In earlier steps, you should have defined top level asset classes that have a lack of correlation to one another and a timeless strategy. Then, you should have selected underlying sectors that strategically boost returns and take advantage of leading indicators. Together, these two categorizations represent your investment strategy.
After you have developed your investment strategy, you are ready to select securities to represent each sector and determine a system you can use to categorize all future holdings. There are four questions to ask in this process.
First, are there indexes which obviously represent this sector?
During the process of selecting underlying sectors, you may have used the behavior of specific indexes to justify the strategy of how to subdivide an asset class. Those same indexes ease the process of categorizing what belongs in each of those sectors.
To do that, use the index to define the sector and compare later investments to the index. Securities that are highly correlated to, share many of the underlying holdings in common with, or in general match the intention of the index should likely be wholly or partially identified as part of that sector.
For complicated categorizations, even your index might not perfectly identify the category. For example, none of the U.S. stock indexes fit neatly into the Morningstar style boxes. Even when they target U.S. Small Cap Value, for example, assets spill out into adjacent boxes like Mid, Growth, and Blend. In cases like this, using a clearly defined categorization method, such as Morningstar's, can guide your security categorization in place of an index.
The hardest cases are when the strategy of a sector is novel and thus not represented by an existing index. We have this problem with Freedom Investing. Stocks from countries high in economic freedom and low in debt and deficit tend to outperform those in less free countries. That being said, there is no investment index for this strategy. The Index of Economic Freedom, from which the theory was created, is simply a ranking of countries put out annually by the Heritage Foundation.
Another hard-to-categorize sector for us is Energy. We allocate some investments to an Energy sector as an inflation hedge. We define the sector as companies who own energy resources. However, energy indexes usually include energy distributors who own pipelines but not the gas that moves through them.
These hard cases require continuing onward to the other questions.
The second question is: do there exist any indexes which, when combined together, can represent the sector?
Although our strategy of Freedom Investing can't be found in a single index, most countries have their own country-specific index. These country-specific indexes can be combined together in semi-equal portions to represent Freedom.
To represent this investment strategy, we split the sector of Freedom Investing further into sectors for each of the underlying countries - Hong Kong, Australia, etc. - dividing the allocation we would have put into Freedom strategically between these new sectors.
For Energy, however, there isn't an index which targets the ideal group of energy companies which fit our intention for the category.
Third, is there an easily discernible method of identifying securities that fit this categorization?
Most sectors without a matching index still have criteria which can be used to judge what should be included in the index. You had some intention when you defined the strategy. Now, the task is to formalize and document that strategy.
For Energy, that meant realizing that in order to meet our goal of providing an inflation hedge, inclusion in our sector required owning resources in the ground. This means that they own actual energy resources not just are a company in the energy industry.
All companies discuss the scope of their business and will often mention how much proven reserves they own of a specific energy resource. This makes the extent to which a company fits our criteria relatively easy to identify.
This definition helps categorize companies, but we don't recommend relying on individual stock purchases to implement your investment strategy. Most energy funds include energy distributors in their allocation, making them less than ideal to represent the category. As a result, some compromise will have to be made.
Fourth, do you need an "undesirable sector" definition?
If the undesirable portion of an index or investment is significant, you can define another sector to categorize the undesirable portion. Then you can split fund categorization between the two sectors accordingly. The split may help you target the portion most helpful to your portfolio while minimizing the less desirable component.
We may split out the portion of energy funds which represent companies that own no resources, for example, into the less desirable sector of Energy Distribution. Then, we can track our allocation to this undesirable category while seeking to maximize our allocation to the desirable one.
Alternately, we may determine that the less desirable category isn't significant enough to warrant the time and effort it would require to catalog and avoid. A correlation of 0.85 or higher with our target selection of stocks is our ultimate goal. For this reason, undesirable components which are less than 15% of a fund will nearly always be good enough to represent the intention of our sector allocation.
The more a less desirable component is correlated with the intended category of stock, the more you can tolerate an allocation to the less desirable sector without losing the benefit of the category. Thus, rather than meticulously splitting each fund into the desirable and undesirable portion you could count the entire fund as allocated to the targeted sector.
If you choose not to split out an undesirable sector, you should still purchase funds that best represent your desired sector.
In the case of Energy, most energy funds have a large enough percentage of companies with proven reserves to cause the fund to move in sync with these companies. Furthermore, when energy companies that own energy are doing well, the companies in the energy portion of the economy are often moving in sync and also appreciating.
As shown, these four questions are helpful in handling even the trickiest sector definitions.
This process of defining your sectors is an attempt to identify the quintessential features of your strategy and formalize your selection criteria. The next step is to identify the best funds to implement the strategy you have developed.