Index Spotlight: FTSE & Russell Partner for Classification System By John Spence May 24, 2002

Index providers FTSE and Russell announced Russell indexes will now use FTSE's Global Classification system to establish sector data. The partnership allows investors to make apples-to-apples sector comparisons across the globe using Russell's domestic U.S. indexes and FTSE's international benchmarks.

We spoke with Jane Staunton, President of FTSE Americas, about the new alliance and what it means for investors who use the indexes.

IndexFunds: There's been a trend toward global sector investing, rather than country or regional investing. Sector proponents say the shift is due to the high correlations between developed markets. Have you found evidence of this? If so, what are some of the factors that have led to country economies across the globe moving more in lockstep?

Jane Staunton: Recent quantitative evidence of this trend toward sector investing comes from Yale finance professor Geert Rouwenhorst. He updated a study he conducted for a 1999 article in the Financial Analyst Journal. That article found country selection was more important than sector selection on the performance of equity markets in Europe through 1998. But in his update, using new data through August 2000, he concluded that industry effect had grown considerably so that now it was at least as important in magnitude as country effects on market performance.

Research published by Merrill Lynch in 2001 also shows that sector-based stock allocation has been the dominant investment theme in Europe since 1998. As of last February, the sector-based approach represented 67% of European fund managers' allocation process. The trend is also supported in data from an August 2000 Goldman Sachs Strategy Focus. In January 1995 global sector influences accounted for just 7% of individual stock performance; by mid 2000 that figure had increased to 18% - eclipsing the importance of both local and global market influence effects at 15% each.

Other specific reasons for this convergence include the introduction of the Euro currency and the effective amalgamation of many European countries into one "economy" and one currency. European portfolios shifting "home country bias" from their own borders to the borders of the Eurozone is another factor. Yet another factor is the growth of international investment and multinational companies. These large multinationals are often very big in country indexes and more similar in business characteristics, and thus they are priced similarly.

IF: This is the second time we've seen a U.S. and an international index provider get together to facilitate consistent apples-to-apples comparisons. MSCI and S&P developed the Global Industry Classification system jointly. Index providers historically haven't cooperated that much. Will we see more collaboration between index providers in the future? What types of projects would require joint efforts?

JS: The spate of current collaboration is the result of index providers responding to trends in the financial services marketplace. One of these has been an increasing move by plan sponsors to issue global mandates and these international and domestic collaborations help facilitate the management of these mandates. Because of this, I expect we will see more collaboration among index providers like FTSE and Frank Russell. There will also likely be more collaboration between stock exchanges and index providers to offer more locally focused products like tradable indexes. FTSE's partnerships with exchanges like Johannesburg, Athens, Madrid and Hang Seng are examples.

IF: When was FTSE's classification system developed?

JS: The FTSE Global Classification System was redesigned in its current form for 1999. Classification systems were originally developed decades ago but by the end of the 1990s they no longer accurately reflected the new economic environment that had developed. One example is the explosion of information technology companies. New economic sectors and industries had developed and the Classification System needed to be redesigned to reflect the new reality.

The FTSE Global Classification System facilitates the comparison of companies within sectors and subsectors and across national boundaries. It allocates companies to the sub-sector whose definition most closely describes the nature of its business. The nature of each business is determined by studying the proportion of overall profit arising from each of its business areas. It is a three-tiered system, comprising 10 economic sectors, 36 industrial sectors and 100 industry sub-sectors.

IF: In July 2000 FTSE formed a strategic collaboration with Russell. What else have you been doing to facilitate greater visibility of Russell indices in Europe, and vice versa?

JS: The initial thrust of the collaboration is to explore joint marketing opportunities for the FTSE All-World ex U.S. and the Russell 1000, 2000, 3000 Indexes to U.S. plan sponsors and asset managers. Our indexes are complementary because they each capture the broadest segment of the domestic and international markets. The two companies share similar philosophies about the approach to benchmark index construction. We are both rules-based, resulting in a consistent, transparent and objective methodology. The partnership between the two companies is the result of a shared determination to deliver a clear structure to help asset owners and managers to better and more consistently manage their overall risk, saving time and money in the process.

IF: How can Russell and FTSE clients benefit from the use of a common classification system?

JS: Through the Russell Daily Holdings File, the entire family of Russell U.S. indexes are available with sector attribution and performance calculations aligned to the FTSE Global Classification System. Because of the common classification methodology, this new service will enable Russell clients to better understand their sector bets across the globe if they are using, for their international investments, the FTSE All-Word ex U.S. index or another FTSE All-World index along with the appropriate Russell U.S. equity index.

If a plan sponsor, for example, is utilizing different classification systems for its U.S. and non-U.S. segments, the aggregate sector weights or bets are more difficult to interpret when different systems are used for each asset class. As sectors become more aligned globally, investors will have the opportunity to experience enhanced sector attribution analysis and make more informed investment decisions. The FTSE and Russell relationship will enable both providers' clients to analyze their sector allocations across all regions of the world using Russell indexes for the domestic U.S. markets and FTSE indexes across the rest of the globe.