Shakeup in Sector Funds Could Trigger More Market Volatility

Reuters reported on June 5 that a reorganization of the Global Industry Classification Standard (GICS) will take place between now and September 28. GICS classifies stocks into 11 sectors and dozens of industries, and is commonly used by professional portfolio managers as a guideline to portfolio diversity. It’s also used to identify stocks that can be included in sector funds (mutual funds and ETFs).

Be ready to read this a few times, because this GICS reorganization is going to cause stock volatility and provide opportunities for several months. Newscasters who don’t know the cause of the volatility will try to connect it to the political news du jour and yell “Italian debt!” and “tariffs!” and “North Korea!” That’s not going to help you invest well. So let’s nail down some of the intricacies of what’s about to take place.

The Tectonic Shift in Sector Funds

The telecommunications services sector will be renamed communications services.

Importantly, Alphabet (GOOGL) and Facebook (FB) will move from the information technology sector to the communications services sector, reflecting an updated definition of the products and services that those companies provide. Therefore, many portfolio managers of information technology sector funds will be required to sell their GOOGL and FB stock, because those shares will no longer fit their investment strategies. The selling activity will push the share prices down. For example, the iShares Global Technology ETF (IXN) holds $1.8 billion of stocks. Three of their five biggest holdings are FB, GOOG and GOOGL.

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In addition, Walt Disney (DIS), Comcast (CMCSA), Netflix (NFLX) and others will move from the consumer discretionary sector to the communications services sector.

Portfolio managers of communications services funds will likely add CMCSA, DIS, FB, GOOG, GOOGL and NFLX to their funds. Here’s the important detail: there are far more information technology sector funds than there are communications services sector funds. Therefore, the total amount of selling activity among CMCSA, DIS, FB, GOOG, GOOGL and NFLX will not be offset by an equal amount of buying among sector funds. The imbalance could cause the share prices to drop and remain low for several months.

While the telecommunications services sector currently makes up less than 2% of the S&P 500, the new communications services sector will comprise 10% of the S&P 500. Now imagine that you are the portfolio manager of the iShares Global Telecom ETF (IXP) with $350 million in assets. Your investment policy states that you are required to be invested in most of the incoming communications services sector stocks. Your asset base does not change: you still have $350 million to play with. But now you’re required to spread that $350 million to cover many more stocks that are joining the sector.

The only way you can do that is by selling portions of your current holdings—the top holdings in IXP are AT&T (T) and Verizon (VZ)—and reallocating that money to GOOGL, FB and others. That’s going to push share prices down on all of the pre-existing communications services stocks that you sell. Individual investors who own the original stocks within the communications services sector will need to be prepared to experience a possible downturn in their share prices.

It isn’t just mutual funds and ETFs that will need to readjust their portfolios.

Most large institutional portfolios, such as pension funds, also allocate capital across sectors in order to maintain diversification and lower overall portfolio risk. These portfolios will be doing much of the aforementioned buying and selling of famous stocks, with a twist. As they reexamine their sector holdings in light of the new category components, they’re occasionally going to find themselves overweight a certain sector. If they’re overweight in communications services, for instance, they’re going to decide which stocks to keep and which to sell.

Given a choice between selling TWO of the following stocks, which would you sell: AT&T, DIS, CMCSA, FB, GOOG, GOOGL, NFLX and VZ? I don’t necessarily mean to imply that T and VZ are bad stocks, but suddenly they’ll be competing for portfolio attention with far more glamorous companies. So there’s going to be ongoing selling pressure for the next four months as literally every professional investor in the U.S. readjusts their portfolios. Wow.

But wait, there’s more. When portfolio managers remove FB, GOOG and GOOGL from their technology sector allocations, they’re going to free up room within their technology sector weighting to add more technology stocks. Whoa. We’re talking about software and hardware and semiconductors and more. Which are your favorites? Apple (AAPL)? Micron (MU)? Intel (INTC)? You’re probably going to see their share prices rise more than if all of this portfolio reorganization had not taken place.

How to Prepare for the Shakeup in Sector Funds

If you are concerned that you own a stock that might see its price decline in the coming months, there are at least four things you can do:

  • You can hold the stock, and consider buying more shares if the price becomes depressed.
  • You can sell the stock now, with the intention of repurchasing the shares if a lower price presents itself.
  • You can hold the stock and use stop-loss orders to protect your downside.
  • You can consider using equity options strategies to protect yourself and/or to capitalize on the volatility.

Here’s some important information from MSCI.com: “MSCI will provide the full list of all companies affected by 2018 GICS changes on July 2, 2018. Updates to the list will be provided on August 1, 2018 and September 3, 2018. MSCI will make available a series of provisional indexes for the Communications Services, Information Technology and Consumer Discretionary Services Sectors starting July 2018.”

You might find all this a bit nerve-wracking. Send me an email with questions and comments as they arise!

Crista Huff

Buy Low, Sell High

Crista Huff is the lead analyst of Cabot Undervalued Stocks Advisor. Her goal is to assist you in outperforming the major U.S. stock market indexes while minimizing risk, by screening many hundreds of stocks for growth, value and bullish technical charts.

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