The sector landscape is about to witness its biggest shakeup since 1999 when the Global Industry Classification Standard (GICS®) was developed. On September 21, securities with a market value of roughly $2.8 trillion will be reclassified within the GICS. The changes will happen across three sectors and 26 stocks, representing 10% of the market cap of the S&P 500® Index.

The massive scope of this reclassification has the potential to disrupt portfolios if sector investors fail to prepare. Portfolios that are not re-weighted could become overweight certain stocks while completely lacking some of the most well-known and profitable companies in the world. The result would be a complete mismatch of exposures that could introduce unexpected tracking error and risk into sector-related portfolios.

To ensure sector investors are prepared, this blog explores the percentage of allocation reductions necessary to maintain appropriate sector exposure and the ramifications of not acting to adjust sector-related portfolios.

Setting the sector reclassification stage

At a high level, these are the changes coming to GICS and the Select Sector SPDR® suite:

  • The Telecommunication Services sector is being transformed, with consumer, media and technology giants joining the three traditional telecom stocks—Verizon, AT&T and CenturyLink—to create the new Communication Services sector.
  • At the close of trading on September 21:
    • 16 Consumer Discretionary stocks, representing 22% of the sector, will be reclassified as Communication Services.
    • 7 Information Technology (“Tech”) stocks, representing 20% of the sector, will be reclassified as Communication Services.
  • For investors seeking exposure to the upcoming Communication Services sector changes, we launched the Communication Services Select Sector SPDR Fund (XLC) in June.
  • We will perform a standard rebalance of the Technology Select Sector SPDR Fund (XLK) and the Consumer Discretionary Select Sector SPDR Fund (XLY) to reflect the underlying index changes effective at the close of business on September 21.
  • For additional insight into these GICS changes, you can read our earlier blogs.

Considerations for maintaining sector exposure

With 10% of the S&P 500 Index being reclassified, sector weights post-September 21 will look quite different than they do now. Below is a table depicting the percentage and number of stocks moving from each sector and how the Select Sector SPDR ETFs will be impacted. This table is important for understanding all the moving pieces of this change.

  • The first column shows the number of stocks moving in each sector
  • The second column shows those same stocks’ market cap percentage of the S&P 500 by each sector. For example, the seven tech stocks moving make up 5.29% of the S&P 500’s market cap
  • The third column depicts the stocks’ market cap percentage of their respective sector. For example, those seven tech stocks make up 20% of the current tech sector. The same is true with the three existing telecom stocks, which make up 100% of that soon-to-be legacy sector.

The last two columns are the ones likely to be of greater interest to sector investors. This data represents the composition of exposure moving within XLK and XLY, the two largest sector funds by assets under management (“AUM”) within their respective sector category.1 As you can see, for XLK the final number of stocks being impacted by the changes, which is captured in the fifth column, is different than the number listed in the first column. This is because the index XLK seeks to track currently includes the three telecom stocks mentioned above that will join the new Communication Services sector. After the reclassification takes place on the close of business September 21, however, those three telecom securities, along with the seven tech stocks, will no longer be a part of the index XLK seeks to track.

Key takeaway: To maintain appropriate sector composition, the majority of sector investors, as defined by AUM, may want to consider selling approximately 25% of their technology sector exposures and 22% of their discretionary sector exposures to purchase Communication Services. Exact percentages will change leading up to September 21 based on market movements, and it will be dependent upon the type of exposure an investor currently uses to gain exposure to Tech and Consumer Discretionary.

The impact of failing to act

For investors who implement sector views with ETFs that are slated to rebalance, such as XLK and XLY, failing to respond to these sector changes may lead to massive weighting differences. To illustrate these differences, we created a portfolio (which we refer to as the “No Change Made Portfolio”) that replicates S&P 500 sector exposures, but we built it using individual sector ETFs. Tech and Consumer Discretionary, however, are represented in the No Change Made Portfolio by their future post-GICS change index exposure that has been announced by S&P. This means the tech exposure in this portfolio does not include Facebook reflecting how Facebook will no longer be in XLK’s index after September 21. We then compared this portfolio to the S&P 500 but reclassified stocks under the new GICS schema. The S&P 500 Index represented below has Facebook exposure, but it has been reclassified as Communication Services.

