How Will the GICS Sector Changes Affect Sector ETFs in the U.S.?

The communication services 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 toward acknowledging the convergence of telecommunications, media, and select Internet companies and overlapping services rendered by these companies, within the GICS structure."

I agree with SPDJI/MSCI that a new classification makes sense, but investors should be aware that 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 measured 1.0 during the trailing three years through December 2017, while the current S&P 500 telecommunication services sector's beta measured 0.6 during that time frame. This is because media and content distributors tend to be more cyclical than traditional phone companies, like Verizon. Also, the current telecommunication services' forward dividend yield measured 4.9% as of 31 December 2017, compared with a 1.4% forward dividend yield for the proposed communication services sector.

Red Rover, Red Rover Send Facebook Right Over
Notable stock migrations from the information technology sector include Facebook (FB, listed in the U.S.) and Alphabet (GOOGL, listed in the U.S.), 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 2018 GICS update. Other S&P 500 names from this subindustry include Akamai Technologies (AKAM, listed in the U.S.) and VeriSign (VRSN, listed in the U.S.), which will remain in the information technology sector under the "Internet services & infrastructure" subindustry. EBay (EBAY, listed in the U.S.) is also currently a member of the to-be-discontinued Internet software & services subindustry and will join the consumer discretionary sector in the "Internet & direct marketing retail" subindustry with the likes of Amazon.com (AMZN, listed in the U.S.), Priceline (PCLN, listed in the U.S.), and Expedia (EXPE, listed in the U.S.).  Netflix (NFLX, listed in the U.S.) and TripAdvisor (TRIP, listed in the U.S.) are members of this cohort that will join the communication services sector from the consumer discretionary sector.

Based on market capitalizations at the end of December 2017, the communication services sector will represent about 10.2% of the S&P 500. In addition to the current telecom services stocks (these represent 2.2% of the S&P 500), the updated sector will draw names from the consumer discretionary and information technology sectors that represent about 3.1% and 5.1%, respectively, of the S&P 500. Exhibit 2 shows how the S&P 500 sector weightings will change based on market cap as of 31 December 2017.

These sector changes help reduce sector concentration within the S&P 500. The five largest sectors currently represent nearly three quarters of the S&P 500's market cap. After the announced GICS sector changes, the top five sectors will represent about two thirds of the S&P 500's market cap.

What Do I Need To Do?
For most broadly diversified equity funds, this GICS reclassification is simply a relabeling exercise, but there could be implications for investors in sector-focused funds. State Street Global Advisors' (SSGA) Technology Select Sector SPDR (XLK, listed in the U.S.) is the largest sector exchange-traded product affected by the GICS update, with US$19.4 billion in assets as of 31 December 2017. SSGA already combines the GICS information technology and telecommunications sectors within XLK.

To represent the newly created communication services sector, SSGA will have to add stocks carved out from the consumer discretionary sector to XLK or create a separate communication services sector exchange-traded fund by carving out communication services sector stocks from XLK and Consumer Discretionary Select Sector SPDR (XLY, listed in the U.S.). Adding the affected consumer discretionary sector stocks to XLK would create a fund that represents nearly 30% of the S&P 500, so it may make more sense to create a separate ETF for the communication services sector. However, an ETF that only targets S&P 500 communication services stocks may not comply with the 1940 Act's diversification requirement, because Alphabet's stock share classes would sum to more than 25% of the portfolio, as of December 2017.

Vanguard does not include telecommunication services stocks in Vanguard Information Technology ETF (VGT, listed in the U.S.). Vanguard will likely carve out affected stocks from VGT and Vanguard Consumer Discretionary ETF (VCR, listed in the U.S.) and add them to Vanguard Telecommunication Services ETF (VOX, listed in the U.S.). Like State Street, Vanguard Financials ETF (VFH, listed in the U.S.) 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 U.S. Technology ETF (IYW, listed in the U.S.), iShares U.S. Consumer Services ETF (IYC, listed in the U.S.), and iShares U.S. Telecommunications ETF (IYZ, listed in the U.S.) may perform differently than their sector index peers that track GICS-defined sector indexes. As of 31 December 2017, the five largest affected ETFs listed in the U.S. 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 views.