The S&P 500 is based on the market capitalization of 500 large companies listed on the New York Stock Exchange. While the index itself uses diverse constituency and weighting methodology to balance out the influence of one particular stock on the index, the S&P has grown to a point where technology stocks dominate a large portion of the index.
According to recent estimates, nearly 26% of the total index is composed of technology stocks. In total, the large technology companies Facebook, Amazon, Apple, and Microsoft represent more than 15% of the index. That 15% is greater than the weights of the entire financial and healthcare sectors respectively. The S&P has realized this problem and is now taking steps to address it.
The largest tech stocks, including Alphabet, Amazon, Facebook, and Netflix will no longer be part of the technology sector. Rather, these companies will be apart of the new communications sector that replaces the out-of-date telecom sector. Many critics argue the reshuffling does not address the issue of big tech influence. Whether or not that is true, the reshuffle will have a major effect on investors across the board. In particular, the sector swap brings to light five things investors need to keep in mind.
First off, investors who use passive index funds and ETFs are the most exposed to tech stocks and the sector swaps. For instance, the Technology Select SPDR Fund (XLK) will be dumping two of their top holdings and get Apple to 21% of the ETF on Monday. Both Alphabet and Facebook, which are currently 10% and 5% of XLK respectively, will be dumped and become much larger pieces of Communication Services. Thus, many technology ETF like XLK will be completely different come market close Monday.
Second off, the creation of the new communication sector gets rid of the telecom sector, which was one of the market’s last truly defensive sectors. Kim Arthur, of investment company Main Management, argues that the only defensive sector remaining is consumer staples. According to Neena Mishra, director of ETF research at Zacks Investment Research, “The telecom sector is traditionally seen as a defensive sector and a value play. The revamped communications services sector will be seen as a cyclical sector with much stronger growth prospects.”
Third, the new communications sector will be very highly concentrated. In total, Alphabet and Facebook will compromise roughly 45 percent of the index. The new sector will represent nearly 10% of the S&P 500 and have a higher percentage of growth stocks than information technology.
In the past, the communications sector, or more accurately known as telecom, had huge dividend yields. The new communication sector will not have those same large dividends. Although both AT&T and Verizon are a number of companies joining the group with dividends, the big players of Alphabet and Facebook do not offer dividends.
Finally, as mentioned previously, the swap will not take care of the overgrowing effect of the tech industry. According to Arthur, when a sector approaches about 30% of the S&P 500, the market goes downhill. In the early 80s, the energy sector reached that threshold, and in 2008, the financial sector got there as well. A quote by DataTrek Research co-founder Nick Colas summarizes the issue well. “Regardless of what you call it, technology’s disruptive influence on society and ‘passive’ investing is unlikely to slow. Where will this weighting be in 5 years? We sincerely doubt it will be lower.”