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As a participant in today's financial industry, you can't afford to become a prisoner of your own past thinking. Periodically, advisors should examine old ideas in a new light. Techniques ridiculed as nonsense a few years ago may make good sense for you and your clients today.

An example may be the concepts of "sector-based investing" and "sector rotation." In this article, I'll suggest why you should open your mind to these ideas.

As you know, the U.S. stock market is divided among broad sectors of economic activity that are tracked differently by various research services. For example, Barron's tracks eight sectors and Morningstar 12. However, the investment world is now rallying around one standard for sector-based analysis called "Global Industry Classification Standard (GICS)." Jointly developed by Morgan Stanley Capital International and Standard & Poor's, GICS currently divides stock markets into 10 sectors, 23 industry groups, and 59 industries. You can learn details about GICS at:

http://www.msci.com/equity/gics.html

The market weightings of the 10 U.S. market GIC sectors, as a percentage of the S&P 500 Index as of 12/31/02, are shown below. This table also shows their weightings in the S&P BARRA Large-Cap Growth and Large-Cap Value sub-indexes.

GICS Sector Weightings as of 1/31/03    S&P 500  LC Growth  LC Value 1.     Consumer discretionary 13.4% 12.1% 14.8% 2.     Consumer staples 9.5% 16.7% 2.1% 3.     Energy 6.0% 0.1% 12.0% 4.     Financials 20.5% 5.7% 35.4% 5.     Health care 14.9% 27.3% 2.4% 6.     Industrial 11.5% 12.6% 10.5% 7.     Information tech. 14.3% 21.7% 6.7% 8.     Materials 2.8% 0.8% 4.9% 9.     Telecom 4.2% 3.0% 5.4% 10.   Utilities 2.9% 0.0% 5.8%   Source: Morgan Stanley Quantitative Research

• A sector-based investment discipline allocates a client's assets among these 10 areas based on a broad diversification strategy, while often seeking to overweight or underweight specific sectors relative to the index.
  
  
• A sector rotation strategy seeks to increase returns by varying these weightings as an economic cycle progresses.

Annualized Annual Returns of the 10 GICS Sectors for periods ending 12/31/02       3 Years   5 Years   10 Years   1.     Consumer Discretionary -14.5% 2.0% 7.8%   2.     Consumer Staples 1.6% 0.5% 9.8%   3.     Energy -3.4% 1.4% 10.3%   4.     Financials -1.5% 2.0% 14.0%   5.     Healthcare -3.8% 2.8% 12.8%   6.     Industrials -10.3% -0.7% 9.3%   7.     Information Tech -35.0% -2.5% 12.5%   8.     Materials 2.4% 7.5% 10.3%   9.     Telecom -29.7% -8.8% 2.3%   10.   Utilities -9.5% -5.0% 3.1% Source: Wilshire

Shunned in the 90s

During the 1990s, most financial advisors shunned sector-based investing and rotation, for valid reasons. During sustained bull markets, these strategies do not work as well as buy-and-hold investing or style-based asset allocation. Also, the U.S. experienced a record post-war expansion, 120 months in duration, that "upset the applecart" of how sector rotation is supposed to work. Finally, it wasn't easy to implement sector strategies during the 90s using either mutual funds or individual securities. Due to these drawbacks, many financial advisors still disparage sector strategies as an exercise in trying to outguess trends that are notoriously fickle.

But is that "prisoner-of-the-past" thinking? Our answer will focus on three key changes that have enhanced sector-based investing.

What has changed?

1. Financial markets and economic cycles--There have now been 10 U.S. economic cycles since 1945. The average expansion phase has lasted 57 months and the average contraction phase 11 months. On average, stock market peaks and valleys have occurred seven months prior to the corresponding points in economic cycles. (Historically, the stock market has been a reliable predictor of market cycles.) Now, many analysts are projecting that average stock market returns over the next decade will be in the mid to high single digits. In such a slow-growth environment, one opportunity to outperform the market average may lie in shifting assets among sectors as economic cycles progress. This technique could become relatively more attractive if cycles return to their traditional duration, instead of repeating the "extended expansion" pattern of the 90s.
   
