How will the proposed 2018 Global Industry Classification Standard changes affect your sector-focused ETFs?
By Adam McCullough, CFA | 11-29-17 | 06:00 AM | Email Article

In mid-November 2017, S&P Dow Jones and MSCI (SPDJI/MSCI) announced that the Global Industry Classification Standard, or GICS, telecommunication services sector would be broadened and renamed communication services. The communication services sector will add select media, entertainment, and consumer Internet stocks from the consumer discretionary and information technology sectors to its current telecommunication services constituents.

Adam McCullough, CFA, is a manager research analyst for Morningstar.

The GICS structure changes will be implemented after the market close on Friday, Sept. 28, 2018. SPDJI/MSCI plan to announce the large market capitalization companies affected by the GICS structure change in January 2018. This change will have an impact on index funds that focus on the telecommunication, information technology, and consumer discretionary sectors.

How Did We Get Here?
SPDJI/MSCI joined forces to create the GICS industry taxonomy system in 1999. GICS organizes companies into subindustries based on the business activities that generate most of each firm’s revenues. GICS is a four-tiered system where subindustries roll up into industries that make up industry groups, which are merged together to create the familiar GICS sectors. The original rendition included 10 sectors, 23 industry groups, 59 industries, and 123 subindustries. There are currently 11 sectors, 24 industry groups, 68 industries, and 157 subindustries. The last major GICS change occurred at the end of August 2016 when SPDJI/MSCI created the new real estate sector as an industry group carve out from the financials sector. Although that change created a new GICS sector, the forthcoming GICS sector reshuffle affects several sectors and will be more complicated than the real estate sector creation, which had an impact on only the financials sector.

Impact Analysis
I evaluated SPDJI/MSCI’s GICS press release to create my projections of the S&P 500 constituents that will make up the newly anointed communication services sector. Note that Exhibit 1 is solely my view, and SPDJI/MSCI plan to provide more information about which large-cap stocks may be affected by the GICS update in January 2018. I calculated stock weightings in Exhibit 1 using market capitalizations as of Nov. 17, 2017. Bold text represents new industry groups, industries, or subindustries.



The newly formed sector adds media-focused stocks from the consumer discretionary sector and information technology stocks that create or distribute content through proprietary platforms to the current telecom services lineup. SPDJI/MSCI explains that categorizing these stocks together “is a step towards acknowledging the convergence of telecommunications, media, and select internet companies and overlapping services rendered by these companies, within the GICS Structure.” Given the integration of Internet, media, and telecommunications companies, I think that the GICS updates accurately reflect the changing competitive environment and are appropriate.

That said, these changes will significantly alter the composition of the current telecommunication services sector, making it considerably broader and less defensive. For example, the new S&P 500 communication services sector’s beta with the S&P 500 (a measure of market sensitivity) would have been 1.0 during the trailing three years through October 2017, while the current S&P 500 telecommunication services sector’s beta measured 0.6 during that period. This is because the media and content distributors tend to be more cyclical than traditional phone companies, like  Verizon Communications  . Also, the current telecommunication service’s forward dividend yield measures 5.6% as of October 2017 month-end, compared with a 1.5% forward dividend yield for the proposed communication services sector.

Notable (possible) stock migrations from the information technology sector include  Facebook  and  Alphabet  , which will anchor the newly established interactive media & services subindustry. Facebook and Google currently belong to the Internet software & services subindustry, which will be discontinued as part of the August 2018 GICS update. Other S&P 500 names from this subindustry include  Akamai Technologies  and  VeriSign  , which will likely remain in the information technology sector under the Internet services & infrastructure subindustry.  EBay  is also currently a member of the to-be-discontinued Internet software & services subindustry and will probably join the consumer discretionary sector in the Internet & direct marketing retail subindustry with the likes of  Amazon.com  ,  Priceline   Expedia  , and  TripAdvisor  .  Netflix  is currently a member of this cohort but will likely move to the new movies & entertainment subindustry to join the communication services sector from the consumer discretionary sector.

Based on stock market capitalizations as of Nov. 17, 2017, the communication services sector will represent about 10% of the S&P 500. In addition to the current telecom services stocks (these represent 2% of the S&P 500), the updated sector will draw names from the consumer discretionary and information technology sectors that represent about 3% and 5%, respectively, of the S&P 500. Exhibit 2 summarizes the S&P 500 sector weighting changes based on current market capitalizations.



The sector changes help reduce sector concentration within the S&P 500. Currently, the top five sectors of the S&P 500 represent nearly 75% of its market capitalization. After the projected GICS sector changes, the top five sectors will represent about two thirds of the S&P 500’s market capitalization.

State Street Global Advisors  Technology Select Sector SPDR ETF is the largest sector exchange-traded product affected by the GICS update, with $19.5 billion in assets as of Nov. 17, 2017. SSGA already combines the GICS information technology and telecommunication sectors into XLK. To represent the newly created communication services sector, SSGA will have to add the stocks carved out from the consumer discretionary sector to XLK or create a separate communication services sector exchange-traded fund. Creating a separate ETF for the communication services sector may make more sense because adding the affected consumer discretionary sector stocks to XLK will create a fund that represents nearly 30% of the S&P 500. As of this writing, SSGA communicated that it would be able to share more-detailed analysis in January 2018 when SPDJI/MSCI announces the large market capitalization stocks affected by the GICS update.

Vanguard does not include telecommunication services stocks in  Vanguard Information Technology ETF . Vanguard will likely carve out affected stocks from VGT and  Vanguard Consumer Discretionary ETF and add them to Vanguard Telecommunication Services ETF . Like State Street,  Vanguard Financials ETF successfully shed its real estate sector stocks from its portfolio without issuing capital gains distributions to its fundholders.

Sector funds that do not use GICS classifications will not be affected. For example, BlackRock’s iShares sector funds track Dow Jones sector indexes and will not be immediately affected by the GICS update. Consequently,  iShares US Technology ETF ,  iShares US Consumer Services ETF , and iShares US Telecommunications ETF may perform differently from their sector index peers that track GICS-defined sector indexes. The five largest affected ETFs as of mid-November 2017 are summarized in Exhibit 3 below.



Understand the Implications for Your Holdings
SPDJI/MSCI incorporates the investment community’s feedback during its annual GICS review and provides a long lead time ahead of potential changes so investors have time to react. Investors who hold affected funds should understand the implications of the upcoming GICS changes, decide if they agree with the reclassifications, and either keep or swap their sector funds to express their investment beliefs.

 

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