The sectors they are a changin’. With apologies to Bob Dylan, one of the biggest changes in the way stock markets are composed in decades happened near the end of 2018.
The event went by quietly and with little investor fanfare. Yet it could have profound effects on many investors and how they allocate their investments.
A bit of background as to why this can be important.
As of the end of 2018, over $13 trillion worldwide were in invested in passive investments such as index funds. Yes, trillion. And approximately 10 percent of that amount was invested in sector index funds.
See: [10 of the Best Stocks to Buy for 2019.]
Investors often use sector funds to focus on opportunities in specific areas of the economy during different business cycles. Some use sector funds as a diversification vehicle. If you had a large part of your portfolio in the stock of the company you worked for, sector funds could provide specific diversification in other parts of the market.
While investors may think they are not affected, many portfolio strategies employed by advisors utilize sector funds or exchange-traded funds as well as many actively managed momentum funds. And with more than $1.3 trillion invested, certainly many are affected.
Why the Change?
At the core of index investing is the broad-based S&P 500, a market value weighted index of the 500 largest companies. The index was made up of 11 separate sectors to make sure it represented all parts of the economy. These sectors were: information technology, financials, consumer discretionary, health care, energy, consumer staples, industrials, utilities, telecommunications, materials and real estate.
The S&P index had a problem. It had to keep up with a rapidly changing economy. Technology was now 26 percent of the S&P 500 and telecommunications was 2 percent and made up of only 3 companies. The index managers at Standard and Poor’s and MSCI decided that many names in the technology sector were better reflected in other sectors of the new economy.
For instance, are Google/Alphabet (ticker: GOOG, GOOGL) and Facebook ( FB) really tech companies or are they communications companies? Are media giants Netflix ( NFLX), Walt Disney Co. ( DIS) and Comcast Corp. ( CMCSA) consumer stocks or communications stocks?
On Sept 28, the sector makeup of the S&P 500 index was changed. The telecommunications sector is no longer but merged into the newly formed communications sector.
See: [10 Ways to Maximize Your Retirement Investments.]
Several stocks from the information technology sector were moved to the communications sector, such as Facebook and Alphabet as well as video gaming companies Activision Blizzard ( ATVI), Electronic Arts ( EA) and Take-Two Interactive Software ( TTWO). Netflix will move from the consumer discretionary to communications along with other companies including Disney, News Corp. ( NWSA), Comcast, CBS Corp. ( CBS), Charter Communications ( CHTR) and Viacom ( VIAB).
Implications for Investors
There is one important point here. If you are investing in a broad-based index such as the S&P 500, nothing changes. There are the same companies with the same weighting.
However, if you or your advisor invest in the sector-focused indices, there are several things you should consider.
A high dividend sector is gone. The old telecommunications sector paid a huge, for today’s environment, 5.4 percent yield. The new sector’s dividend yield is 1.7 percent.
The old telecommunications sector also was one of the more defensive sectors; a safer haven for market ups and downs. As measured by beta, a calculation of market risk, it was 50 percent as risky as the S&P 500. In other words, if the stock market went down 10 percent, an investor holding in the old telecommunications sector would be down 6 percent.
Beware of concentration risk. The reorganization of the sectors will result in several sectors performance being concentrated in the performance of a handful of stocks. For example, in the new communications sector, Facebook and Alphabet will make up about 38 percent of the performance of the sector.
In the new technology sector, Microsoft Corp. ( MSFT) and Apple ( AAPL) make up about 35 percent.
And Amazon.com ( AMZN) makes up about 24 percent of consumer discretionary.
Mutual Fund Tax Implications
For mutual fund investors, the changes in the sectors caused the fund managers to sell positions that were moving to a new sector and buy the stocks of the new positions. This resulted in capital gains inside the funds, which are passed on to investors. It is best to contact the fund company for the details.
See: [10 Long-Term Investing Strategies That Work.]
Not all investors use sector funds. But for those that do, the reshuffling of the companies inside those sectors is significant. The end result is more representative of a changing economy but understanding these changes is critical to be a successful, informed shareholder.
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How the Market Sector Changes Affect Investors originally appeared on usnews.com
