T he accelerating globalisation of business enterprises and the integration of capital markets are altering the equity investment environment. Higher levels of integration blur national borders and diminish the significance of country factors as compared with industry factors. As a result, sector indices have become more important in the investment-management process and may attract even more attention in the future.
The three main providers of cross-country sector indices in Europe are Morgan Stanley Capital International (MSCI), FTSE International and Stoxx Limited, with Stoxx an equally-weighted joint venture between US-based Dow Jones & Co, Deutsche Börse AG, Paris Bourse SA and the SWX Swiss Exchange. All three providers use different sector classification methodology.
Sector classification methodologies have been fairly dynamic in the past few years. Investors who were around in the 1980s will remember that the telecom sector was an integral part of utilities and there were only a few industry indices allocated to services (as opposed to manufacturing) despite the increasingly large proportion of services in western economies. This has changed. Generally speaking, the availability of sector indices has improved.
We believe there are five main reasons for increasing interest in sector indices.
Firstly, the introduction of the euro in January 1999 changed the landscape for institutional investors in Europe, especially, of course, in the countries that have introduced the euro. The unification of different currencies increased the investable universe many times over. As a result, investment strategy has changed. Investors with a top-down approach who were focussing on country factors before analysing sector and stock-specific factors, changed to viewing sectors before country-specific variables. Disciples of the bottom-up approach maintained their primary focus on stocks but, to a large extent, moved to a sector approach as their second variable.
The second factor is globalisation. Globalisation has increased the importance of sectors relative to countries, especially for companies generating the bulk of their revenues in an international market. The limited diversification benefits accrued from allocating funds across developed and integrated economies is well documented.
Thirdly, there is the increasing concentration of local indices in Europe. The most extreme example is the HEX General Index in Finland that has 121 constituents. However, Nokia comprises 71% of the market capitalisation weighted index. The concentration in other single-country indices has increased as well. Early November saw the three largest stocks in the DAX 30, FTSE 100 and CAC 40 account for 33.1%, 26.6% and 28.4% respectively. This concentration made these indices unsuitable for benchmarking purposes. As a result, investors have moved to multi-country benchmark indices, comparing stocks with sector peers as opposed to other constituents in the same country.
A fourth reason is the increase in the dispersion of sector returns in the fourth quarter (Q4) of 1999 and Q1 of 2000 relative to the dispersion of country returns. In other words, in the recent past, the information ratio (active return versus active risk) of an active manager was higher in picking sectors (or styles) than it was in allocating funds on a country basis. A case can be made that the dispersion of sector and style returns will be wider than country returns in the future, given the integration of developed economies and their equity markets. Recent academic research would support this notion. This would further support a sector approach as opposed to a country approach.
A fifth source of demand for sector indices is from the retail investor base. Most investment banks are offering certificates, warrants, reverse-convertibles and guaranteed structures on sector indices or baskets of sector indices. This area is almost exclusively captured by the pan-European as well as Euro-zone market sector indices of Stoxx.
To date, the launch of listed options and futures on sector indices cannot be described as a success story. Monep was first to launch sector derivatives. In March 1999, it launched options and futures on three pan-European sector indices from Stoxx: namely banks, energy and telecom. These series have been ‘temporarily’ discontinued after September expiry 2000 due to low trading activity. In the beginning, there was some activity in the telecom contract – a contract that was easier to trade because there were only 17 constituents in 11 different countries. Most of the stocks were large caps and liquid. The contract on banks, on the other hand, was more difficult to trade as there were 59 constituents spread over 16 countries.
In October 1999, Monep issued further derivatives on more sector indices from Stoxx: namely technology, insurance, pharmaceutical and media. The underlying index from the first series was different from the second. The first sector indices were based on the broad indices including pan-European stocks from the large, mid as well as small cap sub-group of the broad universe of Stoxx. The second series was based on the large and mid sub-indices only. The advantage of limiting the underlying sector indices to the large and medium-size stocks is the trade-ability of the underlying stocks. The disadvantage of a narrowly defined basket is the tracking error with the broad sector index.
Although there are hundreds of retail products on sector indices outstanding, the hedging is not done through exchange traded options and futures. The hedging of these as well as other over-the-counter derivatives is normally done through other means. The market risk (delta) is easily hedged through the different local trading books. Risk parameters derived from contracts which include optionality (gamma and vega risk) are either offset with other positions or hedged through options in the inter-bank market. The inter-bank market is a fast-growing market, in which intermediaries quote and trade options where liquidity on an exchange is low.
A further source of demand for sector indices is from asset management houses, which launch passive funds or exchange traded funds. From a pure marketing perspective, it seems that the main selling point for investment vehicles distributed to retail and private investors in the recent past has been an investment theme. Given that the main theme in the recent past has been TMT, most new sector indices are related to TMT in one form or another. As a result, index vendors are in the process of launching sector indices outside of their traditional sector-classification system.
Alexander Ineichen is CFA, executive director and head of European equity derivatives research at UBS Warburg in London. He is also a member of the Stoxx advisory committee