A major change is coming to how tech stocks are traded, and investors face an avoidable risk

Chip Somodevilla/Getty
  • Starting in September, telecom, tech, media, and entertainment companies will be combined into one S&P 500 sector called Communication Services.
  • It’s set to be the most crowded sector in the market, according to equity strategists at Bank of America Merrill Lynch.
  • Investors should buy currently underweight parts of the sector ahead of its formation and sell afterwards as a “rule of thumb.”

A new stock market sector will launch in September.

S&P Dow Jones Indices announced last November that it plans to bring tech, media, and entertainment companies under one umbrella called the Communication Services sector. This would replace the existing Telecommunication Services sector.

The firm explained that it’s making the changes to better reflect the fact that tech companies have become a lot more integrated.Verizon, for example, has made acquisitions to become a giant provider of content, mobile phone service, and internet connectivity.

Among other things, the change would put Facebook,Amazon,Netflix, and Google– the so-called FANGs – in one S&P 500 sector.

That poses a risk for investors, according to a team of Bank of America Merrill Lynch equity strategists led by Savita Subramanian. For example, Netflix, which is currently classified in the Internet & Direct Marketing Retail sub-industry, will be under the same roof as Alphabet and Facebook, which are currently in the Information Technology sector.

BAML’s survey of large fund managers shows that no other industry is as crowded as Internet & Direct Marketing Retail. This is the case even though active managers have reduced their exposure to these stocks over the last three months.

The strategists wrote: “As part of the changes, we expect some of the most overweight stocks in the two most overweighted sectors (e.g. FOXA,CMCSA, NFLX, FB and GOOGL) to be combined with Telecom in the new Communication Services sector, and the new sector would likely become the most crowded sector (1.25x – on a par with the record set by Tech last year) despite Telecom’s persistent underweight. A rule of thumb says buy the sector [Telecom] ahead of the announcement, and sell on the news.”

Screen Shot 2018 01 29 at 2.08.48 PMBank of America Merrill Lynch

Her note provides two rationales for that strategy of buying the presently underweight Telecom sector now and then selling after the merger into the new Communication Services sector.

The first is that a similar strategy worked when S&P Dow Jones Indices broke out Real Estate into its own sector in August 2016. In November, Subramanian noted that real estate outperformed the S&P 500 by 3.8 percentage points in the 10 months before it became a standalone sector. Since then, it’s underperformed by 28.7 percentage points.

“Losing its standalone sector status adds some risk to fund managers’ already light positioning in Telecom stocks,” Subramanian said in November.

Additionally, it has paid off in most recent years – except in 2017 – to be overweight the stocks that most of the market is neglecting, and underweight the most crowded stocks.

Screen Shot 2018 01 29 at 2.25.26 PMBank of America Merrill Lynch

NOW WATCH: Money & Markets videos

Want to read a more in-depth view on the trends influencing Australian business and the global economy? BI / Research is designed to help executives and industry leaders understand the major challenges and opportunities for industry, technology, strategy and the economy in the future. Sign up for free at research.businessinsider.com.au.