As the financial media has covered heavily, the end of September will see changes to S&P and MSCI’s commonly used Global Industry Classification System (GICS) sector methodology. The Telecommunication Services sector will be renamed Communication Services, and a number of prominent technology names will be moved to this newly christened sector.
While this may seem like a minor tweak to an arcane process, the many high-profile technology companies it affects means investors should understand the motivation for these changes. It’s also important to be aware of the portfolio-management implications, since active sector bets may change radically as a result of these newly defined sectors. Sadly, many of the articles covering this topic are larded with jargon and disguise what is in reality an intuitive evolution of the sector structure to reflect changing markets. Three questions, and their answers, are all you really need to know to be up to speed.
Why are public companies divided into sectors?
Sectors are intended to represent subdivisions of the equity universe in which each stock is assigned to one (and only one) category and each category represents a material portion of the investment universe. The basic desire is to have a high degree of commonality among the business models of stocks within a sector and a high degree of differentiation among the business models of stocks in different sectors. While these divisions will always be a bit arbitrary, the end goal is to have a grouping of stocks that will move somewhat in parallel with economic conditions and whose members are suitable comparisons with other members of the same sector.
What are the proposed GICS sector changes?
In brief, the Telecommunication Services sector will expand and be renamed Communication Services. Media companies (for example, Netflix, Comcast, Disney) will move from Consumer Discretionary into Communication Services. Similarly, internet services companies (Facebook, Google, Tencent, etc.) will move from Information Technology into this new sector. Finally, e-commerce companies (primarily eBay and Alibaba) will move from Information Technology to Consumer Discretionary.
Why are the GICS sectors changing now?
Two main drivers exist for creating the Communication Services sector.
First, the telecom landscape has changed dramatically. Twenty years ago, when GICS sectors were introduced, there were a large number of telecommunications companies globally, each competing with one another for cellular, long-distance, and local phone business. Thanks to tremendous industry consolidation, this has dwindled to only three companies in the US, representing only 2% of the S&P 500® Index. This challenges the notion that the telecom sector is a major component of the equity universe.
Second, the IT sector 20 years ago included primarily hardware companies (manufacturers of computers, chips, and modems) and software companies (providers of prepackaged programs). Since then it has come to include a broad range of companies that do neither, instead using technology to deliver a service (think Facebook or Google), and whose business is most definitely not the sale of hardware or software. This has turned the IT sector into a mishmash of companies that aren’t exactly comparable.
The new sector assignments solve both these problems. By absorbing the shrunken remains of Telecommunication Services, they remove a sector whose prominence has faded such that it no longer warrants sectorhood. Moving internet platform companies out of the IT sector and into the new Communication Services sector sharpens the focus of both. The IT sector now primarily houses companies concerned with the manufacture and sale of software and hardware, while Communication Services primarily houses companies concerned with providing a service via a network, be it the internet or a cellular network.
Implications for investor portfolios
Now that you understand why these changes are occurring, you should also be aware that this evolution could affect sector positioning in your portfolio. For strategies that fully replicate a stated benchmark, this will have zero impact, since every name is held close to index weights, making the before-and-after deviation between sectors negligible. For strategies that allow deviations from the benchmark, the potential exists for sudden unintended shifts in the active sector bets in the portfolio. An extreme example: An active manager who had held only Facebook and Google to represent the IT sector would, as a result of the GICS changes, now hold zero exposure to IT.
Given the size of these changes (nearly 8% of the S&P 500 will be affected), we’ve studied the impact of these sector reassignments on Parametric Custom CoreTM portfolios. Preliminary indications are that we should see little to no impact arising from these sector changes. This isn’t unexpected. We manage our Custom Core portfolios to align with the benchmark across many different factors, including sectors and industries, but as part of the management process we’re also given discretion to deviate from these factors up to a stated limit. Our initial assessment indicates that the new security classifications result in changes that fall within these tolerances for most portfolios.
The bottom line
These GICS sector changes were long overdue, and they figure to inject greater clarity and accuracy into how companies are grouped, which should increase the effectiveness of how portfolios are managed. That said, it’s worth considering whether and how the changes could affect your overall portfolio—and to be prepared to reexamine your sector allocation under the new paradigm.
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Tim Atwill, PhD, CFA – Head of Investment Strategy
Mr. Atwill leads the Investment Strategy team at Parametric, which is responsible for all aspects of Parametric’s investment strategies. In addition, he holds investment responsibilities for Parametric’s emerging market and international equity strategies, as well as shared responsibility for the firm’s commodity strategy.
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