The tech sector is about to get smaller—and that could be good news for tech investors.
Big changes are being made to how stocks are classified by industry sector. The biggest changes will be around some prominent companies that will migrate out of the Information-technology and consumer-discretionary sectors and into a new communication-services sector. Google parent Alphabet (GOOGL) and Facebook (FB) are among those making the switch, which means they will no longer be counted as technology stocks.
That isn't quite right. For instance, Netflix (NFLX)—currently a consumer-discretionary stock, along with Walt Disney (DIS), Ford Motor (F), and Nike (NKE)—will soon become a communication-services stock, with the likes of Verizon Communications (VZ) and AT&T (T). Yet few would dispute that Netflix is a tech company, through and through. And that is something investors should pay attention to.
On the surface, the changes being made to the Global Industry Classification Standard, or GICS, system seem purely semantic. They certainly don't herald any fundamental changes for the companies involved. But they do have the potential to create short-term noise, creating opportunities for investors prepared for the shifts. And the changes might even provide another boost for tech, a group that doesn't need it.
Real money is put to work using the GICS system: The Technology Select Sector SPDR ETF (XLK) has more than $23 billion invested in it, while the Consumer Discretionary Select Sector SPDR ETF (XLY) has more than $15 billion.
So when State Streetrebalances those ETFs after the close on Sept. 21, those funds will have to sell the shares of companies that are no longer part of indexes they track—a not-insignificant amount. The Technology ETF will have to sell slightly more than eight million shares of Facebook, almost a third of its average daily trading volume.
It's even more severe for other companies. Christopher Harvey, head of equity strategy at Wells Fargo Securities, estimates that some legacy telecom stocks could experience selling that is between a half-day's and a full day's average trading volume. The Communication Services Select Sector SPDR ETF (XLC), which already reflects the changes, has been up and running since June, so it won't be buying shares of companies on the move. “On rebalance day, there's only going to be selling pressure for telecoms,” he says.
Don't expect it to last. A recent Deutsche Bank study published demonstrated that stocks that get disproportionately sold when an index rebalances outperform those that get bought over the following 12 months. While the study primarily examined broad index shifts, such as when stocks move between the Russell 1000 (.RUI) and the Russell 2000 (.RUT), it's possible that stocks that are heavily sold when the GICS sectors are reclassified could outperform in the months following. And stocks that get bought by the indexes could lag behind.
The new groupings could also spur changes in how investors perceive some stocks. Old telecom stocks like AT&T and Verizon often got overlooked, but some analysts hope that the glow of new sector-mates like Facebook and Alphabet rubs off. “We may be going from the kids looking in from the outside of the 'cool kids' party to finally getting an invite,” says Wells Fargo telecom analyst Jennifer Fritzsche.
But the biggest winner might be tech stocks themselves. They've been this bull market's big winners, and it hasn't mattered whether they are actually part of the tech sector or not. Amazon.com (AMZN) is still very much a tech stock even if it's grouped with Macy's (M). For active managers, the fact that what are essentially tech stocks will be found in three sectors instead of two, could allow them to buy more of these stocks without running up against constraints. “The changes are positive in that they will offer more flexibility to construct your portfolio without worrying about sector-weight limits,” says Dan Chung, chief executive officer at asset manager Fred Alger Management.
It will also allow portfolio managers to continue betting on tech themes without looking like they're taking too much risk in any one sector, says Jonathan Golub, chief U.S. equity strategist at Credit Suisse. “They can stand in front of a pension board and say they're not taking a big position in tech; they're in communication services,” he says.
None of that would matter, of course, except that tech really is where the growth is. It's expected to increase earnings at a 25% clip, still among the market's best. “If tech were winning just because it was in favor, there'd be nothing to it,” Golub says. “But it's winning because fundamentals are great, and managers are freed to own more.”
That could add more fuel to the tech rally. But it could also lead to more pain once the music finally stops.
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