The tech sector will lose more titans in reclassification

The already stripped-down tech sector is about to be stripped of more companies in the latest shake-up of industry definitions, pushing stock concentration to unprecedented highs.

In 2018, erstwhile tech titans Facebook (now Meta), Netflix, Twitter, Snap and Alphabet, the parent company of Google, were reclassified as communications services companies under the widely followed Global Industry Classification Standards (GICS) framework. Since Amazon is now classified as a consumer discretionary company, this means that only one of the five notorious FAANGs—Apple—was actually technically still a tech stock.

Now Visa and Mastercard, two of the five biggest remaining tech companies, are set to be reclassified as financial, along with the likes of PayPal and Fiserv, while Automatic Data Processing and PayChex are among those being sent to industrials.

The moves would increase the weight of Apple and Microsoft, which already account for a combined 44.4% of the S&P 500’s information technology sector, to nearly 50%.

“The changes reinforce our unfavorable view of technology exchange-traded funds becoming more concentrated. We prefer equal-weight sector ETFs,” analysts at BofA Securities said.

However, the impact will vary significantly from fund to fund. The $158 billion Invesco QQQ ETF ( QQQ ), often considered a technology fund, will not be affected because it invests in the largest non-financial companies listed on the Nasdaq, regardless of sector, ranging from PepsiCo to Walgreens Boots Alliance and Marriott International.

The implications for the $49 billion Vanguard Information Technology ETF ( VGT ) and the $40.1 billion SPDR ETF Technology Select Sector ( XLK ), the two largest sector ETFs in the world, according to data from Morningstar Direct, will differ, however. – in part because some are already as highly concentrated as US regulations allow.

Under the U.S. Internal Revenue Code, regulated investment companies, which include funds, must ensure that no more than 25 percent of their assets are invested in a single issuer or company at the end of each quarter and that the sum of the weights of all issuers, representing more than 5 percent of the fund must not exceed 50 percent.

The S&P 500 Technology Select Sector Index tracked by XLK already appears to have fully maxed out on these parameters, with Apple, Microsoft and Nvidia, the third-largest remaining technology company, having a combined weighting of 50.45 percent and only Apple at 23.04 per hundred.

This means that their weight cannot increase further after the correction, which for the S&P indices will occur after the close of trading on March 17.

As a result, the index and any fund that tracks it, such as XLK, will be underweighted by the Big Three in terms of their underlying market capitalizations and overweight the remaining technology companies, led by Broadcom, Cisco Systems and Salesforce .

Matthew Bartolini, head of SPDR Americas Research at State Street Global Advisors, said the changes were “relatively minor from a weighting perspective and the fund will continue to have a very diversified exposure to the technology sector.”

In contrast, VGT tracks small- and mid-cap technology stocks as well as the blue-chip names in the S&P 500, so its exposure to the largest companies is somewhat reduced.

As of Jan. 31, the most recent data available, VGT’s combined exposure to Apple, Microsoft and Nvidia was 43.6 percent, giving it room to rise further when MSCI (whose index VGT tracks) implements the GICS changes, which will happened in May.

Thus, VGT’s exposures will likely be in line with the underlying market constraints, but will become more concentrated in a handful of stocks.

Vanguard said it was still analyzing the likely impact on its funds, but added that “changes to GICS will have little impact on investors in broadly diversified equity funds, such as the Total Stock Market Index or the 500 Index.”

It’s a different story again for the $8.8 billion iShares US Technology ETF ( IYW ), which tracks a version of the Russell 1000 Technology Index. FTSE Russell does not follow the GICS framework, but instead uses its own Industry Classification Benchmark.

As a result, IYW invested in some companies banned from VGT and XLK, such as Meta, Alphabet and Pinterest. However, upcoming changes to the GICS will narrow the divide, as FTSE Russell does not classify Visa and Mastercard as technology stocks (instead, they are ranked as America’s two largest industrial companies).

The ripples from the GICS rejig will spread even further. BofA believes this will lead to net sales by the payments giants, with technology funds selling $15 billion worth of shares but financial funds buying just $11 billion.

With a combined market capitalization of nearly $800 billion, Visa and Mastercard are on track to become the second and fourth largest stocks in the S&P 500 financial sector, respectively.

Bartolini supported the transfer of Visa and Mastercard, saying they “probably should be in finance, given their connection to the financial industry itself. This change is really welcomed by investors as far as the conversations we have had,” he added.

As for mixing the acronym FAANGs with technology, Bartolini said, “It’s catchy, catchy, and can be confusing.

“It has become mainstream in the financial lexicon and is unlikely to go away, even though FAANGs are not representative of technology, innovation or high growth.”