Leading astronomers made a surprise ruling 12 years ago: Pluto, the smallest planet circling the sun, is not a planet at all.
The cosmic reclassification, giving Earth seven planetary neighbors instead of eight, had ripple effects. Stargazers quibbled over Pluto’s demotion. Grade-schoolers dropped the “P” in jingles for memorizing the solar system. But for most people, Pluto’s revised status didn’t change the way they see the heavens.
Celestial definitions came to mind ahead of a rare move by major index providers to change how more than 2,100 companies across the globe are classified. As with Pluto, fund investors will need to relearn some long-held assumptions as a result of the changes. Most index funds that track broad benchmarks such as the S&P 500 or the MSCI World won’t be affected, but many others geared toward specific business sectors and industries will be. For some, the shifts could prove an opportunity to rethink what they own.
What makes a “tech” company?
Why change things? MSCI and S&P are updating their Global Industry Classification Standards (GICS), a framework developed in 1999, to reflect major changes to the global economy and capital markets, particularly in technology.
Take Google, a company long synonymous with “tech” and internet software. Google parent Alphabet derives the bulk of its revenue from advertising, but also makes money from apps and hardware, and operates side ventures including Waymo, a unit that makes self-driving cars. Decisions about what makes a “tech” giant are not as simple as they once were.
The sector classification overhaul, set in motion last year, will begin in September and affect three of the 11 sector classifications that divide the global stock market. A newly created Communications Services sector will replace a grouping that is currently called Telecommunications Services. The new group will be populated by legacy Telecom stocks, as well as certain stocks from the Information Technology and Consumer Discretionary categories.
Some high-profile stocks will be assigned to new sectors after the reclassification. Facebook and Alphabet will move from Information Technology to Communications Services in GICS-tracking indexes. Meanwhile, Netflix will move from Consumer Discretionary to Communications Services. None of what the media has dubbed the FANG stocks (Facebook, Amazon.com, Netflix and Google parent Alphabet) will be classified as Information Technology after the GICS changes, perhaps a surprise to those who think of internet innovation as “tech.” The same applies to China’s BAT stocks (Baidu, Alibaba Group and Tencent). All of these were Information Technology stocks before the changes; none will be after.
Implications for investors
Index changes present sector investors with new risks and considerations. In particular, revamped GICS-tracking sectors will be increasingly top-heavy with a few, big companies. That means sector performance will benefit more when shares of those companies outperform and suffer when they do poorly.
Apple and Microsoft’s representation in the S&P 500’s Information Technology sector is expected to rise to about 37% from roughly 28%, according to market capitalization estimates from BlackRock using Thomson Reuters data from Aug. 31, 2018. In the S&P 500’s Consumer Discretionary sector, Amazon’s index weighting will rise to roughly 35% from 28%. The new Communications Services sector in the S&P 500 will be highly concentrated as well, with Alphabet and Facebook expected to account for more than 50% of the index. Actual sector index fund weightings are likely to differ from BlackRock estimates in order to comply with diversification standards.
Not all index funds are changing, however, and investors have options if they wish to access the current “tech” holdings in a single fund. The majority of iShares sector-focused ETFs do not follow GICS indexes, and so are not directly affected by the changes. For instance, the iShares U.S. Technology ETF (IYW), which seeks to track a non-GICS Dow Jones index, will continue to include Apple, Microsoft, Facebook and Alphabet.
The iShares North American Tech ETF (IGM) will maintain its exposure to securities in the S&P North American Technology Sector Index, including Amazon.com, Apple, Microsoft, Facebook and Alphabet.