Since inception almost two decades ago, the Global Industry Classification System (GICS) has been the standard taxonomy employed by the financial community to sort business entities by sector and industry group.
Changes to this taxonomy, no matter how small, can have a significant impact on how companies are classified and which enterprises are included in sector index and index products developed by Standard and Poor’s and MSCI. Understanding how these changes impact company and industry groupings is therefore critical for investors with exposure to ETFs.
In January 2018, S&P Dow Jones Indices, a division of S&P Global, introduced several revisions to the GICS structure. These changes, which will be implemented after the close of business on Sept. 28, 2018, impact three specific sectors:
- Consumer discretionary
- Information technology
The MSCI Equity Indexes will reflect these changes as part of its semi-annual index review in November 2018.
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While changes to industry classifications may seem like a drastic measure, they reflect the natural evolution of businesses at the cross-section of information technology, communications and retail. The existing classification system, which was developed in 1999, is no longer sufficient to explain these important changes. The continued integration of telecommunications, media and internet has also led to broad industry consolidation through mergers and acquisitions.
Under the proposed changes, the telecommunications sector will be renamed communications services – a more inclusive banner that accounts for content developers and other media. The new sector will include existing telecommunications companies as well as enterprises from the media industry group, which currently falls under the consumer discretionary sector. This category will also include companies from the internet and direct marketing retail sub-industry along with some big companies currently classified in the information technology sector, including Alphabet Inc. (GOOG) and Facebook Inc.
The internet and direct marketing retail sub-industry, which is currently listed under consumer discretionary, will be updated to include all online marketplaces and e-commerce companies. Companies such as Alibaba Group (BABA) and eBay Inc. (EBAY) will fall under this category.
Finally, the information technology sector will undergo a major overhaul with the internet software and services industry being renamed internet services and infrastructure. Companies such as Shopify Inc. will be impacted. Cloud computing companies currently classified under internet software and services will receive a new category called application software. As a result, the internet software and services industry and sub-industry will be discontinued.
Sector Classification: Before and After
The previous sector weights and the new sector weights after the changes take effect are shown below.
|Current S&P 500 Index||Previous Weights||New Weights|
Taking all these into account, roughly 40% of the S&P 500’s entire market capitalization could be directly and indirectly impacted by the proposed changes. The three sectors most impacted by the changes – consumer discretionary, information technology and telecommunication services – have a total value of $17.6 trillion based on current prices. In terms of direct impact only, the GICS revision affects 10% of the S&P 500 Index market cap, 100% of the telecommunications services sector, 22% of the consumer discretionary sector and 21% of the sector technology sector.
The new GICS structure will be comprised of 11 sectors, 24 industry groups, 69 industries and 158 sub-industries.
How Do These Changes Affect ETF-Focused Investors?
The proposed changes have a direct impact on ETF-focused investors not only for the expected volatility that Sept. 28 will bring, but because of the major rebalancing that is at stake. The reshuffling will impact 23 S&P 500 companies collectively worth $2.7 trillion. As such, sector-based ETFs that rely on the GICS structure may be required to adjust their methodology. Funds with constraints on sector exposure or those that track specific S&P 500 indexes will also be affected.
Click here to learn about the GICS Industry structure.
In an effort to smooth the transition, Vanguard Group has already begun adjusting its sector ETFs, while State Street Global Advisors is launching a new fund to account for the new methodology. This means ETFs such as the Vanguard Telecommunication Services ETF (VOX ), Vanguard Consumer Discretionary ETF (VCR ) and Vanguard Information Technology ETF (VGT ) have been temporarily tracking custom benchmarks in order to reduce tracking error and mitigate market impact. The issuer has also renamed the Telecommunication Services ETF as Communication Services (VOX ). State Street Global Advisors has also launched a Communication Services ETF (XLC ).
The S&P 500’s newly created communications services sector has the following weights:
Under the new GICS structure, science and technology ETFs with exposure to Alphabet Inc. (GOOG) and Facebook Inc will have to sell their existing shares of the companies. At the same time, telecom funds will need to load up on Alphabet and Facebook while offloading some of their investments in AT&T (T), Verizon (VZ) and others. The sectoral shift will therefore create new buying and selling pressure, which means stocks will not be trading in line with their fundamentals.
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From a portfolio management perspective, the new GICS structure will have a significant impact on asset allocation and risk analysis. Telecommunications, long considered to be a “defensive” sector with higher yield potential, will shift to a more growth-oriented focus after the changes are enforced. Therefore, telecommunications will no longer function like utilities (i.e., defensive) but more like information technology.
The telecom revamp leaves consumer staples as the only true defensive play. This sector is represented by ETFs such as the Consumer Staples Select Sector SPDR (XLP ). While ETFs tracking utilities (XLU ) and energy (XLE ) are said to provide a defensive posture, they don’t quite offer the same blend of defensive/value characteristics as telecom.
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S&P 500 indexes will have roughly $55 billion in trading to do to realign their new benchmarks. This includes more than $20 billion in shares that will be traded by ETFs just because of reshuffling. Investors who have allocated assets to specific sectors or industry funds should therefore closely monitor their funds following the changes.
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