Friday's Big Changes In The S&P 500 Illustrate Index Providers' Power

It's that time of the year again for the index gurus. A lot of money will be moved around as a result of the reclassification of some of the best-known stocks on Friday. 

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Have you ever wondered why Walmart ranks as a consumer staple stock in the S&P 500, while similar retailers such as Target, Dollar General, and Dollar Tree are categorized as consumer discretionary stocks? Many people have, in fact, wondered just the same thing as well. 

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There will be a change in that on Friday. 

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A number of consumer discretionary companies, including Target, Dollar General, and Dollar Tree, will move from the consumer discretionary sector to join Walmart's consumer staples segment of the stock market in the near future. 

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A slight drop in consumer discretionary will be compensated by a rise in consumer staples. 

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Is there ever any wonder why Visa, Mastercard, and Paypal, which seem like they would be financial stocks, are actually listed as Technology stocks instead and not as financial stocks? 

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This is also a question that has been asked by others. 

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The situation will change again on Friday as well. 

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Among other names, PayPal, Visa, Mastercard, and Mastercard will be moved to the financial sector. 

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Due to this, technologies will become smaller, and finances will become larger. 

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Investing in stocks is all about where they're placed: the triumph of indexing 

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A third of this would have been of interest only to academics thirty years ago, but almost nobody else would have paid attention. 

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In those days, indexing and exchange-traded funds were not even a consideration. 

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Currently, there are more than $6 trillion dollars directly indexed to the S&P 500 index, the largest index in terms of money tied to it out of all the indexes today. Additionally, there are trillions more dollars that are indirectly indexed to the Standard and Poor’s index. Therefore, many funds use Standard & Poor’s index as a bogey and try to match their return without paying the licensing fees. 

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There is no doubt that $6 trillion is a huge amount of money. It is about 18% of the market capitalization of the S&P 500, no matter what. 

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As you can see, the S&P 500 is not the only index that gives us insight into the stock and bond markets in endless ways. There are thousands of indexes to explore. 

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With the advent of exchange-traded funds (ETFs) a few years ago, investors were now able to purchase indexes in low-cost, tax-advantaged packages that were tradeable intraday. Currently, there are more than $7 trillion in assets under management in the U.S. alone, with most of them being passive (indexed) funds. 

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There are a few other companies that issue ETFs that are related to those indexes (BlackRock, Vanguard, State Street, Schwab, and a few others as well). Most of the time, however, these companies do not own the indexes underlying these ETFs.  There are index providers that license their indexes to them and they use them in their indexes.  A few of the most important are: Standard & Poor's, MSCI, and FTSE Russell (owned by the London Stock Exchange Group which is based in London). 

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A great deal of influence has now been attributed to the people who manage what goes into these indexes, and what comes out of them. 

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The process of classifying stocks in the stock market 

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Have you ever wondered why it is that certain parts of the stock market are described with odd phrases, such as "consumer discretionary" and "communication services"? 

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MSCI and S&P can be credited for this. 

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It was back in 1999, when MSCI and Standard & Poor's established the Global Industry Classification Standard (GICS) as a framework for standardized stock classification, in order to increase transparency in the stock market.

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Major public companies are categorized into 68 industries, 69 industries, and 158 sub-industries according to one of 11 sectors, 24 industry groups, and 69 industries, respectively. Market capitalization determines the weighting of the S&P 500, the most important index.

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Sector weightings in the S&P 500 are as follows:

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• Technology                     27%

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• Health Care                    14%

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• Financials                        12%

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• Consumer Discretionary 11%

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• Industrials                         9%

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• Communication Services   8%

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• Consumer Staples               7%

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• Energy                                  5%

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• Utilities                                 3%

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• REITs                                     3%

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• Materials                              2%

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The classification system is changed every year by S&P and MSCI in March. Changes that were initiated last year will be implemented on March 17th this year. 

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A major shift occurred this year when the "data and processing & outsourced services" industry, encompassing Mastercard, Visa, and Paypal, moved into financials and became the "transaction and service processing services" industry. 

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In addition to Target, Dollar General, and Dollar Tree selling similar merchandise to Walmart, S&P and MSCI all recognize that they belong in the same category of consumer staples.

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Investing implications: what do they mean?

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The changes won't affect S&P 500 index fund investors who invest in a broadly diversified total market fund. 

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Sector trading, which has become increasingly popular, will result in more significant changes. You only have to look at all the money that went through SPDR S&P Bank ETF (KBE) and SPDR S&P Regional Banking ETF (KRE) this week to see how much money moved around. 

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When Target, Dollar General, and Dollar Tree move from consumer discretionary to consumer staples, their weighting will increase (and their performance will change), while consumer discretionary's weighting will decrease. 

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The same is true for technology and financials: Mastercard, Visa, and Paypal will be included in financials, raising their weighting (and changing their performance in the future) while decreasing technology's weighting. 

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It is estimated that the technology sector's weight in the S&P will drop from 27.7% to 24.5%, while the financial sector's weight will increase from 11.5% to 14.2%. 

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Trade Algo asked Dan Draper, CEO of S&P Dow Jones Indices if the indices reflect changes in consumer demand or changes in the marketplace. 

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It also reflects an increasing influence of the people who decide what goes into these indexes. In a world where people buy funds tied to indexes, the people who determine what goes into those indexes have become very powerful indeed. They are not fund managers, they are index providers, but don't let that fool you: they are index providers, not fund managers.