After the market closes on Friday, September 28, S&P Dow Jones Indices and MSCI will implement structural changes to the Global Industry Classification Standard (GICS)—the classification standard they use to categorize companies by sector, industry, and sub-industry within their market indices. Only 3 of the 11 GICS sectors will be affected, but changes to those 3 will be significant. It’s important for equity investors—especially those who use index-tracking strategies—to learn what’s changing and understand the impact of the changes on key characteristics of these sectors.

What’s changing?

At the surface level, here’s what’s happening: Telecommunication services (telecom) will no longer be a sector; it will become part of a new sector called communication services. In addition to containing all of its predecessor’s telecom companies, communication services will absorb some current components of the consumer discretionary and information technology (IT) sectors.

Figure 1

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The new communication services sector will encompass companies involved primarily in facilitating a broader, updated definition of communication, reflecting the ongoing evolution within communication.

Figure 2 shows sector weighting changes due to the GICS realignment. With some of their components shifting into communication services, the consumer discretionary and IT sectors will represent smaller percentages of the overall U.S. equity market than before. Communication services will have a significantly larger percentage of the market than telecom did.

Figure 2

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Because quite a few large, well-known companies will be shifting sectors, large-cap equity indices will be the most affected by the GICS changes.

How will the GICS changes affect style exposures in these sectors?

Figure 3 shows the before/after style breakdowns—value, blend, and growth—of each affected sector. Typically, stocks with lower valuations and lower long-term expected growth rates are considered value, while higher-valuation stocks with higher expected growth rates typically fall within the growth category.

Figure 3

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In the consumer discretionary and IT sectors, the changes in style exposure will be driven by the shifting of some of their previous components. The higher growth exposure in consumer discretionary after the GICS changes will be largely due to Amazon.com, Inc., which will carry a heavier weighting within the sector. For IT, the GICS changes will result in less exposure to higher-valuation growth stocks, leading to a larger percentage of blend stocks after September 28.

Figure 3 also shows the vastly different style exposures the communication services sector will have compared with the telecom sector that’s being discontinued. The new sector will have a hefty weighting of growth stocks—including Facebook, Netflix, and Alphabet, which as a group potentially will influence communication services heavily going forward. These and a number of other companies included in the sector tend to benefit from secular trends toward online/mobile advertising and increased monetization of online media content.

What’s the impact on valuations and growth rates for the affected sectors?

Figures 4 and 5 show the estimated valuations—from lowest to highest—for each sector before and after the realignment (based on the Russell 3000 Index).

Figure 4

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Figure 5

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 With the changes, communication services becomes one of the highest-valued sectors, driven by the heavy emphasis on growth-oriented companies in the new sector. Consumer discretionary and IT remain among the higher-valued sectors; IT valuations do decline modestly, though, due primarily to the shifts of Facebook and Alphabet into communication services.

In Figures 6 and 7, we see the expected long-term growth rates—ranked lowest to highest—for each sector before and after the GICS realignment (based on the Russell 3000 Index).

Figure 6

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 Figure 7

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The most obvious difference is that while telecom ranked lowest for long-term expected growth rate, communication services is expected to deliver the highest. Interestingly, the expected growth rates for consumer discretionary and IT will remain about the same as before. Communication services, IT, and consumer discretionary are expected to potentially be the leading growth sectors; this likely may broaden the universe, from a sector perspective, for investors searching for companies with above-average growth potential.

What’s the impact on index-based (passive) strategies?

Managers of passive strategies that use the GICS system have adopted various approaches to realign based on the recent sector changes, including either rapidly or gradually transitioning toward the affected sectors’ new weights and compositions. These realignments potentially could create some short-term pricing pressure as shares of companies being reclassified are sold.

It’s important to note, however, that the upcoming GICS sector changes have been well telegraphed ahead of time. Also, certain available passively managed exchange-traded funds that track specific sectors either aren’t using the GICS structure or already have begun transitioning. These factors could help minimize volatility as strategies are adjusted based on the sector realignments.

What’s the impact on active managers?

For active managers focused on blend and/or growth equity strategies, the GICS changes create the potential for significant risk within the communication services and consumer discretionary sectors.

  • Communication services likely will be heavily influenced by four stocks: growth stocks Facebook and Alphabet and value-oriented stocks Verizon and AT&T. Their dominance could drive substantial active risk—especially for managers solely pursuing dividend yield or high-growth characteristics and for those seeking a better balance between dividend yield and growth. The prevalence of stocks with widely varying characteristics in the sector potentially could lead to some actively managed portfolios that lack meaningful portions of the sector.
  • Consumer discretionary likely will be increasingly influenced by Amazon. Therefore, holding a sizable underweight to this stock could lead to significant fluctuations in the sector’s relative returns within a strategy. Also, it could become increasingly difficult for diversified growth managers that have a positive outlook for Amazon to add value through this holding given its increased presence within the sector. Active managers facing this situation could pursue other opportunities with potential for high growth—for example, software-related companies that help facilitate e-commerce for merchants and digital payments companies that make online spending possible.
  • Active managers likely may, at the very minimum, reposition portfolios to account for the revised sector weights. While this alone may not generate significant volatility in affected stocks, it bears monitoring over the next several months. For example, one potential outcome within the communication services sector could be that managers closely targeting sector allocations of the S&P 500 Index or Russell 3000 Index need to add positions within communication services to bring portfolio weights closer to index levels (expected to be near 10%). Another potential scenario is that managers focused on growth-oriented companies could replenish some of the IT sector exposure they’d lost due to the move of key stalwarts, like Facebook and Alphabet, from IT to communication services.

Considerations for investors following the GICS changes

Going forward, investors who want to diversify across various technology-driven themes—including cloud computing, digital payments, and e-commerce, among others—will need to look in at least three sectors for these types of opportunities: consumer discretionary, IT, and communication services. Investors seeking exposure to faster-growing companies across these three sectors while balancing the risk of doing so may want to consider investing in actively managed strategies; active managers have the flexibility to identify potential market share winners in these categories while also working to manage valuation risks and ensure adequate diversification.

Index definitions

 

All investing involves risks, including the possible loss of principal. There can be no assurance that any investment strategy will be successful. Investments fluctuate with changes in market and economic conditions and in different environments due to numerous factors, some of which may be unpredictable. Each asset class has its own risk and return characteristics.

Wells Fargo Asset Management (WFAM) is the trade name for certain investment advisory/management firms owned by Wells Fargo & Company. These firms include but are not limited to Wells Capital Management Incorporated and Wells Fargo Funds Management, LLC. Certain products managed by WFAM entities are distributed by Wells Fargo Funds Distributor, LLC (a broker/dealer and Member FINRA).

This material is for general informational and educational purposes only and is NOT intended to provide investment advice or a recommendation of any kind—including a recommendation for any specific investment, strategy, or plan.

 

 

315713  09-18

 

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