Revisions to sector, industry classications pose challenge to investors

For the index community, 2018 will be a year of transition, but most investors may not be particularly aware of the changes and the potential effects on their portfolios.

The two major systems that many index providers and asset managers use for classifying businesses — and testing for sector and industry concentration risk and relative valuations — are set to shuffle how they group companies involved in technology, media and telecommunications.

While the change could open doors for new products from asset managers, it also could make past performance less useful if group members have shifted sectors, market observers said.

Changes announced in fall 2017 for the Global Industry Classification Standard, overseen by S&P Dow Jones Indices and MSCI Inc., will take place in the fourth quarter of 2018. And changes to FTSE Russell's Industry Classification Benchmark, announced September 2017, will be implemented in the first quarter of 2019.

For GICS, the current telecommunication services sector will be renamed communication services and include companies from the consumer discretionary sector currently classified under media and internet/direct marketing, as well as some companies from the information technology sector. For ICB, the telecommunications industry is being expanded; the oil and gas industry is being renamed energy and will be grouped at the sector level by renewable and non-renewable; and real estate is being added as ICB's 11th industry.

(GICS added real estate in September 2016, while Morningstar Inc. included real estate when it launched its classification system in 2010.)

Both GICS and ICB will reveal more information about the transitions throughout the year, beginning with GICS, which plans to announce in January select large cap companies that will be affected.

For the more widely followed and indexed benchmarks, any shuffling of industries and sectors is a potential boon for asset managers, which can market products on the refined sectors or industries. The GICS change, for example, could impact 30 exchange-traded funds, including 11 with more than a $1 billion in assets each, according to a mid-November analysis by ETF.com.

But many in the index fund and investing business have already moved on from the tyranny of specific industry and sector constraints, while staying true to quantitative investment guidelines.

Core to the activity around smart beta and indexed factor investing, espoused through the use of Fama-French factors and core to the work of Research Affiliates' Rob Arnott and BlackRock (BLK) Inc. (BLK)'s Andrew Ang, among others, is that investment portfolio risk and reward can be enhanced (or dampened) by exploiting fundamental qualities of a security that may be dismissed in a market-cap weighted benchmark.

Rory Riggs, CEO and founder of Syntax Indices and Locus Analytics in New York, said that the existing classification systems don't pay enough attention to risk, specifically the risk that comes from an overconcentration of companies that may be subject to the same economic stressors.

A simple adjustment for this concentration risk is evidenced by equal-weight strategies (and even a newly launched reverse-cap weighted S&P 500 ETF) but Mr. Riggs and his company believe that components of market-cap based indexes can be "stratified" to compensate for related-business risk — particularly the kind that presents itself when a sector or industry group gains momentum and an outsize influence on equity portfolios.

Mr. Riggs, who also is the chairman and co-founder of Royalty Pharma, a New York-based investor in biotechnology and pharmaceutical intellectual property, applied his background in organic systems and clinical trials to the mapping of functional aspects in a working economy over time, and ultimately to the attributes of business that make such a system robust.

Syntax Stratified Indexes began tracking on Dec. 27, 2016, and the company has filed to issue an exchange-traded fund for the Syntax Stratified LargeCap Index, which re-weights the components of the S&P 500 stock index for related business risks.

While many ETF managers build products on top of existing sector and industry classification systems, others work with index providers or on their own to redefine classification.

"Given that sector and industry classifications are slow to adapt to new economic realities, you have to essentially ignore them when approaching disruptive themes," said Jay Jacobs, vice president and head of research at Global X Management Co. in New York.

Such is the case for many of the company's thematic ETFs, including its $1.5 billion Robotics and Artificial Intelligence ETF, indexed by Indxx LLC, or the $177 million Social Media ETF, indexed by Solactive AG.