’.

Conclusion

It is fairly easy to make a portfolio sector neutral by imposing weights. Alternatively, the manager can also make the signals he or she uses sector neutral. Simple standardizing the signal at the level of the industry group or sector does the trick. This can easily be done using some spreadsheet software such as Excel.

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