If you or your client owns a Vanguard consumer discretionary, technology or telecom index fund, the holdings will be changing soon—making relative assessment based on past performance or index tracking considerably less relevant. It’s a good time to remind investors that what’s inside drives future performance and they need to regularly review even passive strategies.
On Friday, Vanguard announced that in the second quarter of this year, it will begin to track new transition benchmarks for the three sector strategies in advance of the new Global Industry Classification System sector classifications being implemented by its index partner MSCI later this year. In January 2018, MSCI and its GICS partner S&P Dow Jones Indices determined that many consumer discretionary and tech stocks, including Alphabet, Comcast, Disney and Facebook, would be joining a brand-new Communications Services sector at the end of September 2018 alongside current telecom services stocks AT&T and Verizon Communications. The consumer discretionary and technology sectors would continue to include many widely held stocks, such as Amazon and Apple.
The impact will be felt at three Vanguard ETFs: Vanguard Consumer Discretionary Index (VCR), Vanguard Information Technology Index (VGT) and Vanguard Telecommunications Services Index (VOX), along with their mutual fund shares classes, including Vanguard Consumer Discretionary Index (VCDAX), Vanguard Information Technology Index (VITAX) and Vanguard Telecommunications Services Index (VTCAX). In addition, the telecom products will be renamed Vanguard Communications Services Index funds.
CFRA previously expected that Vanguard could choose to pay a special dividend to its shareholders in an effort to distribute shares of Disney, Alphabet and other impacted companies to owners of VCR and VGT in a tax-efficient manner. However, Vanguard expects the use of transition indices will not result in material capital gains or changes to the funds’ expense ratios. In the past, when Vanguard used transition indices to add in China A shares to Vanguard FTSE Emerging Markets (VWO), for example, there were no capital gains implications. Each month the exposure to the new A shares securities slowly climbed higher, while the percentage in other securities was gradually scaled back.
Thus far, SSGA and Fidelity and other providers that offer other popular sector ETFs also being impacted by the GICS changes have not made announcements on how they plan to proceed.
In an interview with CFRA at Inside ETFs, Rich Powers, head of ETF product management at Vanguard Group, explained how some investors are using Vanguard’s sector lineup within a seasonal rotation strategy moving into and out of certain Vanguard ETFs based on the calendar.
While we think investors rotating from risk-on-oriented sectors, such as consumer discretionary or technology, to risk-offer sectors such as telecom services or utilities (or vice versa) has merits, the GICS changes could make this more of a challenge using Vanguard funds. Many of these rotation strategies are based on past performance of the sector ETFs or their underlying indices. But the index behind and what’s inside VCR or VOX is changing, resulting in the ETFs looking different than their peers.
For example, VCR’s 11.1 percent three-year annualized total return through March 1 was identical with Fidelity MSCI Consumer Discretionary Index (FDIS), but lagged the 12.3 percent gain for Consumer Discretionary Select Sector SPDR (XLY). Both VCR and FDIS are multi-cap, while XLY holds just large-cap stocks in the current consumer discretionary sector. Yet all three have a 15 percent-plus stake in Amazon and 5 percent or more in Comcast and Disney. Other stocks not shifting to the Communications Services sector include Home Depot and Nike. As Vanguard begins its transition process and reduces exposure to Comcast and Disney while increasing exposure to remaining constituents, the performance gap will widen between the trio of consumer discretionary ETFs. This will be driven by what’s inside the portfolio and have much less to do with Vanguard’s ability to track its unique benchmark.
We think Vanguard’s efforts to get in front of the GICS changes will likely have less impact on investors who plan to hold Vanguard ETFs through the GICS implementation than those who plan a more active approach using ETFs. However, all investors need to understand that what’s inside an ETF is not static.
CFRA’s equity ETF ratings combine holdings-level analysis focused on valuation and risk considerations with fund attributes, including expense ratio and trading cost. This is in contrast to other ratings providers that rely solely or heavily on past performance metrics. Investors who choose an ETF such as VCR, VGT or VOX based only on a past performance record will be “buying” invalid performance, since many of the underlying holdings will change to align with the new GICS roadmap.
CFRA reports on these ETFs can be found on MarketScope Advisor.
Todd Rosenbluth is Senior Director of ETF and Mutual Fund Research at CFRA, where he leads the firm’s holdings-based research efforts within the Equity Research and Fund Group.