23 July 2001
TREND TOWARD SECTOR INVESTING HAS
IMPLICATIONS FOR TRUSTEES
The Commonwealth Group believes the growing trend toward a sector-based approach to investing in global equities is
causing trustees to rethink how they allocate investment opportunities.
The Commonwealth Group* today released a discussion paper on the increasing importance of sector investing across global
equity markets. The Commonwealth Group believes the impact of the sector trend offers trustees a number of possibilities
as they manage risk and add value.
The discussion paper explores the impact of globalisation on global equity markets and highlights the growing dominance
of industry sectors and the emergence of the sector phenomenon. It also outlines some of the hurdles to a sector-based
Greg La Peyre, spokesperson for the Commonwealth Group, says globalisation has caused a revision of the traditional
approach to global equity management.
“One of the main objectives of investing overseas is to diversify risk. By investing in a wide range of markets,
trustees expect to diversify the risks associated with any single market.”
“Globalisation has changed the rules. Through the 1990s, economies and markets exhibited greater integration. This has
resulted in increased correlation of market returns.”
“If the world’s major markets are now moving together, the potential to reduce risk and/or add value through
diversification offshore, via a regionally orientated strategy, may be reduced.”
Mr La Peyre says against the background of growing convergence of regional economic cycles, it easy to understand how
industry sectors across regional markets have also become increasingly related.
“The recent rise and fall of tech stocks was a global event. The emergence of global sectors raises the prospect that
sector effects may be significant in terms of equity performance.”
The Commonwealth Group believes options for trustees include appointing specialist sector managers or alternatively
consider introducing a ‘multi-nationals’ mandate that would strip out those companies with global revenue streams.
Another option may be to amend benchmark constructions to recognise sectors rather than regions.
“Local factors will continue to influence but trustees should be satisfied their global managers have kept up with
current thinking and incorporated sector effects into both their portfolio modeling and stock selection process”, says
* The Commonwealth Bank of Australia (incorporated in Australia) and subsidiary companies.
Authored by the Commonwealth Group
GLOBAL EQUITIES – the trend toward a sector based approach
Sector investing is becoming increasingly important across global equity markets. There is clearly a growing sector
influence and at the same time a waning local country factor influence on equity returns. What’s more, this trend is not
just confined to single fashionable sectors, such as technology or health (although these sectors exhibit more global
integration than others) but applies across all sectors.
As a result, the manner in which trustees might wish to ‘slice up’ available investment opportunities in order to manage
risk and seek added value has changed and trustees will need to carefully consider the impact of the sector trend.
Trustees are faced with a number of possibilities. These include appointing specialist managers who have demonstrated an
ability to add value in a sector. Alternatively, they might consider introducing a ‘multi-nationals’ mandate that would
strip out those companies with global revenue streams. Another option may be amending benchmark construction to
recognise sectors rather than regions. At the very least, trustees should be satisfied their global managers have kept
up with current thinking and incorporated sector effects into both their portfolio modelling and stock selection
Many New Zealand investors have eschewed the home bias prevalent elsewhere and embraced offshore investments, seeking
both enhanced returns and risk diversification. As a result, over the past decade, many trustees and fund members have
been rewarded with healthy double-digit performance figures (at least up until March 2000).
This discussion paper explores the impact of globalisation on global equity markets and highlights the growing dominance
of industry sectors. It reviews the traditional approach to global investing before introducing the emergence of the
sector phenomenon through both research and investment industry developments. It also identifies some of the hurdles to
a sector based approach.
Global corporate environment
The fall of communism and the dominance of the market economy, central bank control over inflation, reductions in trade
barriers, the rise of cross border trade and cross border capital flows, European Union, and the impact of technology
have all contributed to new ways of doing business. They have also meant new ways of investing in businesses.
