This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article is by Deepika Sharma, managing director of investments and portfolio manager at Astor Investment Management.
Equity REITs are now a separate sector since Sept. 1, and most funds that use S&P indexes as benchmarks have yet to fully implement the change. But once the transition is all said and done, this will affect investors who hold REITs or financials in their portfolios in various ways.
At Astor, we see several trends taking shape in the REITs market, all of which should impact how they will perform going forward. Here are some of our key thoughts:
- We should see increased demand for REITs in the next three to five years.
Most U.S. equity funds are still significantly underweight real estate, especially in value strategies. Based on a December 2015 J.P. Morgan report, there is pent-up demand of $100 billion for real estate funds, as long-only mutual funds have an average real estate underweight of 2.1%. Plus, new tax incentives for foreign investors in U.S. REITS may drive up demand.
Similarly, EPRA, which promotes the European-listed real estate industry, estimates that the classification will attract institutional investors who don’t currently invest in listed real estate because of volatility in the combined financials funds. This could divert €75 billion of capital to the European REITs market.
Some of this demand is already apparent in investor flows. According to Lipper fund flows data, investors have allocated to real estate in droves since 2011, bringing real estate fund flows to $9 billion since then, the third-highest after health care ($11 billion) and energy ($10 billion). But the under-allocation in institutional funds won’t correct overnight, and we expect that other factors such as the REITs market cycle and the impact of the Fed hike will play a bigger role in investors’ allocation decisions.
- The REITs market cycle is tied to GDP growth.
A high dividend yield and robust returns this year (+14% year-to-date as of Aug. 31) put REITs in the spotlight as an attractive opportunity for “search for yield” trades. Investors are drawn to REITs’ improved balance sheets, stronger liquidity and favorable financing options.
In addition, the REITs market cycle is closely tied to GDP growth, as an improving economy implies rent growth, lower spreads and higher loan to value amounts. Due to sluggish growth, REITs’ overuse of bank debt to refinance has led to higher draws on revolving credit available, and reliance on unsecured term loans. This lack of excess capacity may hinder their capacity to ride out potential market volatility.
- The impact of rate hike expectations on REITs
Historically, REITs have underperformed at the early stages of a monetary tightening, but gradually outperformed when higher interest rates are accompanied by a growing economy. In effect, uncertainty about the Fed’s timing is not good for REITs, especially if investors are worried about the effect on the economy.
This is why REITs were sensitive to the volatility in the 10-year U.S. Treasury yield last year and during the “taper tantrum.” Conversely, continued global easing and negative rates in some countries have helped lift demand for U.S. REITs.
The largest REIT ETF, the Vanguard Real Estate Fund (VNQ), was left unchanged following the Aug. 31 reclassification, even though it doesn’t fully track the new real sector. The fund underweights to specialized REITs as well as real estate management and development companies, which are a combined 15.5% of the new sector.
From our estimates, specialized REITs (35%), retail REITs (22%), residential REITs (13%) and health care REITs (12%) will be the major components of the new real estate sector.
The Real Estate Select Sector Fund (XLRE) was launched in October 2015 to facilitate the sector split for the Financial Select Sector Fund (XLF). On Sept. 16, XLF will issue a special dividend in the form of XLRE shares, bringing AUM for XLRE to close to $3.75 billion. The new ETF has already seen roughly $3 billion in net inflows this week alone.
The Guggenheim S&P 500 Equal Weight Real Estate ETF (EWRE) is also expected to get a boost in AUM, but of a lesser degree, at about $4 million from the corresponding financials ETF.
Other U.S. REIT ETFs to look out for are the iShares U.S. Real Estate Fund (IYR), the First Trust S&P REIT Index Fund (FRI), the Schwab US REIT ETF (SCHH) and the PowerShares KBW Premium Yield Equity REIT (KBWY).
Financials Also Impacted
The classification of REITs as its own equity sector under the Global Industry Classification Standard, GICS, should have ramifications for the financials sector as well. Looking ahead, as this transition is completed in the next few days, we will be watching for three key factors in this sector: volatility, dividend yield and performance.
For volatility, we expect financials’ volatility will increase, because the low correlation with REITs provided diversification.
REITs have a higher dividend yield (~3.5%) versus 2.4% for the financial sector. So, taking out REITs will lower the dividend yield of financial ETFs to between 1.5 and 2%.
And as far as performance, financials ex-REITs will have a higher weighting of interest-rate-sensitive subsectors such as banks, which will be negatively impacted by rate hike expectations over the next few months.
Banks and financial stocks have more than recovered from the temporary sentiment-driven sell-off led by the “Brexit” uncertainty as well as concerns about the Fed’s policy stance. Yet financial stocks remain undervalued relative to other sectors, based on estimated P/E for this year, price/book and long-term debt/capital.
The $3.7 billion Vanguard Financial Index Fund (VFH) made the jump on Aug. 31 and sold REITs, which had represented about 26.4% of the fund. On Sept. 16, other funds will implement the change as well. However, sector funds tracking Dow Jones and Russell indexes will not change. The table below outlines the expected change for some of the financials ETFs:
|Financials ETF||Fund||AUM ($B)||Rebalance Date||% of REITS Before GICS Change|
|XLF||Financial Select Sector SPDR Fund||$15.90||Sept. 16||20.0|
|VFH||Vanguard Financials Index Fund||$3.60||Aug. 31||26.4|
|IYF||iShares US Financials ETF||$1.50||No change||25.0|
|FXO||First Trust Financials AlphaDex Fund||$0.77||No change||25.0|
|FNCL||Fidelity MSCI Financials Index Fund||$0.24||Aug. 31||27.0|
|RYF||Guggenheim S&P 500 Equal Weight Financials||$0.15||Sept. 16||32.0|
|PSCF||PowerShares S&P Small Cap Financials||$0.20||Sept. 16||31.4|
At the time of writing, Astor Investment Management held IYR and FXO among its universe of ETFs included in its multi-asset portfolios. Astor Investment Management is a fundamentally driven quantitative asset manager that seeks to empower clients with economics-based tools and portfolio solutions to reduce risk and help attain investment goals. Contact Astor at 1-800-899-3230 or [email protected]. For a complete list of relevant disclosures, please click here.