Tech Sector Investors Beware: MSCI Tech Sector Losing Some Of Its Strongest Stocks (VGT)

When I recently covered the Vanguard Information Technology ETF (NYSEARCA:VGT) in an article published on February 23, 2022, I mentioned that the Global Industry Classification Standard (GICS) division of index provider MSCI was considering making some major changes in the way that it defines the various sectors and subsectors to which each stock is assigned. The GICS classifications are the classifications used by many of the most popular sector ETFs. The most disruptive changes MSCI proposed were those that affect stocks in the GICS Information Technology Sector.

I explained that it was impossible to evaluate the ETFs that track indexes that hold stocks in the Information Technology Sector until it was clear whether these proposed changes would be adopted as the proposed changes would have a very disruptive impact on the Information Technology sector. The most popular ETFs tracking the sector using the GICS sector definitions are the Vanguard Information Technology ETF which holds all stocks in the sector and The Technology Select Sector SPDR Fund (XLK) which only holds stocks in that sector which are also included in the S&P 500. The Fidelity MSCI Information Technology Index ETF (FTEC) tracks an index that is almost identical to the one tracked by Vanguard Technology ETF.

MSCI Has Decided to Let Energy Stocks Remain in the GICS Information Technology Sector

On March 31, 2022, MSCI released a publication describing which of the many changes they had proposed would be adopted. Not the changes proposed were accepted. Solar Energy companies previously defined in the Semiconductor Equipment subsector of the Information Technology sector will continue to remain in that sector. The Vanguard Information Technology ETF only holds US companies. So the only companies whose loss might have affected VGT were Enphase Energy (ENPH), SolarEdge Technologies (SEDG), First Solar (FSLR), and SunPower Corporation (SPWR). The rest of the solar companies allowed to remain classified in the Information Technology sector, at least for the next couple years were ones domiciled in China.

The total weight of the solar companies that are not going to be removed from VGT was only .31% of the ETF’s total weight back in February 2022 when discussion with stakeholders ended. Had those changes gone through, they would not have had a material effect on VGT’s performance.

MSCI Is Removing All Current Data Processing and Outsourced Services Stocks from the GICS Information Technology Sector

MSCI has decided to go ahead with the changes it had proposed that affect the Information Technology sector. Below you can see the list of US stocks currently listed in the Information Technology Sector which MSCI listed in January as being the ones that would change sectors and the sectors they will move into. Note that this list excluded a few stocks with market capitalizations below $2 billion.

I have also added into this list what the weight was of each of these stocks in VGT as of March 31, 2022, which is the latest date for which Vanguard provides information about VGT’s portfolio holdings. The stocks in the Data Processing and Outsourcing Services subsector that were not included in this list made up less than .005% of the value of the entire VGT ETF.

Stocks Leaving VGT with Their Weights in the ETF

The total weight of the stocks to be removed from VGT based on their weight in the ETF at the end of March is 9.32%.

The New Sectors and Subsectors These Stocks Will Move To

Below you can see the list of the US stocks with market caps greater than $2 billion that MSCI suggested would be removed from the Information Technology Sector, sorted by their new sector and subsector.

US Stocks Likely To Change Sectors and Subsectors

As you can plainly see, the majority of the stocks to be removed, which are those whose loss will make the heaviest impact on the sector’s–and VGT’s–future performance, are transaction and payment processing stocks which are being moved to the relatively sleepy Financials sector. Payment processing has seen much growth over the past decade as consumers’ shopping habits have migrated towards online and card transactions and point of sale cash transactions have declined.

The more heavily weighted companies being moved into the Industrials sector are Broadridge Financial Solutions, which provides software to the brokerage and wealth management industry, and Jack Henry & Associates which provides software for the banking and credit union industry. These businesses have also been growing very fast as the shift to mobile transactions in investing and banking has accelerated.

Payroll companies are also moving to the Industrials sector, though they serve customers in all sectors, not just those in what the average investor thinks of as “industry.”

It is even more baffling to see that the stocks which directly serve the Financial industry are being moved into the Industrials sector. But the change will certainly juice the performance of that sector going forward. That kind of performance improvement appears to be the motivation behind the periodic changes that MSCI makes in its sector allocations.

MSCI claims that its periodic changes make the sectors more balanced. The reality is that it keeps ETF providers from abandoning MSCI’s indexes–and keeps providers paying MSCI for using them. If a sector were to lag too much, investors would abandon it, and that would harm ETF providers.

As we will see, these sector changes benefit everyone except for the poor schnook who invests in a sector assuming it will continue to contain the stocks that have produced the historical record which the investors consult to determine how the sector performs under different market conditions.

