It's not just US tech: Big index changes are coming to every global stock market

  • The biggest change in the history of US stock market indexes just took place, with technology giants Alphabet, Netflix and Facebook moving to the new communications services sector.
  • There are many more index changes still to come, targeting European stocks, emerging markets, Chinese tech stocks and U.S. small caps, which will be significant for U.S. pension funds and index fund and ETF investors.
  • $1 trillion in Chinese tech, $50 billion in U.S. small-cap stocks and $40 billion in European equities will all be caught up in major index moves from MSCI, FTSE Russell and Stoxx before year-end.

The major changes to the U.S. tech and telecom indexes that you've been hearing a lot about reflect the ceaseless merging of telecoms, technology and media companies. But what you may not realize is that these index changes are not ending this week or limited to the U.S. stock market — more index overhauls will be occurring across global stock markets through the end of the year, hitting some of the largest public companies around the world, including Alibaba.

Such integration of technologies may feel seamless in our personal lives, but it may cause disruption to pension funds, global investment portfolios and more index funds than you now realize.

Traders on the floor of the New York Stock Exchange during Alibaba Group IPO, September 19, 2014.
Adam Jeffery | CNBC
Traders on the floor of the New York Stock Exchange during Alibaba Group IPO, September 19, 2014.

The creation of the new S&P communications services sector, which occurred on Monday, could shift billions of dollars of market capitalization around the world. This is arguably the biggest sector reorganization ever, and much has been written about how the communications sector will be more growth-focused and less dividend-paying than the prior smaller, more unloved and significantly cheaper telecom sector.

We believe there are four other global issues to consider that may end up being as important yet not as scrutinized.

1. It's not over yet: $90 billion in US small cap and European stock index moves are coming.

Two other major index providers, the FTSE Russell and Stoxx, follow an entirely different classification system (S&P and MSCI use the GICS), though one that is implementing a similar change at the end of the year. These indices are widely used for U.S. small caps, U.K. and European equities.

For example, the $50 billion iShares Russell 2000 ETF (IVM) tracking U.S. small caps is estimated to be the second-most-traded ETF globally, while $40 billion of assets is estimated to track the Euro Stoxx 50 index, the main index for European large caps.

Meanwhile, MSCI, which estimates that more than 90 percent of U.S. pension fund assets invested in global equities are benchmarked to its indices, is not making the GICS index system tech and telecom changes until the end of November.

Overall, these changes are confusing, and that makes knowing what indices you are exposed to important.

2. FAANG stocks already moved — $1 trillion in Chinese tech stocks is next.

In the United States many of the emblematic FAANG stocks (Facebook, Apple, Amazon, Netflix and Alphabet's Google) are moving sectors with this reorganization, opening up new trades, but so are all their equivalents in China, the world's second-largest equity market.

China's BAT stocks — Baidu, Alibaba and Tencent — and their combined near-$1 trillion market cap, are all moving sectors. Similarly, mega-cap stocks left behind in the now smaller emerging markets information technology sector, such as Apple competitor Samsung Electronics and semiconductor sector giant Taiwan Semiconductor, will get proportionately bigger in the sector and may see some sector ETF inflows. Overall, this is a significant sector change everywhere, but especially so in emerging markets. While the communications services sector now becomes the fifth- largest sector in the U.S., in emerging markets it will be the third largest, and hence a much larger driver of overall index returns.

3. Overseas revenue is a key to the new FAANG play.

Nearly 100 percent of U.S. telecom sector revenue comes from the United States today, the highest proportion of any industry. By contrast, less than 50 percent of Alphabet or Facebook revenue — the top two stocks in the new communication services index — is from the U.S. The software industry, in general, is one of the most globally focused.

International operations are also increasingly where the growth is coming from. Netflix, another major company making the sector switch (from consumer discretionary rather than technology), gained 43 percent of its revenue from outside the U.S. last year, and this is up from only 16 percent of total revenue five years earlier.

This means that U.S. investors who want to trade this sector — and some market strategists think there will be times it offers attractive profit opportunities — need to be increasingly aware of the impact of currency moves, acronyms like GDPR (the new European data privacy legislation) and "Digital Tax'" proposals (a European revenue tax plan aimed at high-tech companies). These factors are going to be increasingly important in assessing sector fundamentals.

4. More big changes are first being considered for big tech, Europe and emerging markets.

The continued growth of ETF and passive investment products only has increased the relevance of the providers of the indices that these products track. To date, the creation of the communications services sector is the biggest sign of that, but more changes are potentially coming.

MSCI is considering proposals to reduce the weighting of companies that do not have equal voting rights. This would reduce the size in indices of a number of major technology stocks, such as Alphabet and Facebook, that have dual-class voting structures, as well as a number of European heavyweights, such as Porsche, Roche and Unilever. MSCI is also considering proposals that would reduce the weight of markets — particularly emerging markets — that have restriction on accessing the local market.

Indices seek to replicate the reality of the investment world around us as much as possible and are becoming ever more important today. The repercussions from all these changes may extend for longer, as investors become used to the new sectors and characteristics.

By Ben Laidler, global equity strategist and head of research for Americas at HSBC

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