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%.)

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