Exploring Safer Investment Opportunities: A Comparative Analysis of Risk-Adjusted Performance in Defensive and Cyclical Sectors
Keywords:
Defensive Sectors, Cyclical Sectors, Risk-Adjusted Performance, Sector Rotation, Sharpe Ratio, Treynor Ratio, Sortino Ratio, Jensen’s Alpha, M-Squared Measure, Sector ClassificationAbstract
Sector rotation theory suggests that performance of different sectors relative to the overall market varies across economic cycles. To enhance risk-adjusted returns, investors reallocate capital between cyclical and defensive sectors during different phases of the business cycle. The unique behaviour and diversification characteristics of sectoral movements help investors achieve their risk diversification objectives. The objective of this study is to determine which sectoral category offers better risk-adjusted returns.
The study was conducted in three stages. First, sectoral equity indices were constructed using a float- adjusted market capitalisation-weighted index methodology. Second, sectors were classified as defensive or cyclical based on the sensitivity of their returns to changes in the market portfolio, using evidence derived from the constructed sectoral indices. Third, risk-adjusted performance measures, including the Sharpe ratio, Sortino ratio, Treynor ratio, M-squared (M2) and Jensen’s alpha, were calculated and compared.
The study covered the period from 1 January 2009 to 31 December 2023. 20 sectoral indices were constructed, out of which seven were classified as defensive and 13 as cyclical. The findings indicate that defensive sectors outperform cyclical sectors on a risk-adjusted basis. Furthermore, defensive sectors appear less exposed to market volatility, making them relatively safer and more stable investment options. In contrast, cyclical sectors offer the potential for higher returns but are accompanied by greater risk. These results remain consistent across all risk-adjusted measures employed in the study. The findings provide valuable insights for investors, policymakers and regulators seeking to make informed investment decisions.
JEL Classification: G11, G12, E32, C43, G18
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