By Denny Fish
The creation of a new Communication Services sector could provide a further tailwind for tech stocks as generalist mutual funds gain a potential opportunity to allocate more capital to the space.
After Sept. 28, technology stocks will be split between three industry sectors instead of the current two.
Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL), Facebook (NASDAQ:FB), Netflix (NASDAQ:NFLX), Disney (NYSE:DIS), Activision Blizzard (NASDAQ:ATVI) and Electronic Arts (NASDAQ:EA) are among those set to join the new Communication Services sector.
Sector changes may create short-term volatility as ETFs reconfigure and long-term opportunities for managers of tech-centric and generalist mutual funds.
A significant shakeup in the way technology stocks are classified may create some short-term volatility as tech and generalist mutual funds, along with passively managed Exchange Traded Funds (ETFs), adjust to comply with the changes.
A reorganization of the Global Industry Classification Standard (GICS) on Sept. 28 will see a number of technology equities exit the Consumer Discretionary and Information Technology groups.
Facebook, Google parent Alphabet, Walt Disney, Comcast (NASDAQ:CMCSA) and Netflix, along with video game makers Activision Blizzard and Electronic Arts, will be among those to move to an expanded pool of telecommunications and media stocks that will be renamed Communication Services.
The changes, intended to better represent communications in the digital age, will take the Communication Services sector's share of the S&P 500 index to about 10% from about 2%. The reorganization will also reduce the emphasis on slow-growing, higher-yielding bond proxies such as Verizon (NYSE:VZ) and AT&T (NYSE:T), with well over half of the members of the new group coming from the growth category.
While the changes may lead to some choppiness as technology-indexed ETFs in particular adjust to reflect new sector weightings by selling shares in companies that are moving from one group to another, there are also likely to be nuanced and lasting implications for managers of both sector-specific and, perhaps more importantly, generalist mutual funds. It's a dynamic that further highlights the importance of active management in these top-heavy sleeves.
Weighing the Options
Mandates of 1940 Investment Companies Act funds that are diversified stipulate that holdings in companies representing 5 percent or more of assets under management (AUM) cannot in aggregate exceed a quarter of total AUM. When the GICS changes take effect, Apple (NASDAQ:AAPL) and Microsoft (NASDAQ:MSFT) will represent about 30% of the MSCI World Information Technology Index. As a result, a diversified technology fund cannot be overweight one of those names without being underweight the other.
On the other hand, today Amazon (NASDAQ:AMZN) is not in the MSCI World Information Technology index, as it is classified as a consumer discretionary company. So if a tech fund holds a 300 basis point position in Amazon, it is considered 100% active, as the company has a zero weighting in the benchmark. However, a significantly greater allocation to Alphabet today for a tech fund manager may not be seen as such an active position, due to its weight in the index. With Alphabet's move out of the tech index, suddenly a much smaller position in the Google owner would be seen as a higher active weighting relative to the benchmark. The same will apply to Facebook which, together with Alphabet, will represent somewhere in the neighborhood of 50% of the Communication Services group.
The changes could also widen the options for generalist fund managers.
Technology currently accounts for about 34 percent of the Russell 1000 Growth Index, to which many general mutual funds are benchmarked. By moving companies such as Facebook, Alphabet, Netflix and the video game makers into Communication Services from the main tech sector, managers may gain discretion to reallocate more capital to sub-sectors such as semiconductors and software while also boosting their tech-related holdings in Consumer Discretionary and Communication Services, all without significantly increasing their exposure solely to the tech portion of the index.
So spreading technology stocks across three sectors instead of two may lead the generalist investor to allocate more of their resources to tech companies, providing a further potential tailwind to companies whose valuations aren't unreasonable, relative to other industries, given their strong financial performance.
Disclaimer: Technology industries can be significantly affected by obsolescence of existing technology, short product cycles, falling prices and profits, competition from new market entrants, and general economic conditions. A concentrated investment in a single industry could be more volatile than the performance of less concentrated investments and the market as a whole.
Investments focused on a single sector, country or region are subject to increased volatility because such investments may react similarly to market developments and a significant portion of assets may be invested in a small number of issuers.
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