   
2. Better instruments with more cost efficiency--Over the past 3-4 years, sector investing has been enhanced with the introduction of sector-based mutual funds and exchange-traded funds (ETFs). If single-digit stock market returns dominate the next decade, cost-efficiency could become a critical factor in any strategy's ability to outperform. Thanks to economical sector ETFs, a sector-based strategy can be among the most cost-effective of all investment disciplines to implement. This gives fee-based advisors flexibility to set their own earnings at profitable levels, without creating an impediment to performance.
   
   
3. Discipline and risk control--In the bear market's aftermath, many investors want a structured discipline that emphasizes risk control. In style-based asset allocation, it's hard to shield equity investors from the stock market's overall risk, because all style categories correlate somewhat strongly with the S&P 500 Index and each other. (The lowest correlation between styles, .65, is between large-cap growth and mid-cap value.) In sector-based investing, three of the 10 GICS sectors have correlations with the S&P 500 of .40 or below, and a number of sector pairs have correlations of .25 or below, according to the research firm FactSet. This increases the advisor's ability to combine sectors into attractive "efficient frontiers" for risk-control purposes. Research coverage of sectors also has greatly expanded in recent years. For example, Morgan Stanley publishes a quantitative model, updated monthly, which ranks all 10 GICS sectors on the basis of six numerical factors. By applying such a model to help investors select or weight sectors, advisors can create a consistent investment discipline that is very efficient to monitor and manage.

Style-Based vs. Sector-Based Correlations

The table below compares correlations of the S&P 500 paired with both style-based asset classes and GICS sectors. It also shows the lowest correlations between pairs of styles and sectors.

Style-Based Pair Corr.   Sector-Based Pair Corr. S&P 500 LC Growth 0.96   S&P 500 1. Cons. Disc. 0.86 S&P 500 LC Value 0.94   S&P 500 2. Cons. Staples 0.11 S&P 500 MC Growth 0.84   S&P 500 3. Energy 0.59 S&P 500 MC Value 0.79   S&P 500 4. Financial 0.75 S&P 500 SC Growth 0.78   S&P 500 5. Healthcare 0.40 S&P 500 SC Value 0.75   S&P 500 6. Industrials 0.84 Lowest correlating style pairs   S&P 500 7. Inform. Tech 0.86 LC Growth MC Value 0.65   S&P 500 8. Materials 0.68 LC Growth SC Value 0.66   S&P 500 9. Telecom 0.68         S&P 500 10. Utilities 0.33         Lowest correlating sector pairs         Cons. Stap. Inform. Tech -0.21         Utilities Telecom 0.00         Utilities Inform. Tech 0.04         Cons. Stap. Telecom 0.05         Cons. Stap. Cons. Discr. 0.08         Healthcare Inform. Tech 0.11 Source: FactSet for the 3-year period ending 1/03.

Sector-Based Strategies

Below are specific ideas for implementing sector-based investing and rotation into your investment strategies.

• Asset allocation -- Sector-based asset allocation can be a viable alternative to style-based allocation. For example, you could create a model consisting of ten asset classes by deleting the three smallest GICS sectors by market weight-Telecom, Utilities and Materials-and adding bonds, cash and international equities. (The seven remaining GICS sectors cover 92% of the U.S. stock market by weight.) A growth or value focus could be added by emphasizing specific sectors. For example, overweighting Financials and Energy would create a value focus, while overweighting Health Care, Consumer Staples and Information Tech would create a growth focus.
  
