The Rise of the Computer-Built ETF

The changes made to the Global Industry Classification System (GICS) are prompting investors the world over to re-evaluate how they invest. In the process of the GICS changes, stocks from sectors like consumer discretionary, tech and telecommunications are joining together into a new Communication Services sector. For the everyday investor, determining how to allocate assets just became even more complicated as a new set of issues joins the existing list of research points to consider before investing in a company: operations, clientele, products, revenues and earnings, and so on.

The GICS is a standardized classification system for equities developed jointly by Morgan Stanley Capital International (MSCI) and Standard & Poor's. The GICS methodology is used by the MSCI indexes, which include domestic and international stocks, as well as by a large portion of the professional investment management community.

Reclassification or not, GICS provides both useful categorization and, for some investors, a limiting approach. Each company is designated to a single classification, although many real-life operations might be split among multiple sectors and areas. There have already been efforts by some investors and firms to reclassify companies according to a more complex (some would say more true-to-life) set of frameworks in order to allow for better risk management and trading cohort classification. More recently, exchange-traded funds (ETFs) began adopting the same approach, all with the help of computer-assisted management.

The iShares Evolved Sector ETFs

BlackRock, Inc.'s (BLK) suite of ETFs, the iShares Evolved Sector ETFs, uses this model. These funds utilize natural language-processing technology in order to analyze company business models and public filings. Then, the program makes a calculation of a given company's business distribution and assigns the company to relevant sectors, including multiple classifications if the program deems it appropriate to do so.

Amazon.com, Inc. (AMZN), one of the most diverse and rapidly evolving companies today, is a good illustration of how BlackRock's new computer-sorted sector system works. Amazon still makes the bulk of its sales through its e-commerce platform, but it also has ventures in many other areas, including cloud computing. Nonetheless, GICS classifies Amazon as Consumer Discretionary.

In the iShares Evolved U.S. Technology ETF (IETC) and the iShares Evolved U.S. Discretionary Spending ETF (IEDI), the two of BlackRock's new suite of funds in which Amazon appears, it is present as a technology company and as a consumer discretionary one, respectively.

Computers to Identify Trends

GICS looks at past sales and earnings, meaning that it is reflexive. It's also possible to use algorithms to make predictions about sector classifications. By analyzing regulatory filings for signs of future trends, the Evolving Sector ETFs aim to capitalize on emerging areas of influence.

For the ETF investor, nothing much has changed when a fund is relying on computers to parse out business models and earnings reports. Indeed, the change may be significantly greater on the management side, as computers receive greater shares of responsibility when it comes to analyzing materials and preparing data, or even making decisions about sector classification and rebalancing holdings.

While there are advantages to BlackRock's system, some investors may wish to rely on the traditional GICS classifications. Beyond that, investors interested in transparency may be surprised to find a consumer discretionary stock showing up in a fund that claims to be focused on tech companies.

Regardless, computer-driven ETFs are neither brand new nor likely to disappear any time soon.