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

Trader Talk

Workers at the Dollar General store.
Jeremy Hogan | LightRocket | Getty Images

The index gurus are at it again. Some of the best-known stocks are getting reclassified on Friday, and that means a lot of money is going to move around. 

Ever wonder why Walmart is classified as a consumer staples stock in the S&P 500, but similar retailers such as Target, Dollar General and Dollar Tree are classified as consumer discretionary stocks?  A lot of other people have wondered as well. 

Friday, that will change. 

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

Consumer staples will get bigger; consumer discretionary will get a little smaller. 

Ever wonder why Visa, Mastercard and Paypal, which seem like they’re financials, are actually listed as Technology stocks instead? 

Other people have wondered that as well. 

On Friday, that too will change. 

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

As a result, technology will be a little smaller, financials a little bigger. 

The triumph of indexing: where a stock is placed matters 

Thirty years ago this would all have been of interest to academics, but almost no one 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 all the indexes in the amount of money tied to it. There is trillions more that is indirectly indexed. That is, many funds use the S&P as a bogey and try to match their returns without paying a licensing fee to Standard & Poor’s. 

Regardless: $6 trillion is a lot of money.  It’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 slice and dice the stock and bond market in endless ways. 

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

The people who issue those ETFs (BlackRock, Vanguard, State Street, Schwab and a handful of others), for the most part, do not own the indexes that are behind the ETFs.  They license those 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 manage what goes in, and comes out of those indexes have now become very influential. 

How the stock classification system works 

Ever wonder why we use odd phrases like “consumer discretionary” and “communication 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 set up an industry benchmark called the Global Industry Classification Standard (GICS).

All major public companies are broken down into one of 11 sectors, 24 industry groups, 69 industries and 158 sub-industries. The weighting in the most important index, the S&P 500, is determined by market capitalization. 

Here’s the current weighting of sectors in the S&P 500:

Sectors in the S&P 500

  • Technology                     27%
  • Health Care                    14%
  • Financials                        12%
  • Consumer Discretionary 11%
  • Industrials                         9%
  • Communication Services   8%
  • Consumer Staples               7%
  • Energy                                  5%
  • Utilities                                 3%
  • REITs                                     3%
  • Materials                              2%

Source: FactSet

Every year in March, S&P and MSCI announce changes in the classification system. This year, the changes set in motion last year take place on March 17th. 

Among the notable shifts this year, an entire sub-industry of technology, called “data & processing & outsourced services,” and including Mastercard, Visa, and Paypal, moves to financials and will now be called “transaction and service processing services.” 

Separately, S&P and MSCI are recognizing that Target, Dollar General, and Dollar Tree all sell similar merchandise to WalMart, so they’re all going under the same consumer staples umbrella.

What’s it mean for investors?

If you’re an investor in a broadly diversified total market index fund like the S&P 500, the changes will make little difference to 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 around in bank stocks this week, much of which went through the SPDR S&P Bank ETF (KBE) or SPDR S&P Regional Banking ETF (KRE). 

Moving Target, Dollar General and Dollar Tree to consumer staples from consumer discretionary will increase the weighting (and alter the future performance) of consumer staples, and lower the weighting (and alter the future performance) of consumer discretionary. 

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

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

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

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

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