A Sector Redo Shuffles Stocks

Some of the market's biggest names are on the move, dealing a new hand to index funds that invest in these corners of the market.

If you own mutual funds or exchange-traded funds dedicated to particular sectors of the market, you may wake up on October 1 to find that some of your stock holdings aren’t where you left them. Market index providers S&P Dow Jones Indices and MSCI Inc. are changing the Global Industry Classification Standard (GICS)—the system used to divide stocks within indexes, including Standard & Poor’s 500-stock index, into industry sectors. The realignment, which will go into effect after the market closes on September 28, will result in changes to three of the current 11 sectors: consumer discretionary, information technology and telecommunications services.

The last sector will be renamed communication services and will group together companies involved in social media, content creation, and internet and telecom services. Joining the likes of AT&T and Verizon in the sector will be internet firms such as Facebook and Alphabet, which were formerly classified as information technology companies, as well as media heavyweights Walt Disney, Comcast and Netflix, which used to be grouped with consumer discretionary companies (firms that provide nonessential goods or services). The information technology sector will also surrender internet retailers such as eBay and Alibaba, which will join the consumer discretionary sector.

Who Will Notice

Investors in broad stock market indexes likely won’t notice the change, but those who use sector funds as diversifiers or strategic plays should examine their holdings after the switch. The high-yielding, value-oriented telecom sector is about to be dominated by fast-growing companies. Some 60% of the sector will operate in social media, online gaming and cloud computing, says Leuthold Group research director Scott Opsal. Stripped of its large internet names, the tech sector will be a purer play on software, hardware and semiconductors.

All told, the move will reshuffle about 10% of the S&P 500, forcing mutual funds and ETFs that track the affected sectors to trade billions of dollars’ worth of stock to get themselves properly aligned. Although some of that trading is already under way, investors could yet see some temporary choppiness in the market. Some financial firms have taken steps to smooth out the impact of the move. Vanguard’s ETFs in the affected sectors began tracking custom benchmarks in May, and they have been gradually buying and selling shares to move the funds into the planned alignment. State Street Global Advisors, which runs the SPDR ETFs, launched an ETF in June that tracks the new communications sector.

The shift will cause some mutual funds and ETFs to offload major positions in Alphabet, Facebook and Netflix, all of which have enjoyed huge run-ups in recent years. ETF investors are unlikely to receive a tax bill, thanks to the practice among ETFs of routinely swapping shares with institutional market makers to limit capital gains.

Investors in mutual funds forced to sell shares will likely receive a capital gains distribution, which will be taxed at 15% in most brackets and 20% for taxpayers in the 37% tax bracket for ordinary income. Fund sponsors will announce any distribution in advance, should investors wish to sell before the distribution date. Tax considerations alone shouldn’t dictate whether you sell a fund, but if its makeover is substantial, consider whether you still want to own it.

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