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ETF valuations hit by index switch-up

S&P shook up its sectors on Monday in a move that saw all but one of the Faangs switched into a newly-formed sector to better reflect modern communication activities.

The long-heralded move by S&P saw the new communication services sector take on some technology companies, among them Facebook, Google, Activision and Twitter, media companies from the consumer discretionary sector, such as Walt Disney, Charter Communications and CBS Corp, as well as certain internet retail companies, including Netflix and Tripadvisor.

In total, more than 8% of the S&P 500 index market cap has been re-classified into the new sector. The move is S&P’s first reclassification since 1999 which is a long time in the technology space. Since then, many tech companies have appeared, floated and grown to lofty sizes, not least the Faangs. The rebalance is to better reflect this growth.

The changes mean investors with a sector-based approach – those investing in sector ETFs – could see their portfolio composition alter to reflect changes in the underlying index, while active managers will need to be aware of the ensuing trading flows and how this might affect stock valuations.

ETFs with broad exposure, such as the iShares Core S&P 500 Ucits ETF were impacted in terms of the sector weights, after the consumer discretionary sector went from a 13% to 10% weight in the S&P 500 index.

A spokesperson for iShares said: “ETFs and other index-tracking funds invest in securities based on the underlying benchmark they track. The aim is to provide a return as close as possible to the index they are tracking. When an underlying index changes, index-tracking funds will follow the changes to remain true to their investment objective.”

Index changes hit trading volumes

Tom Fitzgerald, co-manager of the Amity International fund and Higher Income fund at Edentree Investment Management, said the changes are likely to provoke heightened levels of trading volumes in the associated stocks as investors and ETF providers adjust, but he does not think it will have a material impact on the market.

“If anything, it challenges the case for these passive funds following sectors – investors seeking exposure to Alphabet will arguably not want exposure to AT&T and Comcast and vice versa for defensive and/or valuation reasons.”

According to a research paper by JP Morgan, assuming $2trn (€1.7bn) of assets under management invested in quant strategies ($1.5trn in long-only and $0.5trn in 150/50 long-short strategies), it estimates two-way turnover linked to the classification to be about $100bn. It said the tech and discretionary sectors may experience further outflows from quant rebalancing, but industrials and healthcare stand to benefit from the turnover.

The paper also said at the sector level, the reshuffling of the stocks among the IT, discretionary, and communication services sectors changes the fundamentals managers often rely on for top-down sector selection.

For example, it found that IT is slightly cheaper on price-to-earnings (P/E) after the change, while the new communication services sector now has the highest average P/E, to reflect the intake of relatively expensive technology stocks. In addition, it said the average stock volatility of communication services is the highest among all sectors.

Tech company fundamentals have not changed

David Miller, investment director at Quilter Cheviot, said as an active manager it struck him as interesting that the rebalancing was seen as a big deal because company fundamentals have not changed.

“It was the same company the day before the index changed and will be the same company the day after,” he said. “But there will be plenty of people that need to do something about this because of the sector change.”

“The fact Facebook and Alphabet are moving from IT to communication services and that Netflix is moving from consumer discretionary to communications does not change the valuation or potential of those companies one jot, but if you are running an index tracker or sector strategy and weightings change, you will be forced to make changes for no reason.”

Miller said the changes are symptomatic of technology invading all parts of commerce, making certain sectors redundant.

“The idea we have an IT or retail sector is beginning to become irrelevant,” he said. “What we have is we have companies that are either making changes to use the resources and technology of the modern world or they aren’t, and they can be in any sector you like.”

Communications shifts from value to growth

Commentators have observed that the new communication services sector will no longer contain stocks that are typically seen as bond proxies – high dividend paying, value stocks – that previously frequented the telecommunications sector.

“The communication services sector will hold a majority of growth stocks from consumer discretionary and information technology and will be more sensitive to the broader equity market and less sensitive to bond yields and interest rates,” said M&G investment and risk specialist Sarita Kashyap.

This will also likely affect valuations, said Howie Li, head of exchange traded funds at Legal & General Investment Management.

“Looking at the S&P 500, telecoms companies were pretty much utilities companies; domestic value plays quite leveraged in their nature, and they are now being replaced and supplemented by what we would have traditionally seen as tech companies with higher valuations.

“All of a sudden you are turning one telecoms sector into this new communications sector and that is moving from a value sector play to a much more growth one.”

This switch, he adds, is important for cyclically-minded asset allocators, who like to play sectors, to be aware of.

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Sebastian Cheek

Sebastian joined Last Word Media in 2017 as editor of Portfolio Adviser. He previously spent 10 years as a journalist and editor in the UK institutional investment sector, most recently as editor...

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