As you may know, the Global Industry Classification Standard (GICS) controls how companies are sorted into sectors within stock indices. On September 28, 2018, the MSCI and S&P Dow Jones indices began to make big changes to the structure of the GICS—perhaps the most impactful changes we’ve seen in GICS history. But how will your portfolios be affected? Let’s take a closer look, starting with a breakdown of exactly what these changes entail.
Sectors on the Move
In short, several major components of the technology and consumer discretionary sectors will be moving into the telecommunications sector. The telecom sector is also being renamed communication services. More than 10 percent of the entire S&P 500 market cap will be reclassified, with 24 percent of the consumer discretionary sector and 21 percent of the technology sector being affected. Key names within these sectors (e.g., Facebook, Alphabet, Twitter, Netflix, and Walt Disney) will be moving to the new communication services sector (see Figure 1).
Figure 1. Securities Within the S&P 500 That Are Expected to Be Reclassified
Source: SSgA, S&P Dow Jones Indices, as of July 31, 2018
To provide some perspective, the GICS made a change in 2016 that lifted real estate from the financials sector to create its own sector. But this upcoming change will be the first one to the technology sector since 1999—and it may be long overdue. With advances in technology, particularly Internet services and Internet media, the technology sector has become extremely large at more than 26 percent of the S&P 500. This change will significantly reduce this size. It will also create sectors that make a bit more sense given how telecom, Internet, and media companies have become more integrated over the past several years.
The resulting index breakdown within the S&P 500 is illustrated in Figure 2.
Figure 2. Projected S&P 500 Index Sector Weights
Source: SSgA, Bloomberg Financial, as of July 31, 2018
As you can see from this chart, the tech sector will be reduced to a little more than 20 percent of the index, with consumer discretionary reduced to just under 10 percent. The existing telecom sector will be wrapped in with the new constituents coming over from technology and consumer discretionary to create the communication services sector, which will represent more than 10 percent of the index.
How will this affect investors and asset managers?
Investors in S&P 500 funds will actually see very little impact. Why? The weights within the index are not being changed, only how they are being classified from a sector standpoint. Those who are invested in sector-focused funds or exchange-traded funds (ETFs), on the other hand, may see a greater effect, as the holdings in their funds will likely change as fund providers adjust their products to remain in line with the new sector classifications.
This change could also affect how active managers allocate their portfolios across these new sectors. Many other mutual fund and ETF managers have mandates that keep them within certain ranges of their benchmark sector weights. As such, some managers may be forced to look more closely at the newly formed communications sector and consider adding new names or adjusting existing positions. If portfolio managers find themselves overweight in the communications sector, they will have to decide which stocks to sell. This sector is no longer just AT&T, Verizon, and a handful of other names. Portfolio managers will have to determine whether to sell AT&T, Facebook, or Netflix. It will be interesting to watch the names within the new communication services sector as we head into the fourth quarter.
New communications services sector versus the old telecom sector
The new sector will become a more growth-oriented sector compared with the old telecom sector, which was often used as a bond proxy. Investors looking for the safety and yield that the telecom sector once provided will have to look at individual stocks rather than investing in the sector. The new communication services sector will be more sensitive to the equity market but less sensitive to the 10-year Treasury yield (Figure 3).
Figure 3. 36-Month Beta Sensitivity
Source: SSgA, FactSet, as of May 31, 2018
The new communication services sector will also carry much higher valuations, with an approximate forward price-to-earnings ratio of 18x compared with just 10x for the old telecommunications sector. Valuations in the consumer discretionary sector are expected to increase slightly because of this change, while the new technology sector is expected to have slightly lower valuations.
A Meaningful Change
If you are invested in S&P 500-based products or actively managed mutual funds, you will experience very little impact because of this change, as constituents’ weights will remain the same. But if you are using sector-focused funds or ETFs for exposure to technology, consumer discretionary, or telecom, understand that those funds could change significantly.
Certain sections of this commentary contain forward-looking statements based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict.
Exchange-traded funds (ETFs) are subject to market volatility, including the risks of their underlying investments. They are not individually redeemable from the fund and are bought and sold at the current market price, which may be above or below their net asset value.
All indices are unmanaged and investors cannot actually invest directly into an index. Unlike investments, indices do not incur management fees, charges, or expenses. Past performance does not guarantee future results.
Chris Borden is a financial advisor located at Canby Financial Advisors, 161 Worcester Road, Framingham, MA 01701. He offers securities and advisory services as a Registered Representative and Investment Adviser Representative of Commonwealth Financial Network®, Member FINRA/SIPC, a Registered Investment Adviser. He can be reached at 508.598.1082 or [email protected].
Authored by Brian McCormick, CIMA®, manager, investment management and research, at Commonwealth Financial Network®.
© 2018 Commonwealth Financial Network®