If an investor does not reduce their Tech and Consumer Discretionary sector ETF exposure while establishing a position in Communication Services, the chart below shows the underweights and overweights an investor will hold post-GICS change in their sector portfolio. Given that funds such as XLK and XLY are losing exposure to big-name tech stocks like Facebook, Google and Netflix, the result is very intuitive—it will create an extensive portfolio underweight to Tech and Consumer Discretionary while providing no exposure to Communication Services. Painting this basic picture hopefully shines a light on the potential trouble ahead if investors fail to act.

Brace for impact: Measuring differences in the risk of taking no action

While the result of rebalancing on sector exposure may not be astonishing, the effect beneath the surface is where this shake-up becomes interesting, especially when you look at it from a risk model or underlying holdings perspective.

The information below captures the difference between the No Change Made Portfolio and the S&P 500 Index. To study these rebalancing changes from a risk perspective, we used the Bloomberg US Fundamental Equity Risk Model to analyze active risk—the difference between the portfolio’s exposure and its benchmark.

As shown below, the expected active risk is 1.06%, 58% of which can be explained by industry, style or country risks. Industry risk is the largest, and the remaining risk is attributed to non-factor or stock-specific risk.

Now, let’s go more in-depth on industry risk. Below are the Top 10 contributors to risk at the industry level. The table shows media makes up 61% of the active risk from the industry. This may be an unexpected finding given that it’s three tech heavyweights—Facebook, Google and Netflix—that are receiving all of the media attention for their reclassification. However, this active risk makes sense once you realize your active media underweight is 7.48%, the largest of any industry.

Beyond this industry risk, the style differences are not that interesting, and from a style factor exposure, the overall contribution is low at just 1.46%. The resulting 'No Change Made Portfolio' would have a slight momentum, higher beta bias, but nothing significant.

Getting specific on single stock risk

To decipher the remaining active risk requires looking at the stock-specific risk generated by having zero allocation to the new Communication Services sector. As shown below, some of the names on the move are included, but so are names staying within their sector, like Apple and Microsoft.

To show this another way, below are the names that would be more over- and underweight.

Overall, given the sizeable amount of stock-specific risk from noticeable weighting differences to large, well-known securities, a portfolio that fails to act may be overwhelming susceptible to company-specific events, either positive or negative. With third-quarter earnings season right around the corner, any idiosyncratic news (e.g., Apple beats on earnings, Facebook faces fines or Twitter testifies before Congress) could have an outsized impact on a strategy’s intended exposure and tracking error if investors don’t prepare portfolios.

Avoiding a communication breakdown

The upcoming changes are the largest in GICS history, and investors should consider recalibrating portfolios accordingly. As described above, taking no action can lead to sizeable differences and introduce unexpected risk into a portfolio.

For more information on the GICS changes and the new Communication Services sector, you can read my earlier posts:

For those considering allocation options, XLC, the Communication Services Select Sector SPDR Fund, provides access to the soon-to-be-established Communications Services sector. Investors can contact their SPDR representative at 866-787-2257 for more information.

1Bloomberg Finance L.P., as of 9/6/2018

Definitions

Bloomberg US Fundamental Equity Risk Model
The model employs a multiple factor modeling approach, which allows a responsive yet stable assessment of major risk factors affecting US equity assets and portfolios. The main characteristics of the Bloomberg US Fundamental Equity Model are: Coverage of over 20,000 US equity securities with model start date 1999. 40 industry factors based on Bloomberg Industry Classification System (BICS). 10 style factors and idiosyncratic risk modeling based on a separate structural factor model which incorporates additional variables useful for dissecting non-factor risk

Global Industry Classification Standard (GICS)
A financial-industry guide for classifying industries that is used by investors around the world. The GICS structure consists of 11 sectors, 24 industry groups, 68 industries and 157 sub-industries, and Standard & Poor’s (S&P) has categorized all major public companies into the GICS framework.

S&P 500 Index
The S&P 500, or the Standard & Poor’s 500, is an index based on the market capitalizations of 500 large companies having common stock listed on the NYSE or NASDAQ. The S&P 500 index components and their weightings are determined by S&P Dow Jones Indices.