Big changes in the S&P 500 Friday highlight the strength of index providers

The index gurus are at it again. Some of the best-known stocks will be reclassified on Friday, and that means a lot of money will be moving around.

Have you ever wondered why Walmart is classified as a grocery stock in the S&P 500, but similar retailers such as Target, Dollar General and Dollar Tree are classified as consumer discretionary stocks? Many other people have also wondered.

Friday, that changes.

Target, Dollar General and Dollar Tree will move out of the consumer discretionary corner of the stock market and join Walmart as consumer goods companies.

Consumer staples will get bigger; consumer discretion will be slightly less.

Have you ever wondered why Visa, Mastercard and Paypal, which appear to be financial companies, are actually listed as technology stocks instead?

Others have also wondered about that.

On Friday, that will also change.

Visa, Mastercard and Paypal, along with a few other names, will be moved into the financial sector.

As a result, the technology gets a little smaller, the economy a little bigger.

The triumph of indexing: Where a share is located matters

30 years ago, all this would have been of interest to academics, but hardly anyone else.

That was before the triumph of indexing and exchange-traded funds.

Today, there is $6 trillion directly indexed to just the S&P 500, the largest of any index in the amount of money tied to it. There are trillions more that are indirectly indexed. That is, many funds use the S&P as a bogey and try to match their returns without paying a license fee to Standard & Poor’s.

Regardless: $6 trillion is a lot of money. That’s about 18% of the entire market capitalization of the S&P 500.

And that’s just the S&P 500. There are thousands of indexes that divide the stock and bond markets in endless ways.

Exchange-Traded Funds (ETFs), which started 30 years ago, allow investors to buy these indexes in a low-cost, tax-advantaged package that can be traded on an intraday basis. The ETF business in the US alone is about $7 trillion, most of it in passive (indexed) funds.

The people who issue these ETFs (BlackRock, Vanguard, State Street, Schwab, and a handful of others) mostly don’t own the indexes behind the ETFs. They license these indexes from index providers. The largest are Standard & Poor’s, MSCI and FTSE Russell (which is owned by the London Stock Exchange Group).

And the people who control what goes in and out of these indexes have now become very influential.

This is how the stock classification system works

Have you ever wondered why we use strange phrases like “consumer discretionary” and “communications services” to describe different parts of the stock market?

You can thank S&P and MSCI.

In 1999, in an effort to standardize how stocks are classified, MSCI and Standard & Poor’s created an industry benchmark called the Global Industry Classification Standard (GICS).

All major public enterprises are divided into one of 11 sectors, 24 industry groups, 69 industries and 158 sub-industries. The weight in the main index, the S&P 500, is determined by market capitalization.

Here are the current weightings of sectors in the S&P 500:

Sectors in the S&P 500

  • Technology 27%
  • Healthcare 14%
  • Finance 12%
  • Consumer discretionary 11%
  • Industry 9%
  • Communication services 8%
  • Consumer goods 7%
  • Energy 5%
  • Supply 3%
  • REITs 3%
  • Materials 2%

Source: FactSet

Every year in March, S&P and MSCI announce changes to the classification system. This year, the changes that were put in place last year will take place on 17 March.

Among the notable shifts this year, an entire subsector of technology, called “data & processing & outsourced services,” and including Mastercard, Visa and Paypal, is moving into finance and will now be called “transaction and service processing services.”

Separately, S&P and MSCI acknowledge that Target, Dollar General and Dollar Tree all sell similar items to WalMart, so they all fall under the same consumer goods umbrella.

What does this mean for investors?

If you’re an investor in a broadly diversified total market index fund like the S&P 500, the changes won’t do much for you.

The changes will be more significant if you trade sectors, which is an increasingly popular strategy. Just look at all the money that moved into bank stocks this week, much of which went through the SPDR S&P Bank ETF (KBE) or the SPDR S&P Regional Banking ETF (KRE).

Moving Target, Dollar General and Dollar Tree into consumer goods from consumer goods will increase the weighting (and change the future performance) of consumer goods and lower the weighting (and change the future performance) of consumer goods.

Likewise with finance and technology: Mastercard, Visa and Paypal will enter finance, which will increase the weighting (and change the future performance) of finance and decrease the weighting of technology.

The net effect: technology’s weight in the S&P will drop from approx. 27.7% to 24.5%, while the weighting of finance will expand from 11.5% to 14.2%.

“The key is to make sure these indices are relevant,” said Dan Draper, CEO of S&P Dow Jones Indices, at S&P Global, in a recent interview on CNBC’s ETF Edge. “Do they reflect changes in consumer demand or the changes in market structure?”

Here’s something else it reflects: the people who decide what goes in these indexes have become very influential. They’re not fund managers, they’re index providers, but don’t let that fool you: in a world where people buy funds tied to indexes, the people who decide what goes into those indexes have become very powerful.

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