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Tech talk: Are sector changes skewing your equities portfolio?

Understanding the changes in the Global Industry Classification Standard (GICS) may seem wonky and of little interest, but don’t be quick to dismiss the minutia. In fact, the recent reclassifications have serious ramifications for technology investors—especially those who have been relying on passive exposure to the tech sector. If not wary, at least be aware. 

So what exactly happened? GICS, a standardized classification system for equities, is a default framework for many portfolio managers and index providers to benchmark and classify stocks consistently across different regions and industries. But over time industries change and strategies shift. This past September, GICS created a new Communications Services Sector that merged networking, content providers from the telecommunications, information technology, and consumer discretionary sectors. 

According to MSCI, the creator and administrator of GICS, the new Communications Services Sector was created to reflect “the integration between telecommunications, media, and internet companies.” Today, many of these companies offer bundled services such as cable, telephone, and internet services, while others also create interactive entertainment content that can be delivered across multiple platforms. The business models have evolved, so the logic behind reclassifying and creating a new category seems sound. But as always, there are serious ramifications that may be especially meaningful to technology investors.

For starters, Facebook and Alphabet (aka Google), moved to the new communications sector, along with Netflix, Comcast and Disney. Fine. But that also means that any investor who held the largest tech-focused ETFs no longer has exposure to some of the largest technology-oriented companies, such as Facebook and Google. The net result is that many technology index funds and ETFs have changed materially but now have an even greater concentration problem than before.

SPDR Graph


Take the Technology Select Sector SPDR ETF (XLK) and Vanguard Information Technology ETF (VGT), two of the most popular sector ETFs with almost $40 billion in assets as of March 2019. In the case of the Technology Select Sector SPDR ETF (XLK), after the exclusion of Facebook and Google, the ETF is now absurdly overweight to its top two holdings Microsoft and Apple, a concentrated bet that now make up a whopping 37% of the index, while the Vanguard Information Technology ETF (VGT) has an almost a 30% weight to these two names. This is not the diversified, passive approach to technology-oriented companies many investors may think they are taking.

Passive investors should have always recognized that many sector funds are unable to include dynamic companies that are outside traditional tech, as defined by the GICS sector definition. And now they may be forced to skip out on a few of the most dominant large-cap Internet companies as well. This seems arbitrary and wrong.

We think there are better ways to allocate to disruptive and dynamic companies—those with the potential to drive innovation, capture market share, and provide sustained earnings growth. Here are three characteristics that investors should consider before investing in any technology-oriented sector fund:

1. Disregard sector labels: Instead of focusing on narrow definitions of technology, look for a fund that offers more diversified exposure to innovation, which is no longer concentrated only among traditional tech stocks. Orienting around innovation can help capture opportunities in biotech and healthcare, in addition to more traditional hardware and software plays.

2. Review the portfolio structure: Check the fund’s active share, which is defined as the percentage of holdings in portfolio that differs from the benchmark index. High active share (say, above 80%) illustrates that the manager is willing to stray from the benchmark as a means to capture potential alpha. If your tech fund has a low active share, you may be buying the benchmark (for all practical purposes), which may result in undesired concentration while missing out on many potential opportunities.

3. Beware cap weighting: Look for a fund whereby the average market-cap of portfolio constituents is significantly below that of the most widely followed technology index. Tilting the portfolio toward smaller companies ensures that the strategy can allocate capital to innovative tech-oriented companies long before they become household names.

Investing in technology stocks entails specific risks, including the potential for wide variations in performance and usually wide price swings, up and down. Technology companies can be affected by, among other things, intense competition, government regulation, earnings disappointments, dependency on patent protection and rapid obsolescence of products and services due to technological innovations or changing consumer preferences. These risks are magnified in emerging markets.

There are differences between open-ended mutual funds that are actively managed and passively-managed exchange-traded funds that impact performance. These differences include, but are not limited to, trading, pricing, trading costs, investment strategy, tax implications, fees and expenses, and transparency. These differences should be carefully considered when making investment decisions.

When valuations fall and market and economic conditions change it is possible for both actively and passively managed investments to lose value.

Victory Capital, Inc. is a Registered Investment Advisor. The information in this article is based on data obtained from recognized services and sources and is believed to be reliable. Any opinions, projections or recommendations in this report are subject to change without notice and are not intended as individual investment advice. Not to be used as legal or tax advice.

©2019 Victory Capital Management Inc.

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Consider the investment objectives, risks, charges and expenses of the funds carefully before investing. Download a prospectus or summary prospectus, if available, containing this and other important information for USAA mutual funds from www.usaa.com/prospectus, for Victory mutual funds from www.victoryfunds.com, or for VictoryShares and VictoryShares USAA ETFs from www.victorysharesliterature.com. Read it carefully before investing.

Investments involve risk including possible loss of principal. The value of the equity securities in which the fund invest may decline in response to developments affecting individual companies and/or general economic conditions. Dividends are never guaranteed. International investing involves special risks, which include changes in currency rates, foreign taxation and differences in auditing standards and securities regulations, political uncertainty, and greater volatility. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. You may lose money by investing. There are no guarantees the funds will achieve their investment objectives and strategies may be unsuccessful.

Investments in bank loans may at times become difficult to value and highly illiquid; they are subject to credit risk such as nonpayment of principal or interest, and risks of bankruptcy and insolvency. Fixed income securities are subject to interest rate, inflation, credit and default risk. The bond market is volatile. As interest rates rise, bond prices usually fall, and vice versa. The return of principal is not guaranteed, and prices may decline if an issuer fails to make timely payments or its credit strength weakens.

ETFs have the same risks as the underlying securities traded on the exchange throughout the day. Redemptions are limited and often commissions are charged on each trade, and ETFs may trade at a premium or discount to their net asset value. There can be no assurance that an active trading market for shares of an ETFs will develop or be maintained. The ETFs are not actively managed and may be affected by a general decline in market segments related to the Indexes. The ETFs invest in securities included in, the Index, regardless of their investment merits. The performance of the ETFs may diverge from that of the Indexes. 

Fixed income securities are subject to interest rate, inflation, credit and default risk. The bond market is volatile. As interest rates rise, bond prices usually fall, and vice versa. The return of principal is not guaranteed, and prices may decline if an issuer fails to make timely payments or its credit strength weakens.

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Victory Capital means Victory Capital Management Inc., the investment manager of the USAA Mutual Funds and VictoryShares USAA ETFs. Victory Mutual Funds and USAA Mutual Funds are distributed by Victory Capital Advisers, Inc. (VCA). VictoryShares ETFs and VictoryShares USAA ETFs are distributed by Foreside Fund Services, LLC (Foreside). VCA and Foreside are members of FINRA and SIPC. Victory Capital Management Inc. (VCM) is the investment adviser to the Victory Mutual Funds, USAA Mutual Funds, VictoryShares ETFs, and VictoryShares USAA ETFs. VCA and VCM are not affiliated with Foreside. USAA is not affiliated with Foreside, VCM, or VCA. USAA and the USAA logos are registered trademarks and the USAA Mutual Funds and USAA Investments logos are trademarks of United Services Automobile Association and are being used by Victory Capital and its affiliates under license.

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