The year of 1999 was a particularly interesting year in the world equity markets. The broader indices, as well as most regions and countries, recorded strong returns (in local currency) during the period. These returns, however, masked a strong underlying phenomenon that created wide disparity in the returns observed for global equity investment managers, perhaps the widest for a calendar year in recorded history. At the top of the pack were predominately ‘growth-oriented’ managers, while ‘value-oriented’ managers tended to lag. What drove these differences was, of course, the strong performance of growth or ‘new economy’ industries such as information technology and telecommunications, while more traditional or ‘old economy’ industries such as utilities and consumer staples were poor performers.
Marking the range in returns during 1999 were a return of 99.7% for the MSCI World Information Technology Index (in local currency terms) and a return of –14.7% for the MSCI World Consumer Staples Index. Consequently, the most important factor in portfolio performance last year for most managers was sector selection.
This disparity in sector returns, as well as the enthusiasm for technology stocks, has recently generated an interest from pension funds and institutional investors to dedicate a portion of their total portfolio to global sector funds. These investors have sought out traditional equity investment firms to develop sector portfolios. While generally this recent trend has represented a very small fraction of institutional assets, it has been suggested that sector funds will continue to represent a greater share of placements. These very recent placements are predominately technology-related funds, while some medical technology, biotech and general health care only placements have also been observed.
With the advent of global sector funds has come the necessity to have appropriate benchmarks to measure the investment performance of these portfolios. The Association of Investment Management and Research (AIMR) in their performance standards defines a benchmark as “an independent rate of return forming an objective test of the effective implementation of an investment strategy.” Moreover, they further identify the key variables representing an effective benchmark as: 1) Representative of the asset class or mandate; 2) Investible; 3) Constructed in a disciplined and objective manner; 4) Formulated from publicly available information; 5) Accepted by the manager as the neutral position; and 6) Consistent with underlying investor status (eg regarding tax, time horizon, etc.). Perhaps the most satisfying of these requirements are the global sector returns that are presently being calculated by MSCI, Salomon Smith Barney and FTSE. These firms have recently begun publishing new or improved returns for global sectors based on their broader indices.
MSCI: At the end of 1999, MSCI launched their new Country Industry Indices (CII), which are based on the newly released Global Industry Classification Standards (GICS). These standards, developed jointly with S&P, were designed to effectively categorise each company into its most appropriate industry classification, as well as provide better overall industry groups and sector categories. Each company included in their broader universe is assigned to one of 59 individual industries, which are further aggregated into 23 industry groups and 10 sectors. In addition, these groupings are available for each of the 76 regional indices and 51 country indices that MSCI maintains, allowing for significant flexibility in creating industry or sector benchmarks for any country, region, or broad universe. Moreover, MSCI designs their indices using market capitalisation weights, and consistently tries to capture 60% of each industry group’s weight within each country to provide for broad representation. Therefore, MSCI sector and index methodology satisfies all of the requirements necessary to provide for quality global sector benchmarks to be used in the analysis of global sector portfolios. And by the end of this year, MSCI will have generated history going back to 1990 to further promote the analysis of longer-term sector returns.
Salomon Smith Barney: Similar to MSCI, Salomon Smith Barney (SSB) produces a series of global equity indices that capture industry and sector returns for each country, region or broader universe. For developed countries, SSB produces the Broad Market Index (BMI), which contains all stocks in the 23 developed markets and contains just under 7,000 companies. Furthermore, they separate the BMI into two mutually exclusive sections: the Primary Market Index (PMI), which represents the top 80% of the companies in each market by size, and the Extended Market Index (EMI) which represents the bottom 20% or smaller capitalisation stocks. SSB, however, unlike MSCI, weights the stocks in their indices by available float, rather than market capitalisation. That is, they adjust the market capitalisation of each stock by reducing the total capitalisation by corporate cross holdings, private control blocks, government holdings and legally restricted shares to reflect the full available market capitalization. It is their belief, that this approach is more representative of the investible universe, and more representative of the returns, available to all international investors. While the merits of each methodology is debatable, it is the classification of companies and the construction of industry and sector groups that will be more important in determining sector return differences. It is in these areas that investors should be focusing when determining the appropriate global sector benchmark.
FTSE International: FTSE has been actively addressing these latter items of focus for constructing sector benchmark portfolios in two ways. First, in July 1999, FTSE introduced their Global Classification System, also an improved method of classifying companies into their most appropriate sub-industry segment, allowing for better industry and sector groupings. Their work has resulted in higher in-sector correlations for the companies comprising their sector groupings, which is one measure validating the improvement of their classification system. Second, in conjunction with ING Barings, FTSE recently introduced Global-Pro; a new service to create customised benchmarks using the FT All-World index as its base. Global-Pro will allow users to create, among other things, customised sector benchmarks from their 102 industry sub-groups, or from a listing of individual securities. This system will allow plan sponsor and manager to create in essence a “normal” sector portfolio, providing a flexible method for agreement on the most appropriate sector benchmark.
MSCI, SSB and FTSE all have disciplined, reasoned approaches to constructing their broader indices, as well as constructing industry and sector benchmark returns. Most importantly, they all satisfy the requirements outlined by AIMR for effective benchmark construction. While other investment houses produce sector returns, these benchmark providers generally have the most readily available information, the broadest representation, and the most objective method of construction. They have also designed them with flexibility so that both manager and plan sponsor can agree on the most appropriate benchmark for a global sector portfolio.
Steven E Moeller is product manager, global equity, at Fiduciary Trust in New York