The impending reclassification of S&P 500 sectors will cause upheaval among tech companies like Facebook and Alphabet, and impact investor portfolios.
S&P Dow Jones Indices is reclassifying its industry taxonomy – the Global Industry Classification Standard (GICS). The high growth tech companies – Facebook, Amazon, Netflix and Google parent, Alphabet (collectively known as FANG) – are currently in the Information Technology sector. The stock bull market can be attributer to the FANG companies’ strong performance in recent years.
S&P has stated that these changes are intended to emulate the changes in the tech, media and consumer industries. S&P has seen a convergence of companies in these sectors and the services they offer. Mutual funds typically have internal rules to distribute investments across sectors, which will be affected by the reclassification.
On September 24, S&P will move Facebook, Alphabet and five other companies that collectively make up a fifth of the Technology sector to the Communications sector. The communications sector, previously called the Telecom sector, currently consists of companies like AT&T and Verizon. Heavyweights from the Consumer Discretionary sector, Netflix, Disney and Comcast, will also move to Communications. Amazon will remain in the Consumer Discretionary sector.
The Telecom sector previous only accounted for 2 percent of the S&P 500. With the change to Communications, this sector will now be a more significant part of the market index and subsequently, be a more prominent option for investors. This change allows for greater balance between the Technology and Communications sectors as the Tech sector falls from 26 percent to 20 percent of the S&P 500. In addition, the previously overlooked Telecom sector was especially vulnerable due to the small number of companies included. The augmented Communications sector is much equipped to mitigate the risk of significant changes by the large companies within the sector.
In the new Tech sector, Microsoft, Visa, Intel and Cisco will all increase in weight and join Apple to be the five largest companies in the sector. With the absence of Alphabet and Facebook, the new Technology sector composition will allow investors to get a clearer look at the smaller companies in the sector. Apple is considered to be part of the extended FAANG group and will increase its share of the index’s market capitalization by staying in the Tech sector. Despite the reclassification, the Tech sector will comprise of companies with a proved record of strong performance.
The changes will impact mutual fund managers and their decision making process. Mutual fund providers are already making changes to their offerings with the addition of funds tracking communications services. In addition, the consolidation of companies in the Communications sector could lead to the overvaluation of bids and subsequently, leverage.
Overall, the changes will affect 26 companies across three sectors, resulting in a tenth of the S&P 500 being impacted. The impact is expected to be amplified by the recent growth in exchange traded funds and products.
Trading is not likely to be significantly impacted as the changes were publicly announced well in advance, giving market participants ample time to prepare. However, the reclassification will result in some volatility as stocks are transferred to different industries, causing investors to fine-tune their portfolios. The reclassification also raises the possibility of increased regulations. Facebook and Alphabet are joining the highly regulated companies in the Communications sector, which could indicate expectations that these companies will soon be more regulated.
Our assessment is that this change in classification could be beneficial to the market and investors. While companies and investors are well aware of the upcoming changes, the true impact remains to be seen. We feel that the changes will force investors and fund managers to rethink their strategies for gaining exposure and setting sector-based benchmarks. We also feel that the greater balance among sectors will allow investors to make more informed decisions once the market has settled. Finally, we think the extended FAANG will continue to dominate the growth factors in the U.S. stock market.