by Catherine Yoshimoto, director, product management
Just as we observe distinct cycles of growth and value rotation over time, industries are also known to go in and out of style. But with ten ICB industries comprising our Russell Indexes, industry rotations don’t share the binary and symmetrical nature of style rotations. For investors looking to express tactical views on the timing of these rotations, industry indexes can be useful tools. But if these indexes aren’t designed properly, they can come with unintended security concentrations or exposures.
The ever-rotating industry landscape
Over the past ten years, each of our Russell ICB Industry Capped Indexes has rotated in and out of favor. When comparing calendar year performance, some industries have whipsawed from highest to lowest performance year-over-year, while others have shifted more subtly relative to other industries. As shown below, the Energy industry has been the most extreme in its shifts, jumping from the worst performing industry from 2017-2020 to the top performer YTD in 2021.
Know your industry index
Some investors see the ever-rotating industry landscape as an opportunity to express tactical views as the market changes—either by over- or underweighting industries, or by rotating exposures. Passive funds that track industry indexes can be effective tools for implementing these tactical strategies. There is of course inherent risk in the ebb and flow of the performance of industry sectors. However, it’s important for investors to be aware that if there is additional risk when it comes to picking industry indexes.
For one, industry indexes are a targeted subset of broader indexes—and this can come at the cost of diversification. Without guidelines in place to cap constituent weights, the industry index can be highly concentrated in its largest constituents—and these can have an outsize impact on performance, introducing unintended portfolio risks. This security concentration can also compromise an index fund’s liquidity.
Investors should also recognize that industry classification systems can vary across index providers. Such differences in approaches are evident when comparing the Industry Classification Benchmark (ICB) methodology we use for our Russell Indexes with the Global Industry Classification Standard (GICS). ICB is a comprehensive and rules based, transparent classification methodology based on research and market trends designed to support investment solutions.
As shown below, tech giants such as Alphabet (Google), Meta Platforms (Facebook), and Twitter are all classified as Technology under ICB and Communication Services under GICS.
As of September 30, 2021.
It’s important for investors to note these methodology distinctions when using index funds to express tactical views on industries. Knowing index composition can enable them to align their views with the right industry index strategy—and target them with precision.
Capping guidelines for a more diversified and liquid index
Our particular risk beyond the ebb and flow of sectors, is having exposure to a small range of large constituents. Investors are thus vulnerable to the movement of a narrow range of stocks, rather than a truer reflection of the industry as a whole
A capping strategy is designed to solve for these challenges. For example, a US large cap sector capped strategy would start with the Russell 1000 Index of largest and most liquid companies in the US equity market, using industries within the ICB sector classification framework.
But the methodology would feature lower capping requirements in its index construction methodology—further ensuring diversification for our industry indexes. As shown, relative to both RIC and 40 Act rules, our capping guidelines require lower limits for individual and aggregate company weights.
Effective tools to tactically navigate industry rotation
Capped industry indexes represent diversified exposure to a target market by industry, and can make funds tracking these indexes effective tools for clients looking to implement tactical industry views while meeting liquidity and diversification requirements.
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