We recently wrote a piece relating to a global index where we looked back at six years’ worth of monthly data and focused predominantly on the top 10 stocks. In looking at this data, we noted how on a monthly basis they have changed, and how, being as the index is a market capitalisation weighted one the allocations to these top ten has also been affected. The point of the article was to note how the index of today is not the index of six years ago and there are risks associated. It is very easy to buy an index thinking you’ve got one thing, when in fact, as time progresses, what you have is actually very different.
As everybody knows, the clever people at the leading agencies when it comes to financial instruments categorise stocks into a number of sector groups (MSCI for instance have 11 – listed below) so that investors can understand a little better the markets, their investments and so on.
- Consumer Discretionary
- Consumer Staples
- Information Technology
- Communication Services
- Real Estate
As you can see, these top-level groupings can be considered quite wide in their descriptions, so there are sub-levels employed so that – if needed – greater granularity can be achieved. For instance, within “Consumer Discretionary” there are four industry groups:
- Automobile and Components
- Consumer Durables & Apparel
- Consumer Services
And, once again, within these industry groups, there are further classifications. Take Retailing as an example, there are four extra levels:
- Internet & Direct Marketing Retail
- Multiline Retail
- Specialty Retail
The GICS (Global Industry Classification Standard) in essence is a pyramid:
- 11 Sectors
- 24 Industry Groups
- 69 Industries
- 158 Sub-Industries
A company can only be represented in a single GICS sub-industry level and every now and again due to the evolving world, the sectors can be re-jigged and this “can” cause significant change to this hierarchy, even though – arguably – this is just optics. A company is the same company if yesterday it were in one sector, but today it was in another caused by a change to classifications. These changes do not happen too often though, and the last major change in the US for instance occurred in September 2018 – which we wrote about (if you would like to see it, please do not hesitate to get in touch and ask for a copy).
Back to the World Index that we have been looking at for the past 6 years on a monthly basis. Our last note on this subject – which looked at the largest stocks in the index – mentioned companies like JP Morgan Chase and Apple. Moving up the hierarchy, JP Morgan Chase would be a stock that would be found in “Financials” and Apple in “Information Technology”. Our previous deeper delve into the World Index showed how JP Morgan Chase had fallen from the top 10, whereas Apple had constantly been the largest company in the index, and its market capitalisation had grown so much that its weight within the index had grown significantly.
In late 2014, the allocation of the World Index had 20.65% in Financials and 13.07% in Information Technology and they were the largest and second largest sectors in the index. At the end of July 2020, Information Technology had grown to be the largest sector accounting for 21.40% of the index and the allocation to Financials had fallen to 12.28%. During this time period, Healthcare stocks had become the second largest allocation, representing 13.96% (having grown from 12.30%.)
As previously mentioned, a change of classification can have big implications to investors if you are closely following the index. Due to index classification changes for instance if you were managing portfolios with a passive strategy, or as a manager you were targeted on keeping tracking errors low, you could be forced to buy or sell a stock “just because” and there would be no recourse. Index management is very black and white in this manner – it follows rules. For example, in 2016 the sector “Real Estate” didn’t exist (it was a subsector of Financials). When Real Estate was introduced (at 3.39% of the World Index in September 2016) Financials fell from 19.61% (August) to 15.97% (September).
In September 2018, the sector “telecommunications” disappeared. It represented 2.59% of the World Index. It was replaced by “communications” along with an 8.19% allocation. This goes to show that other sectors were also massively impacted by this change. Consumer Discretionary for instance fell from 12.58% of the Index to 10.11%. Information Technology was 18.96% in September 2018 and 15.40% in October. Consider what allocation the Information Technology sector would carry today if this change hadn’t have occurred! When the changes took effect, the weight for Financials went from 16.23% to 16.35% (this is not suggesting new stocks were added to the financials sector at the expense of other sectors, it could be the stocks in this classification sector could have had a strong month in terms of performance).
In the same way the market capitalisation of Apple is larger than the 6th, 7th, 8th, 9th and 10th largest stocks in the World Index, the Information Technology sector accounts for only slightly less than the allocation to the 5 smallest industrial sectors (excluding cash).
Equity markets reflect a number of things – they represent the realities and the perceptions of investors. Not all investors have the same investment objectives, time frames or expectations though. But, most of all, not every investor has the same tolerance for risk. Risk is a subjective word and shouldn’t be taken for granted. Stocks and industries come into and go out of fashion from a capital markets perspective. Some companies and industries are best suited to access capital outside of the stock market for instance. Others might be best funded by debt or be in the hands of private equity. Many industries are heavily regulated and outsized returns are just not possible. It doesn’t mean though they are a bad investment. It doesn’t mean they should be dismissed from an investment point of view. It doesn’t mean they should be compared to other industries though either and forgotten. The stock market is just another way for companies to access capital. A share price is a way for companies to be valued. It can represent a good investment opportunity and future returns and dividends, but it can also represent future hope which might not be delivered.
Indices represent all of these measures and bring them together in a neat package. The hope, the real. Actual profits and expected profits. Paid dividends, expected dividends. The borrowings, the liabilities, the assets. Don’t forget though, an index is an amalgam of the underlying. It is treated as a product, and regularly traded as one, but certain sectors and stocks can have a bigger impact. Understand what you are buying.
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