Segmentation of Equity Investment Universe

Equity Investment Style Box

$$ \begin{array}{c|c|ccc}
& & & \textbf{Style} & \\ \hline
& & \textbf{Value} & \textbf{Blend} & \textbf{Growth} \\
& \textbf{Large} & \text{Large-cap value} & \text{Large-cap blend} & \text{Large-cap growth} \\
\textbf{Size} & \textbf{Mid} & \text{Mid-cap value} & \text{Mid-cap blend} & \text{Mid-cap growth} \\
& \textbf{Small} & \text{Small-cap value} & \text{Small-cap blend} & \text{Small-cap growth}
\end{array} $$

Size

Companies are classified based on their market capitalization (size). Small-cap stocks are less traded, and the definition of small-cap may change by market and time. They generally represent about 1/3 of the equity universe. CFA L3 exam focuses on understanding the relative sizing of small, mid, and large-cap stocks rather than memorizing specific market cap limits.

Large-cap stocks have economies of scale and are established firms. They are less speculative than small-caps, offering a comparatively smaller return.

Style

Style relates to fundamental factors of equity security. Value stocks have high book value relative to market value, low P/E ratios, and high dividend yields. Growth stocks are on a bullish trend, relatively expensive, and involve trend analysis.

Equity investment style boxes provide a visual representation of portfolio risks. They help managers understand and communicate style, track company changes, and explore portfolio risk factors.

Geographical Segmentation

Dividing equity markets by geographical regions can be a helpful approach. This helps portfolio managers address home bias and enhance diversification. However, it's important to note that some companies are already globally diversified, making additional diversification redundant.

Market Categories:

• Developed Markets: These include stable economies such as Canada, the USA, the UK, Australia, Germany, and Sweden.
• Emerging Markets: These encompass countries such as Brazil, Russia, India, China, and the United Arab Emirates. They tend to be more speculative and often offer higher interest rates.
• Frontier Markets: Examples include Argentina, Bahrain, Kenya, and Bangladesh. These markets can be even more speculative.

Developed markets are generally considered stable, while emerging and frontier markets may carry higher risks. Major index providers, such as FTSE, Standard & Poor's, and Russell, offer detailed segmentation criteria for international equity indexes.

Industry/Sectors Segmentation

Segmenting markets by sectors is another useful tool. Many companies in various industries share specific risk characteristics. By analyzing these traits, portfolio managers can better understand portfolio risks.

There are two approaches for segmentation:

• Market-oriented approach: Segments companies by the parts of the economy they serve.
• Production-oriented approach: Segments companies by their products or services.

Both methods yield different segmentations but should be non-overlapping. The goal is met as long as each company fits within the scheme.

Fundamental market classification structures include:

• Global Industry Classification Standards (GICS).
• Industrial Classification Benchmark (ICD).
• Thomson Reuters Business Classification (TRBC).
• Russell Global Sectors Classification (RGS).

The following example shows how GICS Industry classifications look in practice:

$$ \begin{array}{c|c|c|c}
\textbf{Level} & \textbf{Sector} & \textbf{Consumer Discretionary} & \textbf{Classification} \\
& & & \textbf{of Level} \\ \hline
1 & \text{Industry Group} & \text{Automobiles & Components} & \text{Most broad} \\ \hline
2 & \text{Industry} & \text{Automobiles} & \text{Mid} \\ \hline
3 & \text{Sub-Industry} & \text{Motorcycle manufacturing} & \text{Least broad}
\end{array} $$

Starting from the top, the sector is labeled ‘Consumer Discretionary.’ This suggests multiple industry groups within the sector. For instance, ‘Automobiles & Components’, alongside other retailing and consumer services sectors. As we move down the levels, the focus becomes more specific, offering details about the companies within that segmentation level. In our example, we end with ‘Motorcycle Manufacturing,’ which would be overly narrow as a starting point for segmentation, making it the final level in the process.

Equity Indices and Benchmarks

Equity indices and benchmarks can be constructed using the segmentation tools mentioned earlier. Typical providers offer index creation and tracking, while other investment vehicles, such as ETFs or mutual funds, provide passive management investments that aim to replicate specific index performance.

Some indices, such as the FTSE All-World Index, which covers thousands of stocks globally, are broad in scope. The FTSE Group, a subsidiary of the London Stock Exchange, calculates it. On the other hand, there are narrower indices, such as The S&P Homebuilders Select Industry Index by Standard & Poor's. This index focuses on the homebuilding sub-industry within the S&P Total Markets Index, allowing tracking of market capitalization and growth in this specific sector. Such focused segmentation helps identify shared risk factors among equities in a portfolio.

Question

According to Global Industry Classification Standards (“GICS”), which of the following segmentation levels is the broadest?

1. Industry.
2. Sector.
3. Industry group.

Solution

The correct answer is B.

As of the current writing, GICS divides industries into 11 sectors at its broadest level of segmentation.

$$ \begin{array}{c|c|c|c}
\textbf{Level} & \textbf{Sector} & \textbf{Consumer} & \textbf{Classification} \\
& & \textbf{Discretionary} & \textbf{of Level} \\ \hline
1 & \text{Industry Group} & \text{Automobiles &} & \text{Most broad} \\
& & \text{Components} & \\ \hline
2 & \text{Industry} & \text{Automobiles} & \text{Mid} \\ \hline
3 & \text{Sub-Industry} & \text{Motorcycle manufacturing} & \text{Least broad}
\end{array} $$

Portfolio Construction: Learning Module 2: Overview of Equity Portfolio Management; Los 1(b) Describe how an equity manager's investment universe can be segmented