The industry sectors within the S&P 500 Index (SPX) have undergone a major change this week, and Goldman Sachs is advising investors on how to respond. The old telecom sector has been renamed communication services, enlarged and given a heavy tilt towards growth stocks and tech companies. The most noteworthy change moved Facebook Inc. (FB) and Google parent Alphabet Inc. (GOOGL) from the information technology sector to communication services. This has particularly large ramifications for defensively-oriented investors who had been holding shares of telecom sector ETFs

Shaking Up The S&P 500: Redefining The Sectors:

  • Technology sector share of S&P 500 market cap falls from 26% to 21%
  • Communication services sector now comprises 10% of S&P 500 market cap
  • Alphabet and Facebook represent 45% of communication services market cap
  • Inc. (AMZN) is now 32% of consumer discretionary market cap

Source: Goldman Sachs

Goldman finds that the creation of the new communication services sector, achieved through the combination of various information technology and consumer discretionary stocks with the old telecom sector stocks, will have 5 big implications for investors. These are summarized below.

Improved Risk-Adjusted Returns

Telecom had lagged the full S&P 500 by a cumulative 102 percentage points since the start of 2010, making it the worst performing sector other than energy. However, communication services, as currently defined, would have outperformed the S&P by 74 percentage points with roughly the same volatility, giving it one of the best risk-adjusted return profiles in the S&P 500. In addition to Facebook and Alphabet, communication services includes cyclical media stocks that formerly were in consumer discretionary, as well as Netflix Inc. (NFLX). Meanwhile, the performance of technology and consumer discretionary would been largely unchanged.

Less Macro Sensitivity, More Stock-Picking Opportunities

Communication services should behave more like health care in terms of experiencing less sensitivity to macro variables, most notably interest rates, and lower correlations among its component stocks. Those lower intra-sector correlations mean that the opportunities for stock picking within the sector will rise. On the other hand, communication services is not a defensive play for income-oriented investors, as opposed to the old telecom sector, which had been a bond proxy with a dividend yield that exceeded 5%. The addition of growth stocks that pay no or low dividends has reduced the sector's yield substantially.

Growth at Reasonable Valuation

Communication services is projected to enjoy the second-fastest revenue growth rate in the S&P 500 for 2019, with Facebook and Netflix as the key drivers. However, there is wide variation within the sector, with some new additions suffering sales declines. Nonetheless, despite its above-average growth rate, communication services will have a forward P/E ratio of 18 times earnings, a 5% premium versus the full S&P 500, but well below the 28% premium that it would have averaged during the last 30 years.

Hedge Funds Become Underweight in Tech

Facebook, Alphabet and Alibaba Group Holding Ltd. (BABA) are among the top 10 most popular stocks among hedge funds. Reclassifying them from technology to communication services means that hedge funds, as a group, will shift from being overweight to underweight in tech, while moving from underweight in telecom to overweight in communications services. Large cap mutual funds will be overweight in communication services, while remaining overweight in tech and consumer discretionary despite the shift.

Discrepancies in ETF Weights

Some popular ETFs have weighting restrictions that produce discrepancies between their stock holdings and the actual weights that these stocks hold in the various sectors. The upshot is that these ETFs will hold less of the largest stocks and more of the lowest stocks than the actual sector weights would dictate. This, in turn, will cause the performance of these ETFs to deviate from the performance of the sectors that they are supposed to track.

What's Next

This means that many large investors, such as ETFs and hedge funds, may have to overhaul their portfolios. Also, individual investors who own mutual funds and ETFs, whether actively-managed or passively-managed, will need to re-evaluate and possibly retool their investments. Defensive or income-oriented investors who used the old telecom sector for these purposes may need to look at other equity sectors for defensive options. And investors seeking faster growth will have to consider the new communications sector, which will now have one of the best risk-adjusted returns among sectors in the S&P 500.