At first glance, industry classification may appear to be a straightforward exercise in identifying like companies and grouping them together. But the question of how to do this can be a nuanced one, and classification decisions—either making them or delaying them—can have a material impact on index composition.
We transitioned FTSE Russell indexes to an expanded and improved ICB structure last year—and these enhancements included a change in how we classify Alternative Energy companies. The Alternative Energy sector has since underperformed considerably, shedding light on how classification decisions affect an index’s ability to effectively measure an industry.
Capturing the evolution of the Alternative Energy sector
Businesses don’t stand still—and adapting our classification system to accurately reflect ever-evolving industries requires an ongoing review of our ICB structure. Last year’s adoption of a new framework was part of this approach, where we made several enhancements to ICB.
Noteworthy among these enhancements was the renaming of the ICB Oil and Gas industry to Energy, under which sectors were grouped as Oil, Gas and Coal or Alternative Energy. The Alternative Energy sector now includes both the Alternative Fuels and Alternative Energy Equipment subsectors—capturing companies that both produce alternative fuels and manufacture related equipment.
The decision to include alternative energy equipment companies under Alternative Energy had a significant impact on index composition, perhaps best measured by what the sector would look like in the absence of this decision. Without the inclusion of equipment companies, 86 constituents of the FTSE Global Total Cap Alternative Energy Sector Index would be classified under non-Energy industries—representing 85% of the sector index.
A year of headwinds for Alternative Energy
Alternative Energy has been the worst performing sector in the Russell 2000 Index over the past year. This can perhaps be attributed in part to the industry’s relative nascency. Unlike the multi-trillion-dollar fossil fuel industry, the alternative energy industry is still in its early growth stages—and many companies are in a phase where they’ve invested significant capital that has yet to yield profits. For example, manufacturers of lithium-ion batteries—used to power electric vehicles—have invested considerable capital in new capacity that has yet to bear fruit.
With little returns to show for their investments, alternative energy stocks have underperformed traditional fossil fuels. As shown the Russell 2000 Alternative Energy sector has significantly lagged the Oil, Gas, and Coal sector over the past year.
In fact, with an abysmal return of -65.9% for the year ending February 15, Alternative Energy was the worst performing sector in the Russell 2000—lagging the second worst performing sector by a wide margin.
Alternative Energy’s underperformance was of such significance that it contributed meaningfully to the broader Russell 2000 performance. Although the sector only represented an average of 0.008% of the index, its performance contributed -106 basis points to Russell 2000 performance for the year.
The cost of neglecting to evolve industry classification
These returns demonstrate the Alternative Energy sector’s outsize effect on Russell 2000 performance over the past year. In the absence of our classification decision, these companies would still have been classified under non-Energy industries—and the material impact of their collective performance wouldn't have been accurately represented.
In essence, an index is only an effective measure of an industry if constituents are classified properly—and it’s important to adapt the classification system over time to meet changing markets and businesses. Neglecting to evolve the classification process can have a significant impact on how accurately the index reflects the industry it’s designed to represent.
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