Over the past 10 years, how many investment professionals, individual as well as institutional, have ever asked themselves exactly what they mean when they use the term “tech stock"?
More particularly, in what sense can Netflix (NFLX, Financial) be considered a “tech” stock? Has that company discovered a revolutionary process for increasing the number of transistors on a silicon wafer? Has Facebook (FB, Financial) improved the level of information that can be delivered over a network? Has it developed a software process that will allow up to 32 people to participate in a FaceTime session simultaneously? The answers to these questions, of course, are no, no and no.
Then why is the FANG group all too often considered a collection of tech companies?
Many investors (individual as well as fund managers) have badly conflated or misconstrued rapid earnings growth with technological innovation. This misinterpretation is, in part, due to the omnipresence of the internet as an essential component in the business model for some companies in the FANG group, most prominently Facebook and Alphabet's Google (GOOGL, Financial).
Some fund managers asked these very questions months ago and concluded there were no longer any compelling reasons for maintaining a position in Facebook as part of the tech growth component of their portfolios. Could the reason have been that after reviewing source of revenue figures, these managers realized Facebook was, in essence, a giant tech advertising platform?
After engaging in a long overdue session of critical thinking, index providers have finally decided to redefine the tech stock sector so it reflects economic and technological reality.
For the past decade, these “tech” stocks have been responsible for a disproportionate percentage of the overall market's gain. That is all about to change come September.
Facebook and Google will be purged from the tech sector of the S&P 500. Instead, they will be included in a new communications services group that will also be home to Netflix and Comcast (CMCSA, Financial), both of which are currently housed in the consumer discretionary sector.
As tech funds dump shares of Facebook and Google, undoubtedly this will have an impact, however fleeting, on the price of their stocks. In addition, prior to the changes, funds that track the consumer discretionary, tech and telecommunications sectors will be forced to trade billions of dollars of stocks to realign their portfolio holdings with the new constituent stocks in the index.
Another change, however imperceptible, will be the absence of the subtle, but nonetheless real, effect large market moves have had on lifting other stocks within the sector.
The revisions are an attempt to make the indexes reflect the actual role certain companies play in the 21st century economy. It also addresses the effect of mergers within certain groups, such as the telecommunications sector, which currently contains only three stocks: Verizon (VZ, Financial), AT&T (T, Financial) and Century Link (CTL, Financial). The telecommunications sector’s influence on the S&P 500 has diminished over the years as consolidation within the industry has narrowed the number of companies in the sector.
More importantly, the weighting of the new sectors within the S&P 500 will be more than 10%, a substantial increase over the telecom’s existing 2% according to a report from Credit Suisse.
Here are some interesting statistics that demonstrate the profound effect of changing the composition and sector weighting of major indexes. According to Credit Suisse, based on the revisions proposed, the new communications sector would have beat the S&P 500 every year since 2013 and would have returned 6.9% year to date, compared with 4% gain for the S&P 500 for the same period. The converse is equally instructive. The existing telecommunications sector has suffered the largest losses of all 11 sectors in the S&P 500, dropping 11% year to date.
For some investors, the changes will be welcome.
The whole purpose of passive index funds is to afford investors to participate in a broad cross-section of certain sectors. But for some indexes, due to the oversized weighting and despite how the groups were characterized by the index providers, in the end, there was little sector diversification and hence the index or exchange-traded fund no longer comported with its shareholders' original investment objectives, including allocation of risk.
Investors would be well advised to anticipate the impending changes and be prepared to adjust their portfolios accordingly.
Disclosure: I have no positions in any of the securities referenced in this article.
