The real estate sector’s promotion to headline-level sector status by the Global Industry Classification Standard (GICS), making it the 11th standalone sector overall, has wide-ranging implications for the ETF industry.
Many financial sector focused ETFs hold REITs in their portfolios and now face the prospect of making significant changes their fund’s composition in order to accommodate the change. The impact may be felt the most in the Financial Select Sector SPDR ETF (XLF) which has nearly $12 billion in total assets.
State Street launched the Real Estate Select Sector SPDR (XLRE) in late 2015. In a special dividend distribution, the Financial Sector ETF will spin off its real estate holdings into 0.138 shares of the Real Estate Sector ETF for every Financial Sector ETF share that is held. The move results in $3 billion in assets being transferred from XLF to XLRE.
The composition of the “new” Financial Sector ETF will obviously change. Comparing fund statistics from the end of the 2nd quarter to today, we find nuggets like the fact that the number of holdings has dropped from 94 down to 66. The fund has become a little more concentrated. Banks, which previously represented 33% of the portfolio, now account for 42%. The allocation to Capital Markets has nearly doubled from 11% to 20%. Simon Property Group (SPG) is the only top 10 holding to get dropped from XLF.
The removal of REITs has also made the fund a little less expensive. The portfolio’s price-to-book ratio dropped from 1.22 to 1.10. The forward price-to-earnings ratio also dropped from 14.2 to 13.1. Forward earnings growth estimates for the portfolio are roughly the same while the dividend yield of the fund now stands at 2.4%.
The impact to shareholders of these funds is minimal – their previous positions will simply be split between two funds – but the implications for the real estate sector and REITs specifically are much more significant. Buried underneath the financial sector umbrella, real estate often had a reputation as an “alternative” investment strategy. It was never considered a cornerstone of a portfolio, but instead was viewed as an add-on. Recognition by the GICS as a standalone sector is an acknowledgement that real estate plays a significant role in the financial markets and should be given level footing with the other major sectors for the foreseeable future.
Financials and real estate have some significant structural differences so the case could easily be made that they should’ve been separated a long time ago. From a performance standpoint, the split could put a spotlight on financials’ relative underperformance. The persistent low interest rate environment has hampered the profitability of many banks and financial institutions making them some of the worst performers in 2016. The Real Estate Sector ETF is up nearly 10% on the year but the Financial Sector ETF, including both financials and real estate, is up just 1%.
The elevation of real estate to standalone status could also be a boon for the value of REITs going forward. Investment could begin flowing into the sector as managers begin increasing their allocations to reflect real estate’s place in the broader market. Many investors will also likely find the sector’s high dividend yields particularly attractive.
The spinoff of real estate from the financial sector underscores how far REITs have come over the past decade in the financial markets. The GICS reclassification insinuates that they deserve a place in most investors’ portfolios.