C.J. Lawrence Weekly – The New S&P Sector Construction is Coming, and It Matters

Back in March we highlighted an announcement by S&P Global, Inc. that stated it was realigning three of its eleven S&P sectors, on Sept 28, to more accurately reflect the constituents’ lines of business.  The realignment will result in changes to the make-up of the Technology and Consumer Discretionary sectors and a reduction in their weightings within the S&P 500 Index.  S&P will also change the composition of the Telecom Services sector and change its name to Communications Services.  Some index-based funds have begun the process of adjusting their weightings and fund compositions to ease the transition.  But many have not.  Funds that seek to minimize tracking error (the difference between the fund composition and the composition of the index it tracks) will wait until the cut-over date to initiate their re-balances.  This could create some near-term volatility in stocks impacted by the changes.  It is also likely that there will be a lasting impact on sector strategies that investors and traders employ in investment portfolios, trades, and hedges as historical correlations are broken.

The realignment is based on adjustments to S&P’s classification system, known as GICS (Global Industry Classification Standards).  GICS was developed in 1999 by S&P and MSCI, to foster the consistent categorization of individual securities.  Hundreds of sector and thematic funds base their portfolio construction on these definitions.   In its 2017 annual survey of assets, S&P Global estimated that over $200 billion in assets were invested or benchmarked in S&P sector index products based on S&P GICS sector definitions.  As large as that figure is, it accounts for less than half of total sector index-based products, many of which do not track to S&P Index construction but do utilize GICS definitions in their own index construction.

Sector Shifts – Sector Weightings Within S&P 500 Index | Source: S&P Global, C.J. Lawrence Inc. Research

To many the reshuffle sounds like an academic exercise.  But the impact could be felt in the coming days and weeks as sector funds buy and sell stocks to match the new definitions.  For instance, the S&P Technology Sector Index will no longer include Alphabet and Facebook, and will instead include larger weights in Apple, Microsoft, and Visa.  That means that funds tracking the S&P Technology Sector Index will be selling large amounts of Alphabet and Facebook stock and buying large amounts of Apple, Microsoft and Visa stock in the coming three weeks.  Alphabet and Facebook will be the heavy-weights in the new S&P Communications Services Sector Index, but funds tracking that index are much smaller in AUM (assets under management) and have not been attracting sufficient assets to soak up the new supply.  As an example, State Street Global Advisors is the sponsor of the Technology Select Sector SPDR Exchange Traded Fund (XLK).  It is the largest technology sector ETF with over $23 billion in assets under management.  As of Friday, the fund has an 11.3% weighting in Alphabet, and a 6.3% weighting in Facebook.  On Oct 1, those weightings will both be 0%.  Conversely, the new Communications Services Sector Index will have a ~23% weighting in Alphabet and a ~20% weighting in Facebook, so by Oct 1 the new Communication Services Select SPDR ETF will add positions in those securities to match their new sector index weights.  But the imbalance will be sparked by the large funds selling stocks and the small funds buying stocks.  To use the SPDRs as an example, the $23.0b XLK is selling Alphabet and Facebook, and the $0.6b XLC is buying Alphabet and Facebook.  It could take weeks or months before Communications Services Sector related funds gather enough assets to absorb the other sectors’ abandoned shares.  In the meantime, investors interested in purchasing the new Communications Services constituents like Alphabet, Facebook, Activision Blizzard, Comcast and Disney should not have a tough time finding stock.

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