So long, Telecom. Hello, Communication Services

09-18-2018

Index providers Standard & Poor’s and MSCI are set to unveil some of the biggest changes in sector components in recent memory, with Consumer Discretionary and Information Technology (IT) getting makeovers and Telecommunication Services disappearing altogether. Specifically, media and internet service companies will transfer from Consumer Discretionary and IT, respectively, into a newly renamed Communication Services sector that will include remnants of the former Telecom sector. Additionally, e-commerce companies will move from IT to Consumer Discretionary.

The changes, which take effect at month's end and are aimed at reflecting the current makeup of an ever-changing economy, will impact some of the biggest names in the market. Comcast, Netflix, Disney, Google and Facebook will join the ranks of Verizon and AT&T in the new Communication Services sector, creating a growth-oriented sector out of the ashes of defensive-minded Telecom. E-commerce names such as Alibaba and eBay will join Amazon in Consumer Discretionary, a further recognition of how the online boom has made retail more of a tech player. And collectively, all of these changes should meaningfully reduce the “new economy” growth characteristics of the legacy IT sector.

So what will these changes mean for investors? At an overall market level, the impact should be minimal. No stocks are entering or leaving the major indexes, nor are the weights of individual names set to change. Within the market, however, the changes could create some risk and opportunities as sector-oriented strategies adjust. For example, approximately $21 billion in trading activity is anticipated as sector exchange-traded funds (ETFs) rebalance to reflect the changes. This is because S&P 500 sector weights will be changing meaningfully, as the 1.9% currently held in erstwhile Telecom will jump to 10.2% in the new Communication Services sector, IT will shrink from 25.6% to 20.1% of the S&P and Consumer Discretionary will fall from 12.7% to 10%.

Such turnover could create some short-term volatility into month-end, but going forward, the changes may have more far-reaching implications. Prior to the changes, AT&T and Verizon were the stalwarts of dividend-minded Telecoms. Going forward, these companies will have to compete for capital with three-fifths of the FAANGs—Netflix, Google and Facebook (Apple will remain in IT and Amazon already is in Consumer Discretionary)—in addition to other media giants in the Communication Services sector. By contrast, because older tech names such as Cisco and Microsoft no longer will vie for capital within the IT sector with such higher-growth names as Google and Facebook, they may get a second look from investors. For the retail-oriented Consumer Discretionary sector, the impact may be mixed as traditional retailers no longer will have to compete with large media names but will confront more rapidly growing e-commerce competitors.

These new dynamics may mean certain names may react differently to quantitative factors or fundamental news than they have in the past, underscoring the need for thoughtful active management to identify the risks and opportunities posed by these changes. Federated’s equity teams have undertaken these analyses and, if they haven’t already, will be sharing them with clients soon, so stay tuned.