Best Of 2016: What The New Real Estate Sector Means For ETFs

August 19, 2016

[Editor's Note: We are rerunning some of our best stories of 2016.]

The financial world is about to welcome in September a new sector under the Global Industry Classification Standard (GICS): real estate. The move—a historic first since GICS was created in 1999—will have implications for ETF investors.

GICS was originally developed—and is maintained—by both MSCI and Standard & Poor's, and under the current classification, real estate companies and REITs are part of the financial sector. Come September, they will stand on their own as the 11th sector in the S&P 500.

Any ETF that’s linked to either an S&P or an MSCI financials index will be faced with changes as the sector is split into two. Index providers who do not follow GICS but use different sector classification standards will not implement any changes.

Real Estate All Grown Up

“This decision is a social commentary that REITs are very grown up,” said Howard Silverblatt, senior index analyst for S&P Dow Jones Indices. “Indices reflect the economy, and REITs are now a big part of it.”

How big? Consider that back in 2001, financials represented about 17.7% of the broader S&P 500, and REITs were a mere 0.6% of financials. Five years later, in 2006, REITs snagged about 5% of financials, which had grown to represent about 21.8% of the market. And today, REITs are about 20% of the financials sector, which represents about 15.7% of the total market.

As their own sector, real estate securities will be bigger than both the telecommunications and materials sectors, “and they’ve done well this year,” Silverblatt said.

There are three key broad considerations to make about REITs versus financials, according to the most recent S&P data:

  • From a performance perspective: REITs are up about 10% in 2016, while financials are barely breaking even. Much of the gains seen in the financials sector as a whole this year are tied to the performance of REITs. Once the sector is split into two, those performance differences will be evident.
  • From an income perspective: REITs are offering higher income, too. The financials sector—including 28 REITs at the moment—is yielding 2.26%. But if you exclude REITs, that yield drops to 2.06%. REITs alone are yielding upward of 3%, Silverblatt says. If you take REITs out of financials, you immediately lose about 10% of your income, he adds.
  • From a tax perspective: REITs may pay more in income, but you get to keep more with financials. The majority of the securities that would be left in financials post-split—generating that 2.06% in yield—would be “tax-qualified” securities, according to Silverblatt. That means they face a maximum 20% federal tax rate. REITs are not tax-qualified, generating income that can be taxed up to 39.6%.

Chart courtesy of StockCharts.com

 

Why It Matters

These distinctions highlight the importance of managing this transition carefully, eyeing underlying exposure pre- and post-sector split, as well as tax implications and income potential in your portfolio.

In addition, different ETF providers are handling the transitions differently. There’s no unified approach to splitting the sector and adjusting exposure.

SPDRs Rebalanced

For example, State Street Global Advisors is making this transition in the hugely popular $16 billion Financial Select Sector SPDR Fund (XLF) through a “special dividend” in the form of shares of the Real Estate Select Sector SPDR Fund (XLRE), according to Dave Mazza, head of ETF and Mutual Fund Research for SSgA.

“Effectively, if you are a holder of XLF, you will end up with the same exposure you currently have, but with two line items: one representing financials as they will be going forward; and the other real estate securities,” Mazza said.

More granularly, at some point prior to Sept 16 when the indexes rebalance, SSgA will transfer out via the in-kind process the real estate securities, and transfer in the respective amount of shares of XLRE into XLF.

Investors holding shares of XLF during the transition will own underlying stocks of financial companies as well as shares of XLRE. (The XLF portfolio will be reduced in a proportionate amount to real estate in its current portfolio, which is around 20%.)

$3 Billion Fund Overnight

When the index rebalancing is completed and the transition is over in mid-September, SSgA will make the distribution of XLRE shares to XLF investors. When it’s all said and done, based on current price levels, the $114 million XLRE will become a $3 billion fund almost overnight.

XLF, in turn, will go from a $16 billion ETF to a $13 billion one. The influx into XLRE should also help with the fund’s liquidity, which today is small at about 40,000 shares traded a day with a wide spread of 0.29%.

