Sectors And Style

August 17, 2012

Sector and Style

Index providers continue to deliver new ways to access equity markets in response to investor demands in a highly uncertain climate. Low-volatility and equity-income indexes are just a few examples. Yet two basic mainstays—economic sector indexes and style indexes—remain hugely popular with investors as passive investment vehicles, analytical tools and benchmarks. The sector pie chart and the style box are the first tools most investors reach for—or at least the first tools they see—when reviewing any equity market.

We wanted to take a fresh look at the relevance of the top-down sector and bottom-up style frameworks in the wake of a financial crisis as markets search for some kind of new normal. To do so, we focused on a market and an index that's most familiar to all; namely, U.S. equities and the S&P 500 Index. In the hope of delivering an overarching view, we left aside analysis of how sector and style play across individual market-cap size buckets. For brevity, we also did not address the topic of sectors and style in international equity markets. Country and size effects are the subject of much academic debate. Instead, we focused on the question, Which is a better way for investors to view the market, sectors or style?

The Sector Perspective
Investors have been using sector strategies for longer than they may realize. In the hysteria of the dot-com and housing bubbles, investors allocated huge amounts of capital to the sectors benefiting most from the trends. In the dot-com bubble that meant technology and telecom, and in the housing bubble that meant industrials, basic materials and financials. Although trillions of dollars of wealth were wiped out when both bubbles eventually popped—changing the way we look at the markets forever—sector investing remains popular. Investors continue to use sectors to position themselves to profit from their economic, legislative or technological projections, and the media continue to cover the market as such.

Evaluating Sector Classification Methodologies
To best analyze how sectors have performed over time, it is necessary to first outline how they are defined. When investors look at sectors with the intention of projecting what the reaction to changes in the economic cycle, legislation or technology will be, they should know what rules are used to determine those sector boundaries.

There are currently three widely followed business classification systems on the market: the Industry Classification Benchmark (ICB); the Global Industry Classification Standard (GICS); and the Thomson Reuters Business Classification (TRBC). Each has its own rules-based methodology for determining how a firm should be classified (see Figure 1). While all three are similar, little differences play a big role in determining how the market is sliced into sectors.

Classification Differences

 

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