The income and wealth level of each market
Index providers may create and implement classification frameworks and standards to help group securities and provide additional information to investors. These frameworks and standards can target the following security characteristics:
Assigning securities to a single country to help create country, regional or global indexes
Reflecting the economic development and accessibility of each market (for example a developed, emerging or frontier market)
Reflecting the primary business activity to help the index provider create sector-specific indexes
Assigning securities to company size segments to help the index provider create size-specific indexes (large, mid or small companies)
The above frameworks can be used in isolation or in combination, for example an index focusing on large cap companies in the healthcare sector.
Frameworks and standards may be designed to avoid overlaps (companies classified in more than one category) and gaps (the standard is incomplete and falls short of covering the desired exposure or market segment).
Deciding what country to assign to a given company is not an easy decision. Businesses are no longer bound by borders, and over time legal and regulatory corporate structures have become more complex. There are several company characteristics that can be used:
|Incorporation||The country where the company is registered as a legal entity. This registration will generate legal, regulatory and tax obligations for that business. Usually, this registration cannot be moved to a different country|
|Primary listing||The main stock exchange where its securities are traded|
|Secondary listing||Companies can seek to list their securities in other exchanges to access new investors and raise its profile|
|Headquarters’ location||Usually where the CEO and main executives maintain their offices. This is not necessarily the same as the country of incorporation, and companies may at times move their headquarters’ locations|
|Geographic distribution of its operations||Where the majority of the company’s revenue comes from or where the majority of its assets (e.g. factories, offices, etc.) is located.|
At MSCI, the country classification is generally determined by the company’s country of incorporation and the primary listing of its securities. If both are the same, then the company will be assigned to that country. If not, the secondary listing location will also come into consideration, in addition to some of the other criteria listed above.
A market classification framework groups markets based on common characteristics linked to their economic development and the level of sophistication of their capital markets.
For example, how can an investor compare the markets in the US and India? What are the practical implementation consequences of investments in these markets? By using MSCI’s market classification, an investor can learn that the US is classified as a developed market, while India is classified as an emerging market. Generally, developed markets have more advanced economies and more mature capital markets. Emerging markets tend to have financial markets that are less developed.
A market classification framework focuses on the following three pillars:
The income and wealth level of each market
The number of securities and how easy it is to buy and sell
How open and how secure is the market to foreign investors
The market accessibility pillar can be a particularly informative one for investors as it assesses the ability of international institutional investors to move their investments in and out of a given market and whether any capital gains may also be recovered.
Depending on how a market scores across all three pillars, it will be classified as a developed, emerging frontier or standalone market.
By assigning a company to a sector, an index may also help investors identify what factors could potentially impact its performance. For example, a bank has a different business model compared to a pharmacy. If interest rates on loans go up, a bank may see its profits rise too, while a pharmacy will not necessarily be impacted. As another example, while an oil company may benefit if oil prices go up, an airline may suffer.
Sector classifications can be used to create new indexes and as part of an investor’s portfolio analysis. They are usually based on revenues, and the company is allocated to the sector where most of its revenues come from. These classifications are usually multi-level and can be quite granular. For example, banks and insurance companies may be grouped in one super sector, while insurance companies can be split into life insurers and property insurers sub sectors. Each company is only assigned to one category in each level.
MSCI, together with S&P Dow Jones Indices, developed a leading classification standard — the Global Industry Classification Standard (GICS®). It is a four-tiered, hierarchical system comprising sectors, industry groups, industries and sub-industries.
If a company is listed on a stock market, it is possible to determine its size by looking at its market capitalization. This is calculated by multiplying the number of shares by the share price. The higher the market capitalization, the bigger the company.
To further segment the market, it is necessary to define what is a large, mid or a small cap. After ranking all the companies from the biggest to the smallest in terms of market capitalization, they can be assigned to a size segment in two ways:
In a fixed number threshold approach, the classification could state that the first 500 companies are large caps, the next 500 are mid-caps, and the rest will be small caps.
In a variable threshold approach, an index provider will look at the overall percentile ranking and state that up to a certain percentile, it will be a large cap company. After, and up to a different percentile, it will be a mid-cap company and so on and so forth.
MSCI uses the variable threshold approach for its flagship range. Largecap companies represent the performance of roughly the first 70% of the free-float market capitalization in a country, mid-cap companies 15% of the companies that follow, and small cap companies will be the remaining.
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