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#Investments — 04.10.2018

Changes In Sector Classification

Guillaume Duchesne

The sector indices of MSCI and Standard & Poor’s (S&P) will undergo big changes in the autumn. While S&P has already reclassified its indices (28 September), MSCI will adapt its classification on 3 December.

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What are these changes? 

The change in the Global Industry Classification Standard (GICS®) taxonomy will entail a complete overhaul of the Telecommunications sector, which will be renamed 'Communication Services. This new sector will combine: 

  1. Stocks of Telecommunications Services, such as Orange, AT&T and so on.

  2. Media stocks (Advertising, Broadcasting radio/television, Cable & Satellite, Movies and Entertainment, Publishing), previously classified as Consumer discretionary.

  3. Internet Services - including Alphabet and Facebook - from the technology sector (Internet Software & Services) that will incorporate Netflix and TripAdvisor, initially classified under Consumer Discretionary (retailing). 

Why such a transformation? 

Changes in sector classification are rare (the last one was two years ago, when an eleventh sector, Real Estate, was added). The former classification needed an overhaul to take into account new economic and financial developments. Indeed, the way people communicate, access entertainment content and other information has rapidly evolved over the past decade. Telecommunications, media and internet companies have consolidated through mergers and acquisitions, which are often necessary in an environment of fierce competition. Many of them now offer bundled services such as cable, internet services and telephone services, and even entertainment content for some. 

In addition, technology has become a large heavyweight in indices over the years, particularly in the United States (accounting for 26% of the S&P 500 index). In particular, the 'Internet Software and Services' industry was less relevant, as companies had very different business activities.  This led to the decision to reorganise things:

  • E-commerce companies such as eBay and Alibaba are now classified in the Retailing industry along with Amazon (Consumer Discretionary). Although they only use technology to carry out their business, they cannot be classified as pure tech players.

  • Internet services (Facebook, Alphabet, Tencent, Twitter, Yahoo!) are included in the new 'Communication Services’ sector.

  • On the other hand, Cloud infrastructure activities (Shopify) are kept in the technology sector within the ‘Internet Services & Infrastructure' sub-sector. 

What are the consequences of this reclassification? 

A significant rebalancing between sectors 

The weight of Technology and Consumer Discretionary will decrease in the new nomenclature.  Within the S&P 500 index, the weight of the Technology sector will decrease from 26% to 20%, while Consumer Discretionary will be slimmed down from 13% to 10%. Meanwhile, Communication Services will represent 11% (versus 2% for Telecommunications under the former classification) and will become the fourth-largest sector behind Technology, Health Care and Financials. 

Given the small presence of Technology stocks in Europe, the changes will be less dramatic.  The weight of Technology will be almost unchanged (approximately 5%) and Communication Services will account for less than 5% in the Stoxx 600 index (compared with 2% for Telecommunications). 

A refocusing of technology on its core business 

The technology sector will be more oriented towards semi-manufacturers and hardware and software providers. In the United States, its profile as a growth sector tends to be weakening, with a declining sector P/E, while earnings growth for 2018 will fall from 20% to 17%. The dividend yield will decrease slightly (to 1%). 

A reinforced role of certain stocks 

Some sectors will be concentrated on a handful of large names. Apple for Technology, Amazon for Consumer Discretionary and Facebook and Alphabet for Communication Services. For example, Apple will be even more dominant in the Technology sector, accounting for 20% of the industry (versus 15% under the old nomenclature). 

Communication services, a more cyclical sector 

In the United States, almost half of its components will come from Technology. The remainder will consist of Media and Telecommunications companies. Consequently, the new sector:

  1. will be much more cyclical than the former Telecommunications sector. It will be much more correlated to Technology and Consumer Discretionary.

  2. will have above-average volatility and will yield an estimated return of 1.3% (compared with 5% for the Telecoms sector).

  3. will have a higher beta than in its previous form.

In Europe, however, the cyclical nature of the sector will be less marked. Stocks will be dominated by Telecoms (60% of the sector's stocks against only 20% in the US), while Internet Services will be virtually non-existent (only 3% of the sector's stocks). 

What is the impact on active and passive investment funds? 

These changes will have repercussions for mainly passive funds as active portfolio managers will continue to invest in stocks of their choice. Index-based managers, whenever relevant (sector funds), will need to adjust their positions in view of the change in the benchmark index. This may result in stock rotations, sometimes into or out of large cap stocks, which could potentially increase volatility when the new classification is adopted. As the bulk of Internet Services & Technology stocks are American, the US market will be the first to be affected. 

Note also that not all ETFs follow the GICS industry standard. Accordingly, under the same name, the underlying in certain sectors (in particular Technology) may sometimes vary considerably from one fund to the next.