Sector Shuffles Shouldn’t Ruffle (Well-Diversified) Investors

Meet the global stock market’s new sector—Communication Services—which absorbs several stocks from Information Technology and Consumer Discretionary and all of Telecom. S&P Dow Jones Indices implemented the new structure last week, while MSCI will roll it out in November. The reshuffle involves some of the world’s largest companies, making it sound like a big deal that could send stocks swinging, but it was telegraphed over a year ago and isn’t catching anyone by surprise. So for most well-diversified investors, this change is cosmetic. However, some affected sector funds and exchange-traded funds (ETFs) will see big changes. In our view, this is a reminder to investors to understand what you own—and your approach to investing.

We think the change makes some sense, but the decision to move some companies and not others shows sector classifications are often arbitrary. In the Technology sector, a well-known social media platform that rhymes with Lacehook, an ad-supported search engine that rhymes with Flügel and computer game makers now join your friendly neighborhood phone company in Communication Services. Also joining from Consumer Discretionary: cable companies, news and entertainment providers and advertising agencies. Plopping Lacehook and Flügel in a new media industry group in Communication Services seems logical enough, as both are ad-supported—very media-like. Porting over a certain streaming service that rhymes with Setblix also makes sense, as entertainment now lives in Communication Services. But these decisions are also sort of arbitrary. A $1 trillion Tech firm whose name rhymes with Scrapple gets a lot of its revenue from selling consumer products and operates its own retail stores—why not make it Consumer Discretionary? Another $1 trillion Consumer Discretionary firm happens to produce films and television shows and offers streaming services—rather like some other Communication Services firms. But it is also a leading provider of cloud computing services—very Tech-like. This is all more art than science.

For investors benchmarked against the broad market, the sector shuffle shouldn’t matter. If you are broadly diversified—with exposure across sectors—the change is likely cosmetic. Companies that were part of a cohesive, diversified strategy before the change don’t need to get the boot just because they got a new home in a new sector. Their underlying fundamentals haven’t changed—rather, the index providers have simply recognized what markets already knew.

That said, those using sector ETFs rather than individual stocks may need to take a look at their holdings to ensure they have the exposure they want after the move. Some Telecom sector ETFs appear to have shifted to being Telecom industry ETFs—a subcategory excluding the vast majority of the new Communication Services sector. For those who own a Tech or Consumer Discretionary ETF, you’ll want to check if—and when—you might lose exposure to stocks you previously owned. You may need to adjust your positioning to maintain exposure.

If you had avoided a Telecom ETF due to the sector’s previously small weighting and reputation as a “defensive” play,^[i] then you may want to consider adding Communication Services now that most of it is weighted toward more economically sensitive companies. Conversely, if you targeted Telecom due to its typically defensive characteristics, you probably want a fund that will remain Telecom-focused. Whatever your thesis to own the security was—and you should have one—now is the time to ensure this shift hasn’t undermined it.

Media has spilled a lot of pixels about this pending shift, pondering the impact on market movement, volatility and direction. But in our view, this is overwrought. To the extent this move has an impact, it is much more likely on individual investors’ strategies. Those using sector ETFs who are unaware of this change’s impact on their holdings could reap unintended results.