September 5, 2018—At the end of September, the S&P 500 index is getting a makeover. Below we answer the four most pressing questions related to the changes.

1) What is happening?

On September 30, 2018 Standard & Poor’s is reshuffling their sector schematic, which will include redefining the existing technology, consumer discretionary, and telecommunications sectors. The current telecom sector will be converted to a new communications services sector, which will now include internet services (e.g., Google, Facebook) and home entertainment software stocks from the current tech sector (e.g., Activision Blizzard, Electronic Arts), as well as media (e.g., Disney, Comcast) and digital streaming and internet services (e.g., Netflix, TripAdvisor) from the current consumer discretionary sector. Verizon, CenturyLink, and AT&T—the only three stocks in the current telecom sector—will remain in the new communications Services sector. The tech and discretionary sectors will continue to operate with the exception of those stocks peeled out and added to the new communications services sector. 

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Source: WTIA

2) What do I, as an investor, need to do?

No action is required for anyone holding any of the affected names as individual securities in a separately managed account. The same is true for anyone holding an individual sector exchange-traded fund (ETF) like the Vanguard Consumer Discretionary ETF (ticker: VCR). The ETF providers are automatically taking the necessary steps to move stocks to their new sectors. For those clients utilizing a sector allocation strategy, the weights of the different sectors would need to be adjusted, as the tech sector’s weight in the S&P 500 will be decreasing from 26% to 21%, the consumer discretionary sector from 13% to 10%, and the new communications services sector from 2% (the old telecom weight) to 10%. Such an adjustment would not necessarily constitute a change in view on any of these sectors, but rather an acknowledgment of the new weights in the overall index. The estimated tax impact can vary depending on the holding period. 

3) How will the new sectors compare to the old sectors?

The sector changes outlined above will have the most dramatic impact on the current telecom sector, which has historically been a highly concentrated sector with value characteristics but a very small weight in the overall index, limiting its influence. While equity investors will be losing a bond proxy, the new communications services sector will offer a much more diversified and growth-oriented collection of companies. Whereas the old telecom sector traded at a price-to-earnings ratio of 10x next-12-month earnings estimates, the new communications services sector will trade at a multiple of almost 18x. As you may imagine, given the inclusion of well-performing names like Google, Facebook, and Netflix, had the new communications sector existed over the last five years, it would have outperformed the S&P 500 by 3% per year, compared to the telecom sector which underperformed the index by about 13% per year. Going forward, sector performance could be different, given that the communications services sector will be more evenly distributed between investing styles (growth vs. value and cyclical vs. defensive).

The new tech and discretionary will not look all that different in terms of valuation or historical performance. The new tech sector will generate slightly lower revenue growth (estimates for 2018 revenue growth of 9% versus over 11% under the old classification) and earnings growth. 

4) What are the implications for portfolios?

One of the biggest differences will be adjusting to thinking about names like Google and Facebook no longer as tech plays but rather as part of the new way we communicate in the age of the internet. There will also be a slight adjustment to how investors utilize different sectors to express views in their portfolios. The new tech sector, for example, may not generate the same degree of organic growth that it did in recent years. Also, tactically tilting portfolios toward telecom was a blunt but effective way of protecting portfolios and getting more defensive. The communications sector may no longer serve that purpose and could instead act more like the industrials or consumer discretionary sectors, which provide a diverse array of industries and companies, some with cyclical characteristics and others more defensive.  

Core narrative 

These changes ultimately reflect the view that technology is much more pervasive today than it has been historically—a view we expanded upon in the May issue of Capital Perspectives, “Technology: Going where no sector has gone before.” Technology is utilized by nearly every business model regardless of sector, and technology companies are a key beneficiary of capital expenditure growth by non-tech businesses. The S&P reclassification is one illustration of the view that, going forward, we will need to adjust how we think about technology and its role in the economy. 

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