Will US sector index changes trouble technology stocks or nail Netflix?

Russ Mould
17 September 2018

“The changes due on Friday (21 September) in the S&P sector index classifications may seem esoteric at best and of no interest at all at worst to those UK-based investors who have exposure to American stocks, but they could have profound consequences, and possibly of the unintended type,” says Russ Mould, AJ Bell Investment Director.  

“Possibly to counteract the growing dominance of technology stocks, possibly to shore up a regulation-and-competition-wracked telecoms sector and probably to simply reflect profound industry and technological shifts, index-compiler S&P is changing the make-up of the Telecommunications sector in the USA’s S&P 500 index (and presumably the S&P 1200 Global benchmark) in three ways.

•    Most cosmetically, the sector’s name will change to Communications Services.

•    Thirteen Consumer Discretionary firms will move into the new sector. These will include such media giants as Walt Disney, News Corp, CBS and Netflix.

•    Six Technology stocks will move into the new sector, most notably Alphabet (the parent of Google), Facebook and Twitter, as well as three video game software develoopers.

“Such changes could create more ripples than many realise for three reasons.

•    First, the changes hint at how technology continues to revolutionise so many different sectors, not least by hollowing out their customer bases and profitability. Telecoms has been a poor performer over the last five years.

•    Second, the changes to index composition could drive flows into and out of the S&P 500 sectors and specific stocks, not least because of how tracker and exchange-traded funds will need to respond to new sector weightings and rebalance their holdings so that they can best replicate the new sectors’ composition and provide investors with tracking performance as accurately as possible. According to iShares, Information Technology will drop from 26% to 20% of the S&P 500, Consumer Discretionary will drop from 13% to 10% of the headline index and Communications Services will surge from 2% to 11%.

On a short-term basis, this could distort fund flow out of the names that have been shifted from Technology and Consumer Discretionary, not least because Telecoms tracker funds are smaller and will create less buying to compensate as these passive instruments adapt and welcome the index newcomers.

The SPDR ETFs on these sectors have very different levels of funds under management. The imbalance caused by bigger funds selling stocks, to reflect the lower weightings of tech and consumer discretionary stocks, and smaller ones buying these names as they move into Communications Services, is therefore a potential short-term challenge for names such as Netflix, which is still trying to recapture the ground lost over the summer in the wake of disappointing customer addition figures and fears over its cash-burn rate.

Source: Thomson Reuters Datastream

o    The SPDR Technology ETF has $23.3 billion in assets under management
o    The SPDR Consumer Discretionary ETF has $16.3 billion in assets under management
o    The SPDR Communications Services ETC has just $500 million under management – so its buying may not be enough to offset selling by the other two, at least temporarily.

•    It is therefore tempting to argue that on a funds-flow basis, this shift could check the seemingly relentless rise of technology stocks, at least in the near term. There is also a precedent for such a shift in sector weightings which bodes ill.

On 13 March 2015, S&P announced that it would be splitting the Real Estate sector out of Financials and turning it into a stand-alone group, to enable investors to get better access to the property industry. This change came into effect on 31 August 2016 and it pretty much called the top in the fortunes of the Real Estate sector, which have since been clouded by concerns over the impact on online shopping on bricks-and-mortar retailers in particular. The new Real Estate sector has largely paddled sideways, even as the headline US indices have powered to new all-time highs, including the S&P 500.

Source: Thomson Reuters Datastream

Investors of a nervous disposition could therefore be forgiven for fearing that S&P and the index compilers may be unintentionally ‘calling the top’ in the stocks it is transferring to the Communications Sector in its efforts to better reflects potential winners in the industry – even if the profits and cash flows generated by those firms will ultimately dictate how their shares perform over the long run.

“Shareholders in Disney, Twitter, Alphabet, Facebook and Netflix in particular might like to take note.”

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