Facebook, Google aren't tech stocks? What that means for investors

Changes by index providers mean that funds tracking the current telecom, tech and consumer-discretionary sectors will be forced to trade billions of dollars of shares to realign their holdings.

  • By Danielle Chemtob,
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The technology sector’s dominance of the stock market is about to face a big test.

Facebook Inc. (FB) and Google parent Alphabet Inc. (GOOGL) are expected to say goodbye in September to the highflying tech sector of the S&P 500 (.SPX). They will join a new communications-services group that will also house media giants such as Netflix Inc. (NFLX) and Comcast Corp. (CMCSA) that now reside in the consumer-discretionary group.

This is far more than mere housekeeping on the part of an index provider. The revisions mean that funds tracking the current telecom, tech and consumer-discretionary sectors will be forced to trade billions of dollars of shares to realign their holdings before the moves become effective Sept. 28.

The new sector’s weighting in the broad S&P 500 will be more than 10%, up from less than 2% for the current telecom sector, according to a report from Credit Suisse (CS). Some investors expect a pickup in volatility—and price swings—when the changes take effect as tech-focused funds drop Facebook and Alphabet.

“It’s almost like a philosophical question,” said Jonathan Golub, chief U.S. equity strategist at Credit Suisse. “If we group companies differently, does that change the behavior of investors?”

The answer: most likely. Mr. Golub said he expects there will be “arbitrage opportunities” for traders and investors who are able to take advantage of any volatility.

Here’s what is happening: S&P Dow Jones Indices and MSCI Inc. (MSCI) are restructuring the current telecommunications sector in the S&P 500, which houses only three stocks: AT&T Inc. (T), Verizon Communications Inc. (VZ) and CenturyLink Inc. (CTL). The sector’s influence on the broader S&P 500 has waned over the years because of consolidation in the industry. So the sector can swing wildly when the stock price of just one company in the group moves.

Those issues should be addressed by the index providers’ plan to broaden the sector to include companies that focus on communication and offer content and information. They are scheduled Monday to unveil the full list of companies subject to the restructuring, having in January already named some of the big companies affected by the changes.

Already, some of the big fund companies are trying to limit the upheaval in the markets by setting up new funds that track the proposed communications sector ahead of its launch. So far, investors have been slow to take advantage.

State Street Corp.’s new Communication Services Select Sector SPDR (XLC) began trading June 19, but just $135.8 million has flowed into it as of Friday, according to FactSet. That is less than the amount that flowed into State Street’s technology sector fund on June 19 alone.

Vanguard’s Communication Services Fund, a transition benchmark that began tracking the companies proposed for the new sector in March, has seen minimal fund flow since the announcement, according to FactSet.

“Because you’re bringing in some names with much larger market caps for that index and names that are very top of mind…it wouldn’t surprise us that investors would at least take a closer look,” said Rich Powers, head of ETF product management at Vanguard.

The changes create big opportunities for growth investors who have long shied away from telecom companies, which are considered value plays for their steady dividend payments.

Chris Cook, president and CEO of investment adviser Beacon Capital Management, said he nearly pulled his clients’ assets out of Vanguard’s telecom exchange-traded fund earlier this year because the firm was facing liquidity issues when trying to trade large blocks of shares. Beacon manages $3 billion in assets, the vast majority in ETFs tracking the 11 S&P 500 sectors.

“It wasn’t a diversified sector, and that’s why we buy ETFs and invest at the sector level,” he said.

The proposed communication-services sector would have outperformed the S&P 500 since 2013 and would have gained 6.9% this year through June 15, compared with the S&P 500’s 4% gain through that date, according to Credit Suisse. The current telecommunications sector, meanwhile, has underperformed this year, suffering the biggest losses of all 11 sectors in the index with an 11% decline through Friday.

For those investors who want to make a blanket investment in growth companies, the technology sector may no longer be the best bet. The new consumer-discretionary sector will have the highest share of growth companies, followed by communication services, according to projections from State Street (STT) that were based on the initial list of companies affected. The makeup of the technology sector, considered the darling of growth investors, will fall to 49% growth from 61%.

Meanwhile, investors who favor telecom stocks for their dividends and use passive funds that track the sector as a way to hedge against risk will also need to make changes. The new sector is expected to yield just 1.2%, according to Credit Suisse, compared with the current 5.6% yield of the telecom sector, which is the highest of any of the 11 S&P 500 sectors.

“The guy that may hold [a telecommunications fund] may be an individual who is risk averse and who likes yields,” Mr. Golub of Credit Suisse said. “He may wake up and the weights of AT&T and Verizon in that mutual fund are going to be much smaller, and he’s going to end up with a bunch of Netflix and Google and Facebook. And he may be saying, ‘Wait a second this isn’t what I thought I had.’”

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