  
• Indexing and tax managing -- As shown in the table below, Sector SPDRs are currently available in all GICS sectors except Telecom. So, it's possible to create an index-like fund by combining sector ETFs. For example, buying Sector SPDRs in amounts that correspond to their market weightings would approximate the performance of the S&P 500 Index. (Sector SPDRs correlate to GICS sectors at a near-perfect level.) Several large NYSE firms are now advocating this strategy for tax-optimization. At the end of each year, they suggest that sectors with negative performance be sold to harvest tax losses. The same positions can be bought back after 30 days (the "wash sale period") or else similar ETFs can be substituted. iShares Dow Jones sector ETFS correspond to GICS sectors closely enough to make them viable alternatives to Sector SPDRs, and also the best choice for Telecom exposure.
  
  
• Actively-managed funds -- Several fund groups such as Fidelity, Rydex, Morgan Stanley, MFS and Invesco now offer series of actively-managed sector funds, but there are two problems with them. First, their expense ratios typically run 1.5% -2.5%, compared to .28% for Sector SPDRs. So, they tend to be relatively high-cost implementation tools, especially for fee-based advisors who layer an asset-based charge on top of fund expenses. Secondly, few actively managed sector funds correspond closely to the 10 GICS sectors. For example, many of Fidelity's popular sector funds actually track industry groups, not GICS sectors.
  
  One actively-managed approach that can make sense is to offer a "sector rotation asset class" implemented through one mutual fund whose manager makes allocation and rotation decisions among sectors. Several choices include Rydex Sector Rotation, T.O. Richardson Sector Rotation, MFS Managed Sectors Fund, and Oppenheimer Multi-Sector.
  
  
• Specific sectors and pairs -- One of the 10 GICS sectors stands out for meeting the needs of today's cautious equity investors, and that is Consumer Staples. While it is fundamentally a large-cap growth sector, Consumer Staples has the lowest correlation with S&P 500 Index performance: 0.11. It also correlates very low with Consumer Discretionary, Energy and Financials and negatively with Information Tech. That means an overweight in Consumer Staples could offset some of the volatility inherent in these sectors. Combining Consumer Staples with any grouping of these other sectors produces a more attractive historic risk-adjusted return than the S&P 500 Index as a whole. Consumer Staples was one of the two GICS sectors (along with Materials) to finish the three-year bear market period 2000-2002 with positive performance.
  
  
• Passive rotation -- A sector rotation strategy need not be aggressive to pay off. The most passive rotation strategy is simply to rebalance each sector back to a model weighting at the end of each period. During the bear market of 2000-2002, this would have preserved assets better than rebalancing a style-based allocation, because it would have specifically whittled back exposure to Information Tech and Telecom. Another relatively passive strategy overweights the best performing sectors on a lagging basis, perhaps quarterly, on the assumption that the momentum of an economic cycle will continue for at least several more quarters.
  
  
• Active rotation -- Smart financial advisors who pursue active rotation strategies combine common sense with proven expertise in identifying sector trends. This expertise may be obtained from a few Registered Investment Advisors who have produced credible track records in calling sector moves, and also from quantitative models that avoid guesswork. Even if an active rotation strategy is not always on target, it can give clients the discipline they need to maintain their investment commitment, along with the confidence that professionals are taking action to anticipate and adjust portfolios based on current trends.

During the booming 90s, buy-and-hold strategies built around passive asset allocation made sense and were rarely questioned by profit-happy investors. However, it may be "prisoner-of-the-past" psychology to assume that in the more difficult markets ahead, investors will pay hefty fees to advisors who do little or nothing to adjust portfolios. At the least, a sector-based strategy with some rotation can demonstrate professional service that responds to today's market dynamics.

Sector-Based ETFs

The table below lists the 10 GICS sectors along with their corresponding Sector SPDR Exchange-Traded Funds (ETFs). Alternative ETFS also are shown.

