Now for the classification wars

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As globalisation shifts the investment focus onto industrial sectors and away from geographical regions, so index providers have been sharpening up the way they define those sectors.
Starting this year, Standard & Poor’s is using the Global Industry Classification Standard (GICS) as the sole system for all its indices worldwide. Throughout the last year, S&P was classifying its indices under both an earlier system as well as GICS in order to give users time to adjust to the change.
But now it is dropping the parallel use of the old system. It has urged asset managers to take note of the change to avoid confusion in rebalancing portfolios in 2002.
At the same time, the current sector classification system used in Paris for French companies on all Euronext regulated markets has been dropped in favour of the FTSE Global Classification System. Stocks listed on the Marché Libre of Euronext Paris – an unregulated market which focuses on small and medium-sized companies — will be reclassified according to the FTSE system.
This system has already been adopted by Euronext Amsterdam and Euronext Brussels.
The indices affected by the S&P switch include the S&P 500, the S&P MidCap 400 and the S&P SmallCap 600 indices in the US as well as the S&P Global 1200 index.
Particularly in turbulent market times, reliable sector groupings have been shown to be vital, says S&P. “The
market’s gyrations in recent years, when technology boomed and swooned, demonstrates the importance of accurate and consistent industry classification,” says David Blitzer, chief investment strategist at S&P.
“GICS was originally developed in response to a market demand for one globally consistent set of sector and industry definitions,” he says, adding that he was confident that the flexibility of the GICS system would support the future developments in global sector asset allocation.
GICS was developed jointly by S&P and Morgan Stanley Capital International. They aimed to establish a common global standard for categorising companies into sectors and industries. The point was to enable asset owners, asset managers and investment researchers to make seamless comparisons across indices by industry, region and globally.
The system is designed to classify a company according to its main business activity. To determine what that is, S&P and MSCI judges by revenues. But earnings and market perception are also recognised as important and relevant for the purposes of classification, says S&P, and these factors are taken into account in the review process.
The old S&P industry classification methodology had two levels of detail that consisted of 11 economic sectors and 115 industry groupings. By comparison, the GICS has four levels of detail – 10 sectors, 23 industry groupings, 59 industries and 123 sub-industries. The GICS methodology takes a bottom-up approach, classifying each company at the sub-industry level. Following the hierarchical structure upward, each company is then automatically assigned its respective industry, industry group and sector.
FTSE and Euronext say the FTSE system is comprehensive and precise, and enables comparison of companies within sectors, sub-sectors and across national borders. Revenues of each of a company’s business units are used determine the sub-sector which most accurately reflects that firm’s profile.
So, the three main competing classification systems are S&P/MSCI’s GICS, the FTSE Global Classification system and Dow Jones own system which includes the Stoxx indices. So far, FTSE’s system is gaining currency in Europe, winning a 52% market shares, says Marc Russell-Jones, regional director of FTSE in Paris.
Most market experts agree that dividing the market up into industrial sectors is useful. “There is a difference between sectors in terms of how they react to certain macroeconomic events,” says Dan Fox, analyst at Commerzbank. But does it really matter which classification system index providers opt for?
FTSE says its system is superior, pointing to a study carried out by ING Barings in which researchers concluded that the FTSE system was the more useful tool for constructing and controlling portfolios. This system
provided the better asset class definition, they said.
ING Barings quantified this definition as the greater difference between the average correlation of stocks in their own sector index (self-similarity) minus the average correlation of stocks to sector indices other than their own (independence).
The resulting figure is 0.14 for the old MSCI system, 0.16 for the new MSCI/S&P system and 0.17 for the FTSE system. Sector risk and return estimates would therefore be easier to calculate and stock selection better, the ING Barings study said.
But some analysts say claims from financial data firms that their classification systems are distinct are simply marketing tools. Fox, at Commerzbank, says there is little consequential difference between the classification systems.
“I don’t think they’re very different. At the margins you will find there are some companies which are classified one way or the other… but I expect if you looked at returns, you’d find they are fairly similar”, he says.
Guy Fisher, index analyst at ABN AMRO acknowledges the huge competition between index providers, but doubts that the differences between the systems are material. “I’m not sure this issue is quite as important as people make it seem,” he says.

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