It is now common for companies to generate the majority of their earnings from markets outside their national
boundaries. For example, Sony, Glaxo Wellcome, Coca-Cola and Adidas all earn over 65% of their revenue outside their
New technologies, particularly web-based technologies, have changed the business model for many companies and
industries, revolutionising their interaction with suppliers and consumers, domestically and abroad.
It is not only companies that have changed as a result of these trends. Sharemarkets are also structurally adapting to
the global marketplace. Many large companies are listed on more than one stock exchange to make it easier for investors
to actively trade in their shares. Australian-based Newscorp is an example, listed on the Australian, London and New
York stock exchanges. Twelve out of the top fifteen companies on the London exchange are also listed in New York.
Moreover, the market capitalisation of the global companies in the London exchange is over twice the size of all UK
Traditional approach to global equity management
One of the chief objectives of investing offshore is to diversify risk. By investing in a wide range of markets,
trustees expect to diversify the risks associated with any single market.
Global equity mandates have typically been broken down into regional or country blocs; North America, Continental
Europe, United Kingdom, Japan, and Asia/emerging markets (with Australia and New Zealand now usually considered a single
local equity market). This approach is supported by historical evidence that shows country effects have had the most
influence on stock returns . That is, equity returns in any particular market are more likely to reflect local factors
occurring in that market. For example , the Peugeot share price is likely to behave very much as that of any other
French firm rather than as that of other foreign car manufacturers. The ability to add value at stock selection in this
paradigm is dependent therefore, to a large degree, on local knowledge.
Furthermore, the returns across different countries have varied due to the cyclical nature of local conditions and
factors. In support of this, “until the mid-1990s, all the published empirical studies reported that national stock
markets remained weakly correlated” . Over this period, returns for one region were likely to bear little resemblance to
returns for another region. In addition to providing trustees and investment managers with opportunities to reduce risk,
global equity investment also offered potential to add value through shifting funds from one region to another. For
example, where an investment manager believed North America offered better conditions than Japan, it would reduce
exposure to Japanese stocks and increase holdings in North America.
In short, country or regional oriented strategies have dominated global equity portfolio management at both a stock
selection and asset allocation level. While sectors might be been considered as a part of the strategy, they were of
less importance, and certainly not significant in terms of the ability to add value or reduce risk.
A new paradigm
Globalisation has changed things however. Through the 1990s, economies and markets have exhibited greater integration.
This has resulted in increased correlation of market returns. This in itself is not surprising. The Asian crisis and the
Russian default are examples of how events in single regions or countries can trigger significant global responses. When
the U.S. Federal Reserve recently moved on interest rates, it triggered a domino effect among central banks around the
The significance is that if the world’s major markets are now moving together, the potential to reduce risk and/or add
value through diversification offshore via a regionally oriented strategy may be reduced.
At the same time, against the background of growing convergence of economic cycles between regions, it is easy to
understand why industry sectors across different regional markets have become increasingly correlated. Consider
technology, where the recent rise and fall of tech stocks was a global phenomenon. The emergence of global sectors
raises the prospect that sector effects may be significant in terms of equity performance.
Many analysts believe “the degree to which global economies and capital markets are integrated plays a critical role in
the relative importance of country and sector effects in global stock returns” . Financial analysts are asking whether
the blurring of national boundaries has diminished the impact of country effects, and instead, are sector influences now
more critical? Furthermore, is the sector phenomenon restricted to a few sectors, such as technology, or is it more
First however, it is appropriate to ask, “what is a sector?” This paper suggests that sectors possess some descriptive
power in terms of explaining stock price performance. Working from this hypothesis, it might seem appropriate to develop
sector definitions using a statistical approach. For example, cluster analysis could be used to group together
industries that have demonstrated a high correlation of returns in the past. Using this methodology however, may well
result in sector definitions that defy intuitive logic.
