Why your ETF or mutual fund may be losing Facebook, Alphabet and other top stocks

Is Facebook a high-tech stock?

Of course.

But it’s also an advertising-industry stock — one of the world’s largest.

As much as 90% of the company’s revenues come from advertising.

But, then again, you could also argue that it’s a media stock.

A large proportion of the American public gets its news through Facebook.

Amazon.com is another example.

Though Amazon is of course is a retailer, you could also make a compelling case that — via its increasing presence in producing TV shows and films — it’s a media and entertainment company.

You could also be excused for thinking that, due to its dominant cloud computing presence, it’s in the computer hardware and software business.

Welcome to the complexities of industry classification. Investors and financial advisers alike blithely assume that companies slip easily into various industry and sector indexes to which myriad funds and ETFs are benchmarked.

In fact, the classification process is anything but neat.

Facebook and Amazon are among a number of well-known companies moving from one sector to another after two big index providers — S&P Dow Jones and MSCI — announced changes to their methodology for the Global Industry Classification Standards.

Facebook, for example, is being reclassified from Information Technology to Communication Services, which is the new name for what used to be called Telecommunication Services. GOOGL, the parent company of Google, is being reclassified the same way as Facebook. Amazon will remain in the Consumer Discretionary sector.

What will these changes — slated to take effect later this year — mean for investors?

It’s safe to say that “it depends.” Some ETFs will lose previously prominent members and outstanding performers, while others will gain them.

Whether that will be good or not for those ETFs’ future performance is anyone’s guess.

But the changes do mean that investors will need to look beyond an ETF’s track record and examine its holdings, both current and past. Jeffrey DeMaso, editor and director of research for the Independent Adviser for Vanguard Investors, contends that “the old line about historical performance having nothing to do with future performance is really going to be true when these reconfigured indexes are born.”

DeMaso wonders, for instance, how Vanguard’s Telecommunication Services ETF would have performed had it owned Alphabet/Google all along.

“Telecom Services ETF gained 147% since its 2004 inception through February 2018 [lagging the S&P 500]. Alphabet was up over 1,000% over that stretch.”

At a minimum, he adds, the various “sector ETFs’ track records should have an asterisk next to them.”

From my vantage point as a performance monitor, I’m betting that these changes will mean that the already difficult job of betting on individual sectors is going to become even more so.

And that suggests your odds of beating the market through sector or industry rotation strategies will become even lower.

That’s saying something, since those odds already are discouraging. Consider the 87 sector-rotation strategies that my Hulbert Financial Digest tracked for any period of time over the last four decades.

They on average lagged the market by a huge amount.

To reach that conclusion, I calculated the annualized return of each sector rotation over the period it was tracked, along with its Sharpe Ratio.

I then compared these metrics to similar ones for the Wilshire 5000 index over the same period.

On average, the sector rotation strategies lagged the Wilshire by 4.6 percentage points annually.

And because the average sector-rotation strategy was riskier than the market as a whole, it lagged the Wilshire 5000 by an even greater amount on a risk-adjusted basis.

The odds therefore are heavily stacked against you if you play the sector-rotation game, and are likely to become even worse.

But if you nevertheless want to try, exercise more than the usual degree of care in coming months as various ETFs transition to the new industry classification system.

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