Investors do have other choices. If you no longer wants to own financials as currently defined, you can sell XLF. Or you will now be able to express different views by underweighting or overweighting your allocation to REITs versus financials after the transition is over. The two ETFs represent different sectors of the economy—one driven by the business of land development, the other driven by the business of money.

In-Kind Tax-Free Move

Mazza said the transition should not result in costs to investors. The dividend distribution will be characterized as return on capital and income for tax purposes, he says. Ideally, it should be an in-kind tax-free move, but the company will be providing more “specifics” on the breakdown between return on capital and income to its investors in September, Mazza notes.

And until Sept. 16 when the indexes rebalance, fees on XLRE will remain waived to avoid any double-counting of fees during the period when XLF owns XLRE shares.

“We are using the best of the ETF structure to effect this,” Mazza said. “We are doing an in-kind of shares out, and an in-kind of ETF shares in, and distributing those shares. Without the ETF structure, we actually couldn’t do this, and it would be potentially detrimental to the underlying shares because there would have to be massive selling—about $3 billion worth—in the market. This gives investors exposure and choice.”

Guggenheim Taking Similar Approach

Guggenheim is widely known as a pioneer of sorts in the smart-beta segment thanks to its equal-weighting approach to the S&P 500. Among the funds the company offers is the Guggenheim S&P 500 Equal Weight Financials ETF (RYF)—a fund that will be directly impacted by the sector reclassification.

Much like SSgA, Guggenheim is transitioning real estate securities out of RYF through an in-kind transaction that would replace those securities in the fund with shares of the Guggenheim S&P 500 Equal Weight Real Estate ETF (EWRE). Fees for EWRE are also temporarily waived.

At the end of the transaction, “RYF intends to make an in-kind distribution of its shares of EWRE, plus a small amount of cash for fractional shares, to shareholders of RYF such that, following the distribution, RYF will continue to hold stocks included in the reconstituted S&P 500 Equal Weight Financials Index,” the company said.

REITs and other real estate management companies represent about 30% of RYF. According to company estimates, the transition should translate into an influx of about $40 million into EWRE. RYF is today a $145 million fund.

 

Vanguard’s Approach Is Different

The Vanguard Financials Index Fund (VFH), a $3.6 billion fund, tracks an MSCI benchmark. Due to the GICS reclassification, about 24% of the securities in that fund will be transitioned out. Unlike State Street, Vanguard’s plan is to simply rebalance as the index will, selling the underlying securities that no longer belong in the financials index.

“The turnover created by the GICS structure change should be minimal,” a spokesperson for Vanguard said. “However, the fund will engage in trading to complete the transition to the new MSCI GICS structure.”

In theory, the selling of REITs should be a taxable event because REITs have done well in recent months, but Vanguard is hoping there will be no capital gains distributions stemming from the transition. As Todd Rosenbluth, senior director at S&P Global Market Intelligence as well as director of ETF and Mutual Fund Research, noted, the firm has a stellar track record at keeping tax activity low in its funds over the years.

Vanguard itself said it can’t at this time elaborate on “specific estimates of turnover, transaction costs, or capital gains/losses” because all of that depends on the market during trading. The firm did note that VFH will see minor changes to its investment strategy “to indicate it will no longer be investing in real estate, but will continue to invest in mortgage REITs,” the Vanguard spokesperson said.

Some Of The ETFs To Be Impacted

Other examples of ETFs linked to S&P and MSCI benchmarks beyond XLF, RYF and VFH—and therefore likely impacted by the transition—include:

As you navigate this first-ever addition of a new sector under GICS, it’s important to know what benchmark your ETF tracks, and communicate with your ETF provider on how the transition—if any—will take place and impact your portfolio.

Of note, even though Dow Jones indexes are now part of S&P Dow Jones, they will not be impacted by these changes, Rosenbluth said. Funds like the popular iShares U.S. Financials ETF (IYF), with $1.1 billion in assets, will not face changes, as it tracks a Dow index.

Contact Cinthia Murphy at [email protected].

 

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