How Sector Changes Impact Portfolios

Should you change your portfolio to adjust to the new GICS sector classifications?

On Friday, Sept. 28, the new GICS sector reclassifications, upon which S&P and MSCI base hundreds of indices, will finally be complete.

ETF.com has covered the impending changes extensively (read: "Changes Ahead For 24 Sector ETFs"). In short, the telecommunication services sector will expand and be renamed the communication services sector, into which will move Facebook (FB) and Alphabet (GOOGL), along with thousands of other companies currently in the information technology sector. Meanwhile, online marketplaces like eBay and Alibaba, previously classified as information technology, will move to consumer discretionary, joining Amazon (AMZN).

But what do all these changes really mean for investors' portfolios?

"This is one of the largest sector reclassifications investors have ever faced," said Daniel Prince, head of iShares’ U.S. Wealth Advisory Product Consulting at BlackRock. "It's time for investors to re-evaluate what that means for their models going forward."

From Defensive To Cyclical

For starters, the new sector will dramatically change in its sensitivity to the broader economy.

Traditionally, telecommunication services was one of the more defensive sectors in the GICS classification. Like utilities or consumer staples companies, telecom stocks tend to be more insulated from big market swings. Plus, they exhibit inelastic demand: Whether markets go up or down, consumers in the 21^st century will always need their cellphones and data plans.

All that's changing with the GICS reclassification. Communication services will instead heavily skew toward tech stocks over telecom, meaning the new sector will behave far more cyclically than its predecessor.

That matters because defensive sectors, which post low earnings growth but strong dividends, are often an excellent source of regular income for investors who need it. Meanwhile, cyclical sectors post higher earnings growth and weaker dividends—and are much more connected to market volatility.

Investors who need that income therefore shouldn't sit on the sidelines for the change, says Prince.

How Popular Indexes Will Change

As a result of the GICS revisions, several popular S&P and MSCI indexes—as well as the ETFs based on them—will shift in their sector compositions.

For example, the S&P 500 Index, the basis for the popular SPDR S&P 500 ETF Trust (SPY), the iShares Core S&P 500 ETF (IVV) and the Vanguard S&P 500 Index ETF (VOO), will revise from a 2% sector weight in telecommunication services up to an 11% weight in communication services. Meanwhile, the weight comprised by information technology and consumer discretionary in that index will decrease by 6% and 3%, respectively:

Sources: MSCI, iShares; "GICS Reclassification Changes: Implications For ETF Investors" August 2018

In the MSCI All Country World Index (ACWI), upon which the iShares MSCI ACWI ETF (ACWI) is based, financials will become the largest sector post-GICS change, instead of information technology. Communication services, meanwhile, will comprise 9%, up from 3% for telecommunication services.

The most dramatic shift, however, comes in the MSCI Emerging Market (EM) Index, the benchmark for the iShares MSCI Emerging Markets ETF (EEM). Information technology will no longer be the largest sector for this index either; post-changes, it will be equal in weight to communication services (15%). In addition, communication services significantly increases in weighting from 4% for telecommunication services:

Sources: MSCI, iShares; "GICS Reclassification Changes: Implications For ETF Investors" August 2018  

Which ETFs Will Be Impacted?

To be clear, no stocks will enter or exit these indexes because of the GICS reclassifications. The indexes' existing constituents will remain the same; they'll just switch which particular sector bucket they fall into.

Furthermore, if you only invest at the broad market level, rather than the sector level, "this is a nonevent for you," said Prince.

What will change, however, is the composition of ETFs that slice-and-dice these indexes along sector lines. We've previously reported on that list of funds; we reproduce an updated version below:

Sources: ETF.com, FactSet; data as of Sept. 19, 2018

(For more information, read: "Changes Ahead For 24 Sector ETFs.")

In addition to these vanilla market-cap-weighted funds, certain smart-beta ETFs that use the S&P and MSCI indexes as baselines for their strategies will also be impacted, such as the Invesco S&P 500 Equal Weight Consumer Discretionary ETF (RCD).

Plus, at least one new ETF has launched dedicated to the new communication services sector: the Communication Services Select Sector SPDR Fund (XLC). In its three-month life span, the ETF has already accrued $977.5 million in assets under management.

Question Of Timing

To reflect the reclassifications, GICS-based indexes will require rebalancing, the timing of which differs depending on the indexer.

S&P Dow Jones Indices have already rebalanced their relevant indexes, coinciding with a quarterly rebalance on Sept. 24. The only exception is the S&P North American tech sector, which rebalances on Dec. 21. (This index serves as the basis for the iShares North American Tech ETF (IGM), which, according to Prince, will retain Facebook and Alphabet, among others, despite the GICS reclassifications.)

Meanwhile, MSCI will rebalance its indexes as part of its November 2018 semiannual index review, effective Nov. 30.

That means MSCI indexes (and presumably the ETFs based on them) could begin tracking significantly out of step with their underlying GICS classifications throughout the next two months.

Capital Gains On The Way?

Regardless of the timing of a rebalance, it will mean turnover—which could in turn lead to capital gains. However, some ETF issuers have worked hard to avoid capital gains events for their investors, baking the expected changes into their funds slowly.

Vanguard, for example, appears to have used the in-kind creation/redemption process for several weeks this summer, in order to avoid large capital gains distributions from occurring in its two ETFs impacted by the GICS changes: the Vanguard Information Technology ETF (VGT) and the Vanguard Consumer Discretionary ETF (VCR) (read: "Behind Vanguard's Strange 'Heartbeat' Flows").

But there's no guarantee. Investors should remain aware that big rebalances and reconstitutions could lead to an unwelcome tax event come next April.

GICS Vs Non-GICS

One last caveat: Investors should remember that not all sector ETFs are based on GICS classifications. For example, iShares, Invesco and First Trust all offer sector ETFs based on non-GICS benchmarks, including Nasdaq indexes, Dow Jones indexes and self-branded indexes.

After the GICS changes, meaningful differences are likely to emerge in the performances of GICS-based ETFs versus non-GICS based ones, says Prince, due to the varying exposures. He cites the example of the iShares U.S. Technology ETF (IYW), which will retain exposure to Facebook and Alphabet, versus the Technology Select Sector SPDR Fund (XLK), which won't.

"More investors will become aware of the GICS changes once they start to note changes in performance," he added. "Investors will need to know what they own, and be able to tell the difference between two funds that have similar names but very different holdings."

Contact Lara Crigger at [email protected]