Sector    Sector SPDR Symbol    SPDR Expense    Ratio SPDR Assets $ millions          Alternative ETFs 1. Cons. Discretionary XLY 0.28% 134 iShares DJ US Consumer Cyclical 2. Cons. Staples XLP 0.28% 225 iShares DJ US Consumer Non-Cyclical 3. Energy XLE 0.28% 274 iShares DJ US Energy 4. Financials XLF 0.28% 652 iShares DJ US Financial Sector iShares DJ US Financial Services 5. Health Care XLV 0.28% 132 iShares DJ US Healthcare Sector 6. Industrials XLI 0.28% 236 iShares DJ US Industrial 7. Information Tech XLK 0.28% 984 iShares Goldman Sachs Tech, iShares DJ US Tech 8. Materials XLB 0.28% 247 iShares DJ US Basic Materials 9. Telecomm None N/A N/A iShares DJ US Utilities Sector 10. Utilities XLU 0.28% 505 iShares DJ US Utilities Source: Morgan Stanley

freeERISA.com FOCUS:

Stay Abreast of Changes in Non-Qualified Plans

FreeERISA.com offers several databases that can help you identify companies in your market that offer qualified retirement plans. They also offer one database of "Top Hat Plans"-- unfunded deferred compensation plans that are required to declare their existence in a public filing. (These plans are not required to file a report annually.)

So, while you can't usually tell from FreeERISA data whether or not a company in your market offers non-qualified benefits for a select group of key executives, it's a good idea to ask about these plans as you prospect. Among companies with 50 or more employees, you may find that a significant number offer either a non-qualified deferred compensation (NQDC) program or a Supplemental Executive Retirement Program (SERP). When you can serve both a company's qualified plan and also its non-qualified executive plan, you will increase your revenue potential and time efficiency in selling and servicing accounts.

In an NQDC, executives typically agree to defer part of their pay in exchange for promised future benefits. In a SERP, the employer and executive agree to future benefits that will be paid to the executive (typically in retirement or at death), often based on the executive's service continuity and performance. NQDCs and SERPs differ from qualified retirement plans in two important ways: 1) they may discriminate in favor of highly-paid employees and key managers; 2) they are more likely to be funded with life insurance. Along with Corporate Owned Life Insurance (COLI) and "split-dollar plans," these programs have become important sources of business for life insurance companies and agents. COLI is sometimes used to provide funding for NQDCs and SERPs. Split-dollar is an arrangement under which an executive receives life insurance coverage and benefits, while the company typically pays premiums and then recovers those premiums at death or payout.

While there are many issues in qualified retirement plans that you can discuss with companies in your market, you also can make them aware of important developments affecting COLI, split-dollar NQDCs and SERPs. In qualified plans, you have plenty of "good news" to report such as higher contribution limits, new tax credits, and increased benefit formulas. In non-qualified plans, however, most recent news is not positive. Some of it threatens existing plans, and all of it is highly technical and confusing. This presents an opportunity to help companies in your market "sort the wheat from the chaff" and then make decisions or changes.

Focusing on the Big Picture

The "big picture" has two parts. In part 1, Congress loves qualified retirement plans and has bestowed on them more benefits, while the IRS distrusts non-qualified plans and has persistently sought to curtail them. Part 2 is called "Enron fallout." Among Enron's many schemes, several involved flagrant abuses of non-qualified plans to heap rewards on the top executives at the center of the scandal. Details on specific financial arrangements are only now emerging, so the fallout continues.

The best way to help companies in your market address specific concerns about these plans is to team up with an expert, such as a benefits consultant or tax attorney. The summary below is meant to help you discuss developments with this type of expert, or probe for needs that a specialist can help your prospects or clients address.

