One way to invest with the business cycle and diversify an equity portfolio is using sector-based securities and funds. In order to employ this type of strategy, you should know how sectors and industries are comprised.
Thinking of the market in terms of sectors can be advantageous for investors, however, sorting stocks into separate sectors and industries may not be as clear cut as it may seem. This may be due in part to companies belonging to different industries, depending on the criteria used. Most classification systems use one of two approaches to sort companies in to industries and sectors; the production oriented approach and the market oriented approach.
The production oriented approach focuses on grouping companies that produce similar products or use similar inputs used in the manufacturing process. In product oriented approaches, many companies that manufacture products are classified differently than those that provide services, for example.
The market oriented approach focuses on classifying companies by the markets they serve, rather than on the products they produce. In addition to how the company earns revenue, this approach also focuses on how customers use the company’s products.
Sector classification structures
There are three main classification schemas. They are the Global Industry Classification Standard (GICS), the Industrial Classification Benchmark (ICB), and the Thompson Reuters Business Classification (TRBC).
These classification schemas are designed to provide an acceptable and meaningful method for standardizing industry definitions so that comparison and analysis can be conducted between companies, industries, and sectors worldwide, and for creating benchmarks.
Comparison of Major Sector Classification Systems
|1st||11 Sectors||10 Industries||10 Economic Sectors|
|2nd||24 Industry Groups||19 Supersectors||28 Business Sectors|
|3rd||68 Industries||41 Sectors||56 Industry Groups|
|4th||157 Sub-Industries||114 Subsectors||136 Industries|
*Source: Thomson Reuters, S&P/MSCI, FTSE/Dow Jones
The following is an overview of each of the three major schemas and their corresponding structures:
The Global Industry Classification Standard (GICS) is a market-based classification system. According to GICS as of March 2014, over 43,000 companies worldwide have been categorized using the GICS, consisting of 11 sectors, 24 industry groups, 68 industries and 157 sub-industries. The first tier of the GICS structure divides the market into the following 11 sectors.
|Energy||Materials||Industrials||Consumer Discretionary||Consumer Staples|
|Healthcare||Financials||Information Technology||Real Estate||Telecommunication||Utilities|
Each company classified in the system is assigned a GIC classification code at the sub-industry level, according to the firm’s primary business activity.
The Industrial Classification Benchmark (ICB) classifies more than 70,000 companies, in more than 70 countries, into 10 industries, 19 supersectors, 41 sectors, and 114 subsectors. The first tier of the ICB structure divides the market into the following 10 industries:
|Oil & Gas||Basic Materials||Industrials||Consumer Goods||Healthcare|
The ICB allocates each company in the database to the subsector level that most closely represents the nature of its business, as determined by its source of revenue, or where it derives the majority of its income.
Developed in 2004, the Thomson Reuters Business Classification (TRBC) is an industry classification schema that includes over 70,000 companies from 130 countries. Unlike the other major classification systems, TRCB’s classification system has10 economic sectors, 28 business sectors, 56 industry groups, 136 industries, and 837 activities. The first tier of the TRCB structure divides the market into the following 10 economic sectors:
|Basic Materials||Cyclical Consumer||Energy||Financials||Healthcare|
|Consumer Services||Non-cyclical Consumer||Technology||Telecommunications||Utilities|
*Source: Thomson Reuters
Each company in the TRCB schema is assigned at the lowest level to an activity. The other levels of the schema are assigned according to a company’s primary activity. When companies have multiple business segments, a company’s primary activity is that which provides the largest revenue contribution.
Slight differences in methodologies
In many ways, the methodology used by the three main classification systems is more alike than different. However, there are subtle distinctions that can have a significant impact on the formation of sector funds and indexes, portfolio construction, and benchmarking. It may be beneficial for investors to be aware of these nuances in classification methodologies when trying to compare performance metrics across indexes, sectors, industries, and other sub-groupings.
If one excludes the two consumer related sectors from each schema, the remaining eight industries of the ICB seem to be an exact match to the remaining eight sectors in GICS. However, the company groupings in each of these may also be considerably different. For example: under GICS, coal companies are found in the Energy sector, while ICB puts them into the Basic Materials industry.
The Airlines provide another good example of how companies can be classified differently, depending on the methodology used. TRBC and GICS classify airlines as part of the Transportation subsector or industry, and to Industrials at the highest level, with other passenger transportation and delivery service firms. TRBC further segments companies at the lowest level, into those providing transportation or as those providing Airline or Airport services.
ICB, on the other hand, puts Airlines into the Travel and Leisure industry. By putting airlines in the Travel and Leisure supersector with bars and restaurants, ICB creates a grouping that may have a much different sensitivity to the business cycle than the transportation group, as defined by TRCB or GICS.
|Schema||1st Level||2nd Level||3rd Level||4th Level|
|TRCB||Industrials||Transportation||Airline Services||Airline/Airport Services|
|ICB||Consumer Services||Travel & Leisure||Airlines||N/A|
*Source: Thompson Reuters. MSCI, and Dow Jones
Although in many cases the differences in these classifications systems may appear subtle, they can be significant for investors. This can be especially true for those that use sector-based assets or funds to invest with the business cycle.
For this reason, those investing using a sector-based strategy should understand how companies might be classified, and what the potential implications may be. This can be especially important when investing in funds that are designed to track certain sectors or industries, since the fund or index could be based on one of these various classification systems.