This will be the last Invest-Notes in its current iteration. Actually, there’s only been one version of the Invest-Notes blog since my friend Rob set it up as a birthday gift in 2011. Your next visit will still find thoughts on investing and economics – including the full archive – but will be easier to navigate and better share the spotlight with music and art. Hoping you will enjoy the changes.

Of Banks and Buildings

There’s another, bigger change coming soon, and this one will affect the equity indexes, and thus the benchmarks for a lot exchange-traded funds. Individual stocks of major companies will find that the description of what business they are in will change. This matters because the Big Daddies of indices, S&P Dow Jones and MSCI, use the GICS stock classifications to determine things like whether Home Depot should be identified as a Consumer Staple, or a Consumer Discretionary stock. In their turn, the Big Daddies of funds, Blackrock and Vanguard, use the stocks in the S&P 500 and MSCI to decide what stocks will be included in the ETFs that individual investors are buying in ever increasing amounts.

First a quick review of the Global Industry Classification Standard (GICS), a worldwide standard for stock classification. Established in 1999 with ten sectors, the GICS consisted of: Consumer Discretionary; Consumer Staples; Energy; Financials; Health Care; Industrials; Technology; Materials; Telecom; and, Utilities. With the equity holdings of hundreds of ETFs and mutual funds based on the composition of these sectors, definitions are important. So, Phillip Morris (PM), a maker of tobacco products is a Staple and Home Depot (HD) is a Discretionary. Clear as mud, right? Cigarettes are something everyone needs, but the ability to affect repairs to your home or apartment isn’t so necessary? But I digress.

On August 31, 2016, the first ever change to the original Big Ten took place when the Financial Services Sector became bifurcated, creating a new sector, the Real Estate Sector. At the time of the split, real estate companies made up around 20% of the Financial Services Sector. REITs are a major component, with those and other entities involved with real estate related investments often paying sizeable dividends. These include shopping malls and strip centers, home builders, office buildings, holders of actual mortgages, industrial warehouses, apartment complexes, long-term care facilities, property management firms, timberland and now buildings occupied by computers that make-up “The Cloud.” Real estate stocks, particularly real estate investment trusts (REIT), have typically been considered niche investments.

Since the time of that first change to the GICS, banks have done well, REITs not so much so. In retrospect (also known as Monday Morning Quarterbacking) the headwinds were building for the real estate sector at the same time banks were beginning a genuine recovery from the financial mayhem of 2009. The upcoming change to the Telecom Services Sector will likely be more seismic since there will be three sectors involved and much larger ones at that. If you own any sector funds, now is a good time start thinking about what these changes might mean for your portfolio.

Communications Services Sector

The transition taking place on September 30, 2018 will see three sectors face major changes in their composition. Telecom Services will be renamed as Communications Services. The smallest of the eleven sectors composed of the stocks in the S&P 500, when Telecom becomes Communications it will grow from 2% of the index to 10%. More challenging for investors is determining what to do with current sector holdings when the biggest stocks in the S&P get shuffled around. Google, Verizon and Disney are not niche investments.

Now, what happens to the Information Technology Sector when Google, Facebook and other heavy hitters are no longer part of Technology ETFs and become components in the new Communication Services Sector? Or the Consumer Discretionary Sector (a sizable ETF holding in my personal account), Netflix, Disney and other big companies will be moving out. And is it time to go ahead and add one of the big Telecom ETFs – IYZ or VOX – in advance of the reshuffle? A tough call to make since the logic underpinning the changes is hard to understand.

Skeletons Walk Where Questions Begin

Disney and Netflix are currently the fourth and fifth largest holding in the Vanguard Consumer Discretionary ETF (VCR) and account for 9% of the total holdings. In the Information Technology ETF (VGT) Facebook and Google make up 15% of the fund, holding the third, fourth and fifth positions (Google, now known as Alphabet, has two classes of stock, each traded independently). As for Telecoms (VOX), 50% of the total holdings are the top two stocks, Verizon and AT&T, with the ETF offering a yield just north of 4%.

One incorrect assumption when banks and real estate divorced was the big dividend being paid by the real estate stocks would make it a more attractive offering. Yet the high yield was not able to offset a drop in the value of the underlying equities. Facebook, Netflix and Google don’t pay a dividend which would suggest that a sector known for its generous payout won’t be anymore. Frankly, it is not clear to me what connects these businesses. Netflix and Verizon? Disney and Facebook? Google and AT&T?

Finally, for those of us invested in S&P 500 cap weighted index funds – SPY or VOO – it turns out that Facebook, Google, AT&T and Verizon are also top holding. Due to the size of the largest holdings, it is possible that the new Communications Services funds really won’t offer anything other than a focused version of the biggest stocks in the S&P 500 ETFs. Maybe, it’s time to pull back a bit from diversification through sector funds since that seems to be the last thing being achieved by grouping really big companies in ever smaller index sectors.

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One Response to Ch-ch-ch-changes

  1. Bill Pfeiffer says:

    Thank you again for your clear explanation of this little know area of investing. Because of your research and inquisitive financial diligence to learn more…..I have come out of the “Dark Ages” of economic and financial obtuseness.

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