The Rise of the Computer-Built ETF

The Global Industry Classification System (GICS) is undergoing changes that are causing investors to rethink how they invest. As part of the GICS changes, stocks from sectors like consumer discretionary, tech and telecommunications will be merged into a new Communication Services sector. This makes asset allocation more complicated for everyday investors as they now have to consider a new set of factors when researching companies: operations, clientele, products, revenues and earnings, etc.

The GICS, or Global Industry Classification Standard, is a way of classifying stocks that was created byMorgan Stanley Capital International (MSCI) and Standard & Poor’s. This system is not only used by MSCI indexes- which track both domestic and international stocks- but also utilized often by professional investors.

GICS might offer investors a helpful categorization, but it also has its limitations. Every company is restricted to fit only one classification– even if the company’s real-life operations branch out into multiple sectors. In recent years, some investment firms have made an attempt to reclassify companies using different frameworks that are more accurate representations of what the business really does. The goal is better risk management and prevention of bad trades in general. Exchange-traded funds (ETFs) began using computer-assisted management recently to follow the same method.

BlackRock, Inc.’s (BLK) line of ETFs uses a cutting-edge model that analyzes company filings and business models. The technology behind it, natural language processing, then calculates the sector each company should fall into. Using this method often leads to more accurate results than traditional classification methods., Inc., among the most rapidly developing companies today and an excellent exemplar of BlackRock’s new computer-sorted sector system, demonstrate how successful the system is. Although Amazon generates the majority of its sales via e-commerce, it also has a few other areas of focus, including cloud computing. GICS still categorizes Amazon under Consumer Discretionary.

Amazon is present as a technology company in BlackRock’s new iShares Evolved U.S. Technology ETF (IETC) and as a consumer discretionary one in the iShares Evolved U.S. Discretionary Spending ETF (IEDI).

GICS looks at sales and earnings from the past to make predictions about sector classifications in the future. Algorithms are used to Look for signs of future trends by analyzing regulatory filings, so that the Evolving Sector ETFs can aim to capitalize on emerging areas of influence.

For the ETF investor relying on computers to dissect business models and earnings reports, not much has changed. The change is likely greater for management as computers are taking on more responsibility such as analyzing materials, preparing data, making decisions about sector classification and rebalancing holdings.

Although BlackRock’s system has benefits, some investors may prefer to stick with the more classic GICS classifications. Also, those interested in knowing where their money is going might be startled to see a consumer discretionary stock appear in an investment portfolio that allegedly focuses on tech companies.

ETFs that are computer-driven aren’t new, and they probably won’t go away soon.

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