Just as chemists need universal and stable units of measure to create precise formulations, investors need objectively defined investment categories to design and carry out efficient portfolio strategies. While each company may be unique, many business and economic factors could impact similar companies in the same way. As a result, analysts rely on consistent and unbiased classifications to compare companies, evaluate industries, and isolate regional from global trends.
Prior to the introduction of the Global Industry Classification Standard (GICS) in 1999, Standard & Poor's used a classification system with 11 sectors and 115 industries, similar to the Standard Industry Classification (SIC), which was introduced in 1937. Economies evolve, however, so by the 1990s, the existing SIC system had displayed significant limitations in its ability to:
- Detect important emerging industries, such as telecommunications or information technology
- Accommodate the shift to a service economy
- Recognize the growing global economy or the attendant decreases in regional variations
- Take into account the advent of instantaneous worldwide communications
Everything that relied on existing classification systems, from investment research to allocation decisions, could be compromised by growing inaccuracies and lack of clarity.
Standard & Poor's and Morgan Stanley Capital International (now known as MSCI Barra) took on the challenge of creating a single, consistent set of global sector and industry definitions to meet the needs of the world financial community. The result was the GICS, which successfully resolves many of the issues with previous classification systems. The GICS is now an accepted framework for investments because:
- It is universal. This is a global classification system applicable in both developed and developing economies.
- It is accurate. It reflects the current state of all industries.
- It is flexible. With 4 increasingly specific divisions, it can identify very specialized subindustries.
- It can change. MSCI and Standard & Poor's review the entire framework annually to ensure that it remains as accurate a reflection of the marketplace as possible. In addition, significant corporate events will trigger a review of an individual company's placement.
This article explains the methodology behind the GICS classification scheme and its implications for both passive and active portfolio management.
The GICS framework
The GICS structure comprises 11 sectors, 24 industry groups, 68 industries, and 157 subindustries. This is far more granular than the 2-level hierarchy in use previously. The GICS methodology is still very much based on industries, but the sectors now reflect our current economy:
- Communication services
- Consumer discretionary
- Consumer staples
- Health care
- Information technology
- Real estate
Industries can be classed by what they produce or by the markets that purchase their products and services. GICS sectors are more market oriented than production oriented. For instance, rather than try to create a clear distinction between consumer goods and consumer services, GICS divides the consumer economy into "consumer discretionary" and "consumer staples." Each of these can accommodate goods and services, but in this case, analysts can distinguish companies based on their expected response to changes in business cycles.
GICS classifications can be presented in text or numeric format. The full GICS classification for each company is an 8-digit code with text description. The full code is easily understood, as it is built from the codes for each level. Take household appliances, for example:
- Sector: consumer discretionary (GICS code: 25)
- Industry group: consumer durables and apparel (GICS code: 2520)
- Industry: household durables (GICS code: 252010)
- Subindustry: household appliances (GICS code: 25201040)
How a company gets its slot
A company is assigned to a single GICS subindustry based on what Standard & Poor's and MSCI consider to be its primary business activity. This is measured primarily by the revenues derived from that activity, although earnings analysis and market perception are also considered. Its subindustry classification automatically determines its industry, industry group, and sector.
What about companies with more than one significant business activity? Generally speaking, they are classified in the subindustry that generates the majority of revenues and profits or which Standard & Poor's and MSCI together agree best reflects its principal business. Companies participating in different sectors may be classified in industrial conglomerates or multi-sector holdings. Subsidiaries that file separate financials are generally considered separate entities and classified separately.
GICS and the S&P 500
The S&P 500 aims to be representative of the industries in the US economy, and sector classification is 1 of the 8 primary criteria considered. Thus, both the accuracy of GICS sectors and the assignment of companies within those sectors contribute to the overall validity of the S&P 500.
The GICS enables Standard & Poor's to develop sector indexes and index products from a common global standard. All S&P indexes, not just the S&P 500, use the GICS structure, creating an entire family of sector-based indexes that offer a global, consistent set of benchmarks.
GICS and portfolio management
The GICS methodology provides the transparency and accuracy needed for more accurate comparisons. Its 4 classification levels allow for specificity in indexing and thus customization and targeting in structuring a portfolio. In layman's terms, it is now possible to compare not just apples to apples, but the same varieties of apples against each other.
This is true for both passively and actively managed portfolios. Passively managed portfolios—those whose goal is to replicate the performance of the indexes on which they are based—rely on GICS-derived indexes to be accurate representations of the global marketplace.
Actively managed portfolios, where the goal is to outperform a benchmark in some way, benefit from this transparency and accuracy as well. In addition, analysts and managers are better able to track emerging markets and identify high-potential niches. Diversification and asset allocation decisions are better informed because of the greater transparency GICS provides, both across industries and among geographical markets.