There’s a fundamental change coming to the way Wall Street classifies companies, and it could have major implications for a group of exchange-traded funds that together hold tens of billions of dollars in assets.
In November, MSCI and S&P Dow Jones announced revisions to the Global Industry Classification Standard, which sorts individual stocks into one of the 11 primary sectors based on their business (for example: energy, financial, health care, and so forth). The biggest changes involve the telecommunications services sector, currently the smallest in terms of components, as there are only four companies that fit into it.
Read more about how companies are placed into sectors here
The revamped sector will be broader in scope, tracking the communications sector. In addition to traditional telecom companies, the new sector will also include traditional and internet media companies—for example social media companies and search engines—which currently fit into the information technology sector. Separately, companies that act as online marketplaces will be classified consumer discretionary companies, as opposed to tech companies.
Chart courtesy Credit Suisse Trading Strategy. The graphic is a generalization of the coming changes for the purposes of illustration.
Don’t miss: How the new Communication Services sector could look
Changes of this magnitude are rare, though not unprecedented. Last year, a real-estate sector was created, with the companies spun out of the financials sector, where they had previously been.
The changes will have an impact on several sector-tracking ETFs, which mimic the performance of an underlying sector index by holding the same securities it does, and in the same proportion. Under the revamp, the funds that track the technology sector, for example, will have to completely cut their stakes in the companies that are being moved to a different sector while buying any new ones that enter as a result of the rebalancing.
“According to our estimates, the changes could potentially affect 26 existing ETFs totaling over $60 billion in assets under management, including 10 with over $1 billion,” Credit Suisse wrote in a report. “By our interpretation, this suggests previous tech stalwarts such as Facebook FB, -0.82% Google GOOGL, -0.24% eBay EBAY, -0.47% Activision ATVI, -0.13% Electronic Arts EA, -0.24% and Tencent 0700, -0.54% would need to be sold by current tech sector funds.”
Selling of this nature could mean short-term volatility in the stocks, although MSCI and S&P Dow Jones will be releasing a list of the largest impacted companies in January, and a full list in August 2018, which could mean that the impact is priced into the shares long before any changes occur.
Sector funds are dwarfed in size by broad-market funds, which track indexes like the S&P 500 SPX, -0.52% but they are favorite holdings of investors who feel that a particular sector is poised to rise, but don’t want to take on single-stock risk. The most popular suite of sector funds—the SPDR family, run by State Street Global Advisors—has more than $130 billion in assets across ten primary funds.
The Technology Select Sector SPDR ETF XLK, -0.53% which has $18.9 billion in assets, is expected to be the fund with the biggest impact from the sector changes, followed by the $16.7 billion Vanguard Information Technology ETF VGT, -0.52% The $12.8 billion Consumer Discretionary Select Sector SPDR ETF XLY, -0.58% and Vanguard’s $2.3 billion consumer discretionary ETF VCR, -0.66% will also be impacted.
“There could be nearly $3.4 billion in selling from consumer discretionary ETFs that follow GICS-based sector indices, of which more than 80% would be from XLY,” wrote Victor Lin, a director in Credit Suisse’s quantitative equity trading strategy division. XLY refers to the SPDR consumer discretionary fund. “More than 20% by index weight of S&P and MSCI sector based funds will need to be sold.”
The revamped structure of the discretionary sector will mean Amazon.com Inc. AMZN, -1.40% holds an even larger weight in it. The online retail giant currently accounts for 16.25% of the sector; it could rise to 22%, per Credit Suisse’s analysis. That would make the overall sector much more tied to a single stock’s performance, which could increase volatility.
The change in sector definition reflects how many major companies now operate in multiple business sectors at once. Amazon is probably the most obvious example, as in addition to its e-commerce division it also operates a cloud-computing business, produces television programs and movies, and is moving into grocery stores with its acquisition of Whole Foods. Amazon Web Services, the cloud-computing division, is by itself one of the most valuable businesses in the country, based on a Morgan Stanley analysis; were it a separate company, it would undoubtedly be one of the biggest components of the technology sector.
Among other quirks, telecommunications companies are in the technology sector ETF; their year-to-date underperformance has limited the advance of the tech ETF relative to the tech sector.