Ex-US Stocks to Be Removed from the Information Technology Sector

Below you can see the list of ex-US stocks with market caps greater than $2 billion that will also be moving into other sectors and their new sectors and subsectors. Their impact on the weighting of ex-US ETFs will depend on how their indexes are constructed.

Ex-US Stocks Likely to Leave the GICS Information Technology Sector

As was the case with US stocks, we see that the stocks removed are mostly those involved with payment processing and a few stocks that serve the investing industry that are, inappropriately, moving to the Industrial sector.

Other Sector ETFs That Will Be Impacted By These Changes

ETFs and funds that track the Financial and Industrials sector will be most heavily impacted by these changes. The most popular of these would be:

Financial Sector ETFs Affected

Financial Select Sector SPDR Fund (XLF), Vanguard Financials ETF (VFH), and Fidelity MSCI Financials Index ETF (FNCL).

Industrial Sector ETFs Affected

Industrial Select Sector SPDR Fund (XLI) and Vanguard Industrials ETF (VIS).

How These Changes Will Be Implemented

MSCI tells us

A select list of large market capitalization companies affected by the changes will be announced no later than June 30, 2022. The full list of companies affected by these changes will be made available to clients no later than December 15, 2022.

Furthermore, these changes

… will be implemented as detailed below in GICS Direct and S&P DJI’s indices after the close of business (ET) on Friday, March 17, 2023. MSCI will consult with clients regarding implementation in their indexes.

The last time that MSCI made big and destructive changes to the Information Technology Index was in 2018 when it moved hot stocks Alphabet (GOOG) (GOOGL) and what was then Facebook (FB) into what had been the sleepy Telecommunications Services sector, renaming it the Communications Services Sector and greatly improving its performance going forward.

In order to make this change more invisible to investors, MSCI provided ETF and fund providers whose sector funds track MSCI sectors with transition indexes which allowed them to gradually reduce their investments in the stocks being eliminated from the sector over an extended period.

For example, VGT had been following the MSCI US Investable Market Information Technology 25/50 Index, but after the 2018 changes to the Sector were announced, MSCI provided it with a new index, the MSCI US Investable Market Information Technology 25/50 Transition Index, which VGT followed from May 3, 2018 until December 2, 2018 when it switched back to the original index. Expect to see something similar happen.

Once again, we see how passive index investing finds itself doing some very clumsy stock picking. In this case, however, the stock-picking is being done to improve the performance of the Industrial and Financial Sectors which have lagged the Information Technology sector for a long, long time. Owners of ETFs that track the MSCI Information Technology sector are the ones who will be making the sacrifice to allow this to happen.

Alternatives for Technology Sector Investors

There are few Technology sector ETFs that don’t use the GICS classification system. One is the iShares U.S. Technology ETF (IYW) which uses an FTSE Russell Index which uses the ICB sector classification framework to define what stocks go in what sector. A quick look at IYW’s portfolio holdings reveals that it still holds shares in Alphabet and Meta, which GICS dropped in 2018. But IYW does not currently hold shares of Visa, Mastercard, PayPal, ADP, or Jack Henry & Associates, the important Data Processing and Outsourced Services stocks that are going to be removed from the indexes that use the MSCI classifications.

Other popular Technology sector ETFs track popular subsectors like semiconductors and aren’t affected by this change, but also don’t give you a way to invest in the entire Tech sector.

Any ETF that tracks the current Data Processing and Outsourced Services subsector that is being removed from the GICS Tech sector will be facing an existential threat since only a few stocks being moved to the Industrials sector will retain that subsector definition. Actively managed mutual funds might provide an alternative for tech sector investors, though they are likely to have much higher expense ratios. The Fidelity® Select Technology Portfolio (FSPTX) is one such choice.

Below you can see a chart comparing the performance of these various ETFs and Funds over the three years since GICS removed Alphabet and FB from its Technology Sector.

Total Return Compared for Popular Technology Sector Investments

Conclusion: Sector ETFs Are Best Held in Tax Advantaged Accounts

Given the tendency of MSCI to change the constituents of its heavily-tracked sectors, it seems clear that investors would be well advised to hold sector funds that track MSCI sectors in IRAs or other tax advantaged accounts so that they can sell a sector fund if they aren’t happy with how the sector definition changes. MSCI is very likely to keep removing high-performing stocks from high-performing sectors and move them into weaker sectors.

I wish I had known that when I bought VGT in a taxable account! But my investing career tends to offer one useful lesson after another. At least, you my readers can profit from my mistakes!