|
Page 1 of 7
 Industry classifications drive many aspects of modern investment management. For an industry grouping to be useful, its constituents should have a tighter correlation to each other than each has to the overall market. Indeed, analyses based on industry classifications assume that the personality of each industry group differs from that of the market in general, and that each industry responds to economic factors in a consistent but unique way. This paper examines these assumptions; shows that industry groupings in Thomson Reuters Business Classification (TRBC) are effective; and contrasts pairs of industries commonly selected during the five stages of the economic cycle, based on a simple sector rotation strategy.
Introduction
Most portfolio managers, index builders and exchange-traded fund developers implicitly assume that market-based industry classification schemes are sound tools, that companies within industries are more tightly correlated than a random sample of companies. From retail investors reviewing mutual fund reports to institutional custodians allocating assets, the ability to make investment choices based on industry categories has never been greater. Clearly, market participants endorse industry groupings constructed by third parties as a meaningful way to analyze the market, balance risk and create benchmarks. But is this a reliable way to segment the market—and is every industry grouping equally robust?
Over 1 billion pairs of time series data for the U.S. market were used to test the correlation between constituents within industry groups, between the groups themselves and between groups and the market. The results demonstrate that correlations are higher within industry groups, on average, and that the effectiveness of an industry group to perform distinctly from the market varies across time and between industries.
Usage Of Industry Data Within The Investment Community
Industry-based investment strategies are often centered on a belief that sector rotation will allow investment managers to select groups of equities that will behave in accordance with the economic cycle. For example, if a manager believes the economy is heading for a downturn, he may overweight defensive industries, such as consumer noncyclicals or utilities, because consumers continue to purchase tobacco, beer and electricity, irrespective of economic cycles. If the manager believes the economy is entering a growth phase, he may overweight consumer cyclicals or technology, anticipating a rise in these sectors as consumers increase discretionary spending and businesses accelerate capital investment. Such a top-down approach allows managers to focus on understanding and predicting broader economic trends, versus a bottom-up approach involving more time-consuming stock-by-stock analyses.
A standard interpretation of a five-phase economic cycle, coupled with some commonly used sector groupings, is shown in Figures 1A and 1B. It was originally published in Stovall and further explored in Stangl, Jacobsen and Visaltanachoti.
The proliferation of index vehicles has made it easier than ever to build cost-effective strategies to adjust industry weightings throughout the cycle. For example, Thomson Reuters sector indexes will provide approximately 7,000 industry indexes across 42 countries and seven regions.
Stovall’s analysis uses a grouping of standard industrial classification codes. In 1996, there were no widely used market-based classification systems available. But today there are many market-based systems, prompting the question, why are these favored by the investment community? Analysis by Bhojraj, Lee and Oler shows that market-based schemes, such as the Global Industry Classification Standard (GICS), offer several advantages over production-based codes.
Market-Based Classification: What Is It?
The defining feature of a market-based classification system is that companies are categorized based on the market they serve rather than on the products they produce—the idea being that the share price performance of companies that, for example, produce ball bearings for planes will differ from companies that provide ball bearings for wind turbines. The airline industry is driven by business travel and is hindered by high energy prices, whereas the wind turbine industry is driven by tax incentives and is helped by high energy prices. Intuitively, businesses that serve the same end markets are more likely to have similar reactions to headwinds and tailwinds, as opposed to peers that produce the same materials for different market segments. This is why providers of market-based classification systems assign companies to industries after researching various revenue streams, examining each business unit within larger organizations to determine which markets are being served.
Market-Based Classification: The Providers
The major index providers offer a number of market-based tools. S&P and MSCI publish GICS. FTSE and Dow Jones publish the Industry Classification Benchmark (ICB). And Thomson Reuters has recently announced the release of a new market-based system, the Thomson Reuters Business Classification (TRBC), which will serve as the basis for approximately 7,000 sector indexes and become a global standard across Thomson Reuters content and product offerings.
These three industry classifications share many characteristics (see Figure 2). Each has four levels of detail, with companies classified at the lowest level within a strict hierarchy, rolling up into higher levels that provide larger baskets of stocks used to create indexes, compile aggregates or conduct other analyses.
While each provider has written extensive marketing literature on the benefits of a market-based approach, there is little publicly available academic research that tests the underlying assumptions or gauges the effectiveness of each industry grouping.
The next section describes the testing conducted by Thomson Reuters in evaluating the rigor of the TRBC market-based scheme.
|
Previous Page