An alternative is to use a descriptive framework where a series of industry or sector definitions is developed and
companies placed into groups based on descriptions of their business. Following this approach, MSCI and Standard and
Poor’s, earlier this year, developed the Global Industry Classification Standard (GICS). GICS is a four tier equity
classification system containing 10 sectors, 23 industry groups, 59 industries and 123 sub-industries. The ten sectors
are energy, materials, industrials, consumer discretionary, consumer staple, health, financials, information technology,
telecommunications and utilities.
In launching GICS, David Blitzer, Chief Investment Strategist and S 500 Index Committee Chairman, claimed the new standard “reflects the profound changes both technology and the global
economy are having on the nature of corporations and their business models”.
Empirical support for sector influences
Research to date has largely focussed on the correlations of returns. Where returns are highly correlated, that is,
likely to move together, there is less opportunity to diversify or add value. Where returns are not well correlated, the
opportunity to diversify and /or add value is greater.
At a recent investment management conference in Sydney , a number of leading equity analysts presented material in
support of growing sector influences. The extent of the influence, particularly in terms of the number of sectors
exhibiting stronger correlations, surprised even the presenters. Over the last four years, the correlation between local
currency price returns for sectors within a regional market was found to have reduced while the correlations between
sectors across markets has increased. Cross-market sector correlations are now higher than within market correlation.
Moreover, the increase in cross-market sector correlation has occurred in all sectors, not just technology.
These findings are supported by industry literature. Cavaglia et al suggests industry factors are economically
significant and growing in importance relative to country factors. Baca et al found “a significant shift in the relative
importance of national and economic influences in the stock returns of the world’s largest equity markets”. In these
markets, the impact of industrial sector effects is now roughly equal to that of country effects. In addition to
supporting the notion of increasing global capital market integration, these findings suggest that country-based
approaches to global investment management may be losing their effectiveness and diversification across industries
rather than countries has been more effective in reducing the risk of global equity portfolios.
Focussing on Europe, Roulet and Adjaoute found that post the establishment of the Euro in 1997 the correlations of the
returns of the country indices for 15 MSCI Europe constituents were far above pre-establishment correlations. They
concluded, “in practical terms, this means that diversification opportunities in a country asset allocation setting have
diminished within Europe”. On the other hand, the average industry correlation increased only modestly, suggesting
opportunities to diversify at the industry level still exist.
It should be stressed however, that local country factors still influence equity returns, but that the extent of this
influence appears to be diminishing.
If sector returns within a country are less well correlated than before, does this mean trustees need not invest
offshore to achieve diversification? In short, the answer is still yes. The sector phenomenon is still relatively new
and country factors still count. Secondly, not all sectors are equally represented in all regional or country markets.
Sectoral composition may be used in part to explain the performance discrepancies of regional markets. For example,
Table 2 shows the technology sector makes up more of the United States market than that represented in the MSCI World
Free index. Likewise, the United Kingdom has a heavier concentration in both the financials and telecommunications
sectors, but has little technology exposure. Telecom’s dominance of the local market is well documented.
Sector* MSCI World Free % NZ % US % UK %
Energy 5.7 0.1 5.1 10.5
Materials 4.0 11.4 2.2 2.9
Industrials 10.0 14.0 10.6 5.7
Con Discretionary 12.4 18.4 12.1 10.9
Con Staples 7.2 5.9 7.6 7.5
Health 11.7 0.8 15.2 14.7
Financials 20.8 8.9 16.1 26.0
IT 16.0 2.7 21.3 3.8
Telecoms 8.4 24.5 6.1 14.8
Utilities 4.0 13.1 3.7 3.3
Source: Colonial First State * As per Global Industry Classification Standards.
With uneven sector cover, any single country market is unlikely to provide sufficient diversification to prudently
manage risk. Sector analysis therefore strengthens the argument against over investing in the local market (home bias).
How has this trend manifested itself in the investment industry? The impact can be examined at both stock selection and
asset allocation levels.
In terms of stock selection, some managers have reconstructed their investment teams based on a sector rather than
regional basis. Others, including Colonial First State, have developed a two tier structure, with sector based teams
supplemented by regional teams in an effort to capture both sector and country dynamics in their portfolio construction.
