Portfolio diversification generally starts with asset types, and investment styles have become the second most important factor to consider. Concentration of investments can also be thought of in terms of sectors and regions. As demonstrated in recent years, pursuing a growth investment style via Internet stocks leads to substantially different portfolios and results than pursuing growth via healthcare stocks. Similarly, a portfolio investing in smaller stocks around the world also yields different result than that of investing in smaller companies of an emerging-market country.
Revamping Sector Structure
However, inconsistency is apparent in standard sector systems. 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. Such methods also imply that cyclicality exists only in certain sectors. Moreover, most systems require investors to juggle percentages for 10 or more sectors that makes it difficult for individuals to quickly grasp a fund's sector tilt.
Morningstar is introducing a new sector structure that is more unified and consistent than existing approaches, allows for intelligent portfolio diversification, and makes it easier to understand the investment choices being made by portfolio managers. This new structure divides the stock universe 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 more in-depth analysis (see Table1).
While several of the 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. For more details about the new Morningstar sector structure, please click here.
Refining Region Breakdown
Another aspect to assess a portfolio's concentration is its geographical allocation. Despite globalization of world markets, each region still encounters its own set of special circumstances, e.g. political stability. Besides, an increasing number of regional-focused funds launched over the years makes a more refined region scheme practical for portfolio analysis.
The new Morningstar region structure has expanded to divide the world into 10 regions that can be rolled up to three super geographic regions, namely, the Americas, Greater Europe and Greater Asia (see Table 2). In the meantime, emerging markets are split into four regions -- Latin America, Europe Emerging, Asia Emerging and Africa/Middle East. While the region breakdown is based on equity assets only, countries are further classified as developed or emerging based on per capital gross national income groupings defined by the World Bank. This structure serves as the basis for the region breakdown portfolio calculation and a tool for investors to evaluate their equity exposure in various markets.
Table 2: New Region Structure
| Super Region
|
Region
|
| Americas
|
North America
|
| Latin America
|
|
| Greater Europe
|
United Kingdom
|
| Europe Developed
|
|
| Europe Emerging
|
|
| Africa/Middle East
|
|
| Greater Asia
|
Japan
|
| Australasia
|
|
| Asia Developed
|
|
| Asia Emerging
|
What They Mean for Investors
Morningstar Asia will begin using the new sector and region structures in November 2004. They provide easier comparisons of funds and portfolios and allows for better portfolio construction by clearly showing if a new fund would complement current holdings or simply overlap the current sector or region exposure of an investor's portfolio. They also provide better insight into the strategies and decisions of portfolio managers, as well as serving as a basis for understanding relative fund performance.
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