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Sector and industry has long been popular with investors with exchange traded funds ushering in a new wave of long-term devotion to this tactical style of investing.
Just look at the 100 largest ETFs by assets. Nearly 10% are sector-specific ETFs and judging by the sizes of the ETFs in that group – a range of $18.54 billion to $74.65 billion – there’s much more than just speculative retail money sitting in these funds.
For those that consider themselves indexing nerds, they probably know that when it comes to the global industry classification system (GICS), which is the foundation on which industry and sector membership is determined, two companies loom large: MSCI and S&P Dow Jones. Some of the largest sector/industry ETFs on the market today, including State Street’s famed sector SPDR funds, follow S&P benchmarks.
With that in mind, advisors allocating client capital to S&P-linked sector/industry index funds and ETFs should be aware of some changes that are scheduled to go into effect on Sept. 23. We’ll explore those shifts below.
Addressing Top Heaviness on the Agenda
The bulk of the largest sector and industry funds cap-weighted, meaning the largest stocks by market value in those groups have the biggest weights in the related funds. That can lead to concentration issues with technology being a prime example.
Just look at the popular Technology Select Sector SPDR (XLK) where just two stocks – Microsoft (MSFT) and Nvidia (NVDA) – combine for 42% of the ETF’s roster. Upcoming adjustments by S&P attempt to reduce issues such as that. Previously, S&P sector indexes were adjusted if a single stock account for 24% of the benchmark or if the sum of the stocks with weights of at least 4.8% exceeded 50%. S&P’s new capping mechanism will do things differently.
“The aggregate weight of the larger companies will be reduced to 45% and the larger companies’ individual weights will be determined by their relative proportions, after checking for any breaches in the single company cap. The minimum index weight of each of the larger companies will be 4.5%,” according to S&P Dow Jones Indices.
Tech isn’t the only offender when it comes to highly concentrated sector indexes. Communication services, consumer discretionary and energy are, too, but S&P’s capping mechanism attempts to contend with those issues while taking into account shifting market dynamics.
What to Expect
For advisors trying to get a handle on what some S&P index sector funds could look like after the changes go into effect on Sept. 23, expect changes among the funds’ largest holdings. Tech serves as a good example as S&P notes its likely its tech index – tracked by XLK – is likely to feature lower weights to Microsoft and Nvidia while Apple’s (AAPL) weight will increase.
And remember these two words: diversification and proportion.
“The New Capping Mechanism is designed to better retain FMC proportions among index constituents, while still being mindful of diversification thresholds,” concludes S&P.
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