Thursday, May 26, 2011

Morningstar Announces Their New Sector Structure – And It Does Have an Impact on the Management of the AIM Equity Funds

This week Morningstar announced their new sector and industry structures. For those of you familiar with the AIM program, since the inception of the AIM program we have been assigning student-analysts to be responsible for the management of specific sectors of the AIM equity funds. 

Since 2005, the AIM student-managers have been assigned the responsibility for overseeing the holdings of the AIM domestic and international equity portfolios according to individual sectors and industries that were based on Morningstar’s 'older' classification scheme. With the announced changes to the Morningstar sector structure (which is finally more consistent with Standard & Poor’s global industrial classification standards or GICS), some of the AIM students will be assigned new sectors. This means that the funds might not be ‘sector neutral’ following the change and that some of the holdings will need to be reweighed.

In the practical application of modern portfolio theory, diversification is generally thought of in terms of market capitalization and investment style (large growth, small value, etc.), yet sector diversification is also considered to be important. As demonstrated in recent years, pursuing a growth investment style via Internet stocks could lead to a substantially different portfolio—and results the result could be much different than pursuing a growth strategy via healthcare stocks.

Standard sector systems, such as Morningstar's new scheme, have several drawbacks as well. Most classification systems define some sectors by the types of businesses in which companies are engaged, such as technology or healthcare, and others by the expected behavior of stocks, e.g. consumer cyclical or defensive. Such methods also imply that cyclicality exists only in certain sectors. Moreover, most systems—which require investors to juggle percentages for 10 or more sectors—make it difficult for individuals to quickly grasp a fund’s sector tilt. Nevertheless, the proposed Morningstar sector alignment (shown below) is an improvement over the previous system.

Morningstar’s New Sectors
Morningstar’s introduction of their new sector structure appear to be more unified and consistent than their previous approach. This should allow for a better understanding of the impact of portfolio diversification and make it easier to understand and track the investment choices being made by the AIM funds’ student-managers.

This new structure divides the economy into three “Super Sectors:” the Information Economy, the Service Economy, and the Manufacturing Economy. Each Super Sector contains four sectors, for a total of 12. Within each sector, industry groups composed of individual industries allow for a more in-depth analysis by the AIM student-managers.

While several of Morningstar’s sector names remain the same, most are new and represent a substantial overhaul of the previous categorizations. Perhaps the most significant change is the replacement of the “technology” sector—which included a broad range of companies with different performance trends—with separate sectors for software, hardware, and telecommunications.

The result of the change is a unified system that is applicable to both funds and portfolios. It should allow our student-managers to evaluate the performance of their portfolios to the benchmark and other funds by comparing exposure to the three Super Sectors. The system will also permit further examination of holdings and fund performance at a granular level. This will be particularly useful when the students perform attribution analysis at the sector level.

The new Morningstar sector structure should allow for better portfolio construction by clearly showing how a new stock complements the current holdings or whether it simply overlaps the current sector exposure of the AIM portfolios. While this change will require some juggling of the current AIM student-managers responsibilities, it should allow our students to compare their sector performance to other funds that use the GICS format - helping them to talk about their strategies with other portfolio analysts and managers. 

The following represents a brief description of the three ‘Super Sectors’ and their underlying constituents.

Information Economy
Companies engaged in the design and marketing of computer operating systems and applications. Examples include Microsoft, Oracle, and Siebel Systems.

Manufacturers of computer equipment, communication equipment, semiconductors, and components. Examples include IBM, Cisco Systems, and Intel.

Companies that own and operate broadcast networks and those that create content or provide it to other media companies. Examples include AOL Time Warner, Walt Disney, and The Washington Post.

Companies that provide communication services using fixed-line networks or those that provide wireless access and services. Examples include SBC Communications, AT&T, and Alltel.

Service Economy
Includes biotechnology, pharmaceuticals, research services, HMOs, home health, hospitals, medical equipment and supplies, and assisted living companies. Examples include Abbott Laboratories, Merck, and Cardinal Health.

Consumer Services
Includes retail stores, personal services, home builders, home supply, travel and entertainment companies, and educational providers. Examples include Wal-Mart, Home Depot, and Expedia.

Business Services
Includes advertising, printing, publishing, business support, consultants, employment, engineering and construction, security services, waste management, distributors, and transportation companies. Examples include Manpower, R. H. Donnelley, and Southwest Airlines.

Financial Services
Includes banks, finance companies, money management firms, savings and loans, securities brokers, and insurance companies. Examples include Citigroup, Washington Mutual, and Fannie Mae.

Manufacturing Economy
Consumer Goods
Companies that manufacture or provide food, beverages, household and personal products, apparel, shoes, textiles, autos and auto parts, consumer electronics, luxury goods, packaging, and tobacco. Examples include PepsiCo, Ford Motor Co., and Kraft Foods.

Industrial Materials
Includes aerospace and defense firms, and companies that provide or manufacture chemicals, machinery, building materials, and commodities. Examples include Boeing, DuPont, and Alcoa.

Companies that produce or refine oil and gas, oilfield services and equipment companies, and pipeline operators. Examples include Exxon Mobil, Schlumberger, and BP Amoco.

Electric, gas, and water utilities. Examples include Duke Energy, Exelon, and El Paso.

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