Although a global trend, sector investing has become particularly popular in Europe, due in part to the creation of EMU
which has resulted in a significant reduction in trade barriers, together with an increase in M activity. Research conducted by Merrill Lynch/Gallup has shown that in Europe, 63% of funds are now allocated on a
sector basis, up from 22% in 1997. Following the extensive support sector investing has received in Europe, State Street
Global Advisors announced its intention to launch earlier this year, subject to regulatory approval, a range of European
sector Exchange Traded Funds, or Trackers, based on MSCI sector indices.
Another example of the impact of the new paradigm are sector neutral funds, where the portfolio is constructed so that
its sector weightings are equal to those of the relevant index but the manager has discretion about selecting stocks
within each sector.
In terms of asset allocation within a sector-based environment, managers have sought to diversify risk and add value
through shifting funds from one sector to another. Few global equity managers would not have sought to explain at least
part of its performance in terms of exposure to technology stocks. While the level of exposure to certain regions may
have had some impact on returns, a portfolio’s exposure to technology stocks is likely to have had an even greater
impact. Going forward, it is likely that more managers will move funds between sectors, rather than between regions, as
they seek to reduce risk and add value.
While there have been very few moves in the local wholesale market towards specific sector allocations, Australia’s
UniSuper did award a specialist technology sector mandate in 1999. However, obvious signs of support for sector
investing can be found in the retail arena with the recent introduction of sector funds in New Zealand and Australia.
For example, a number of managers now promote Global Health and Biotechnology Funds, Global Resources Funds, and Global
Technology and Communications Funds.
Hurdles to the sector approach
However, as persuasive as some of these sector arguments appear to be, they do come with a health warning. World markets
are neither wholly integrated nor wholly segregated, and while country influences may be diminishing they have not been
eliminated. Local factors will continue to provide explanatory power for equity returns. There are also other hurdles in
front of the sectoral approach.
Sector exposure implies inherent currency exposure. Not surprisingly, different sectors contain different currency
exposures. For example, Table 2 shows investment in the energy sector offers greater exposure to the GB pound and Euro
than investment in all sectors would. The same investment would provide for lower exposure to the Japanese Yen and US
Dollar. Investment in the information technology sector would offer a completely different currency exposure mix with
more US Dollar exposure and very little GB Pound exposure.
% EUR GBP JPY NZD USD
All Sectors 20.32 10.26 10.01 0.08 49.30
Energy 30.44 19.68 1.18 0.13 43.70
IT 11.87 2.37 9.57 68.80
MSCI Sector Cap Weighted Currency Composition 31 January 2001 Source: State Street Global Advisors
Sector tilts therefore imply currency tilts. The challenge is to determine the currency impact on sector returns. Some
analysts suggest this might not be a straightforward exercise, which may explain why initial efforts have been focussed
on Europe, where the Euro has provided a cross border currency neutral marketplace.
Cross border valuation
Meaningful sector analysis and investing requires cross border comparability. This is not a new challenge to global
equity investors. For example, it is not always meaningful to compare price earnings ratios between two countries.
Earnings figures are the result of accounting data and, of course, accounting treatment varies from country to country.
In the same way as the Association for Investment Management and Research Global Investment Performance Standards and
GICS are becoming prevalent, so global accounting standards are taking hold and will continue to facilitate sector
investing. The harmonisation of global standards in these areas are themselves an indication of global integration. They
both reflect integration and promote it.
It therefore appears that in addition to its conceptual attractions, a sectoral approach to global equity investing also
has quantitative support. There is clearly a growing sector influence and at the same time a waning local country factor
influence on equity returns. Moreover, this trend is not just confined to single fashionable sectors, such as technology
or health (although these sectors exhibit more global integration than others) but applies across all sectors.
The sector trend has significant implications for trustees as they seek to reduce risk and add value through investment
in global equities.