As noted in our previous blog, Real estate’s elevated sector status could be a catalyst for equity REITs, real estate will become the 11th Global Industry Classification Standard (GICS) sector beginning after market close on Aug. 31, 2016. Below, we examine the potential impact for investors as certain indexes, and the exchange-traded funds (ETFs) that follow them, realign to reflect this historic change.
As a result of real estate’s new sector status, S&P Dow Jones Indices announced in June that it would modify the index constituents of its Financial Select Sector Index. Accordingly, the Financial Select Sector SPDR Fund (ticker: XLF) will also make adjustments in order to continue to track that index. With $15.7 billion in assets under management as of Aug. 23, 2016, XLF is one of the largest ETFs available and makes up over 40% of the Lipper Financial Services Funds Category.1 Furthermore, XLF holds close to $3 billion in equity real estate investment trusts (REITs).2 While REITs were initially expected to remain in XLF, they will now be spun off into a separate ETF called the Real Estate Select SPDR Fund (ticker: XLRE) on Sept. 16, 2016.
In addition, we expect other ETFs that track a GICS-defined financial sector index to reduce real estate exposure at the end of August. (Indexes that use other classification systems besides GICS would not be affected.)
As indexes realign, will investors follow?
Current XLF holders will receive shares of XLRE in order to maintain their current real estate exposure. It is uncertain if investors will keep their newly created XLRE holdings or if they will sell this security once it’s received. While we cannot forecast the future, we believe this has the potential to introduce volatility to the US REIT market over the next few weeks.
Taking the long-term view
From a portfolio management perspective, we continue to view REITs’ elevated sector status as a long-term positive. Potential benefits include increased visibility, a larger investor base and a reduction in long-term volatility. We will closely monitor the REIT market for relative value opportunities that may arise from index and ETF changes, essentially nonfundamental drivers of performance, over the short term.
1 Source: Lipper, data as of July 31, 2016
2 Source: State Street Global Advisors, data as of Aug. 23, 2016
Investments in real estate-related instruments may be affected by economic, legal or environmental factors that affect property values, rents or occupancies of real estate. Real estate companies, including REITs or similar structures, tend to be small- and mid-cap companies, and their shares may be more volatile and less liquid.
The profitability of businesses in the financial services sector depends on the availability and cost of money and may fluctuate significantly in response to changes in government regulation, interest rates and general economic conditions. These businesses often operate with substantial financial leverage.
Investments concentrated in a comparatively narrow segment of the economy may be more volatile than nonconcentrated investments.
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