COLI

The major threat to COLI has come from the IRS, which has successfully prosecuted several lawsuits against companies that created questionable plans. Typically, these companies bought life insurance coverage on large groups of employees, often without their knowledge. These policies featured large amounts of premiums and cash value build-up along with attractive loan provisions. Soon after funding such policies, companies would borrow millions of dollars from cash value (to fund more premiums) and claim large tax deductions for interest expense. In three prominent 2002 cases involving American Electric Power, Winn-Dixie Stores, and Camelot Music, the IRS won court decisions disallowing millions of dollars in claimed interest deductions. The IRS revealed in court filings that it is currently investigating 50 similar corporate plans and expects to challenge them, also. In two official announcements (2002-96 and 2002-97), the IRS offered to settle with corporate taxpayers who voluntarily terminated abusive COLI plans and paid taxes and penalties, prior to litigation.

Interpretation: COLI has been used by responsible companies for more than 60 years. Ironically, it played an important role in helping some companies at Ground Zero recover from the shattering effects of 9/11 and the deaths of employees. The IRS is specifically targeting companies that claim large interest deductions or engage in "basis shifting" techniques. COLI programs designed to emphasize death benefit protection do not appear in jeopardy. It is possible that future regulations will require disclosure to employees that the company owns life insurance in which they are insured. Also, in the current environment of IRS scrutiny and litigation, all companies are looking at COLI more cautiously and with greater compliance concern.

Split-Dollar Plans -- Here, the IRS is wearing the "white hat." Two clouds hovered over split-dollar in 2002, one created by the IRS and another by Congress. In a revenue ruling, the IRS had cast doubt over the tax consequences of "equity" split-dollar arrangements in which the employer pays premiums on a policy owned by an employee. Then, in response to Enron and other corporate scandals, Congress passed the Sarbanes-Oxley Corporate Responsibility Act of 2002. Among its provisions was a controversial Section 402, which prohibited public companies (under threat of criminal sanctions) from issuing loans to directors or executive officers. This created confusion regarding whether split-dollar arrangements would be considered loans between public companies and their directors or executives.

In January of this year, the IRS provided some relief by issuing Notice 2002-8. This ruling clarified that split-dollar may be deemed a loan only if the employee owns the policy. Also, it determined to what extent premium payments made by the company, on policies owned by the company, may generate currently taxable income for the executive.

Interpretation: Split dollar has been in existence for 35 years and is among the most popular programs benefiting key executives. Clearly, there are concerns raised by Sarbanes-Oxley for public companies that establish these programs for directors or officers. Currently, the Securities and Exchange Commission is considering amendments that would require companies to disclose these arrangements in public filings (8-Ks), even if they do not constitute prohibited loans under Sarbanes-Oxley. For other companies and arrangements, the IRS has now provided a road map for how split-dollar plans should be structured. In general, the life insurance industry is satisfied with this outcome.

Nonqualified Deferred Compensation and SERPs -- The threat to non-qualified executive compensation programs is coming mainly from two sources: 1) bills proposed in Congress; and 2) possible reaction to the unfolding Enron saga, which is expected to reveal flagrant use of these programs to generate huge rewards for scoundrels. The bills considered by Congress during 2002 include S.1971, which would give the U.S. Treasury more authority to set rules for taxing benefits from these programs, and H.R.5095, which would specifically target favorable tax treatment in the "Rabbi Trusts" that are often used to fund these arrangements. Until now, these trusts have been considered one of the safest ways to fund non-qualified benefits, because of clear guidance from prior rulings.

Interpretation: The composition and mood of Congress will determine whether and how tax treatment of these programs is changed. If voters demand that tax laws stop favoring top executives who grant themselves NQDCs and SERPs, Congress may respond with new provisions. Ironically, the recent trend in these programs has been to push them down into middle managers ranks, helping non-wealthy people pursue financially security. The life insurance industry is working hard to make sure Congress understands that point, but the outcome is uncertain.

One of the best places online to stay up-to-date on these developments is the Web site of the Association for Advanced Life Underwriting (AALU), a life insurance organization active in lobbying and public education. Go to www.aalu.org. Then click "Public" and "Issues and Positions." Also, stay abreast of Pension Round-Up at FreeERISA.com for monthly updates on specific regulations and technical issues.