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.
Please see our Russell 1000 ICB Capped Indexes page for more information. Subscribe to our blog for more on global equity strategies.
© 2021 London Stock Exchange Group plc and its applicable group undertakings (the “LSE Group”). The LSE Group includes (1) FTSE International Limited (“FTSE”), (2) Frank Russell Company (“Russell”), (3) FTSE Global Debt Capital Markets Inc. and FTSE Global Debt Capital Markets Limited (together, “FTSE Canada”), (4) MTSNext Limited (“MTSNext”), (5) Mergent, Inc. (“Mergent”), (6) FTSE Fixed Income LLC (“FTSE FI”), (7) The Yield Book Inc (“YB”) and (8) Beyond Ratings S.A.S. (“BR”). All rights reserved.
FTSE Russell® is a trading name of FTSE, Russell, FTSE Canada, MTSNext, Mergent, FTSE FI, YB and BR. “FTSE®”, “Russell®”, “FTSE Russell®”, “MTS®”, “FTSE4Good®”, “ICB®”, “Mergent®”, “The Yield Book®”, “Beyond Ratings®” and all other trademarks and service marks used herein (whether registered or unregistered) are trademarks and/or service marks owned or licensed by the applicable member of the LSE Group or their respective licensors and are owned, or used under licence, by FTSE, Russell, MTSNext, FTSE Canada, Mergent, FTSE FI, YB or BR. FTSE International Limited is authorised and regulated by the Financial Conduct Authority as a benchmark administrator.
All information is provided for information purposes only. All information and data contained in this publication is obtained by the LSE Group, from sources believed by it to be accurate and reliable. Because of the possibility of human and mechanical error as well as other factors, however, such information and data is provided "as is" without warranty of any kind. No member of the LSE Group nor their respective directors, officers, employees, partners or licensors make any claim, prediction, warranty or representation whatsoever, expressly or impliedly, either as to the accuracy, timeliness, completeness, merchantability of any information or of results to be obtained from the use of FTSE Russell products, including but not limited to indexes, data and analytics, or the fitness or suitability of the FTSE Russell products for any particular purpose to which they might be put. Any representation of historical data accessible through FTSE Russell products is provided for information purposes only and is not a reliable indicator of future performance.
No responsibility or liability can be accepted by any member of the LSE Group nor their respective directors, officers, employees, partners or licensors for (a) any loss or damage in whole or in part caused by, resulting from, or relating to any error (negligent or otherwise) or other circumstance involved in procuring, collecting, compiling, interpreting, analysing, editing, transcribing, transmitting, communicating or delivering any such information or data or from use of this document or links to this document or (b) any direct, indirect, special, consequential or incidental damages whatsoever, even if any member of the LSE Group is advised in advance of the possibility of such damages, resulting from the use of, or inability to use, such information.
No member of the LSE Group nor their respective directors, officers, employees, partners or licensors provide investment advice and nothing contained in this document or accessible through FTSE Russell Indexes, including statistical data and industry reports, should be taken as constituting financial or investment advice or a financial promotion.
Past performance is no guarantee of future results. Charts and graphs are provided for illustrative purposes only. Index returns shown may not represent the results of the actual trading of investable assets. Certain returns shown may reflect back-tested performance. All performance presented prior to the index inception date is back-tested performance. Back-tested performance is not actual performance, but is hypothetical. The back-test calculations are based on the same methodology that was in effect when the index was officially launched. However, back- tested data may reflect the application of the index methodology with the benefit of hindsight, and the historic calculations of an index may change from month to month based on revisions to the underlying economic data used in the calculation of the index.
This publication may contain forward-looking assessments. These are based upon a number of assumptions concerning future conditions that ultimately may prove to be inaccurate. Such forward-looking assessments are subject to risks and uncertainties and may be affected by various factors that may cause actual results to differ materially. No member of the LSE Group nor their licensors assume any duty to and do not undertake to update forward-looking assessments.
No part of this information may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without prior written permission of the applicable member of the LSE Group. Use and distribution of the LSE Group data requires a licence from FTSE, Russell, FTSE Canada, MTSNext, Mergent, FTSE FI, YB and/or their respective licensors.