The difference between banks and buildings

There is a big change coming soon for a widely used equity index (the benchmark for many exchange-traded funds (ETF)). First a quick review of the Global Industry Classification Standard (GICS), a worldwide standard for stock classification. Established in 1999 with ten sectors, the GICS is set to add a new sector for the very first time. The original ten sectors are: Consumer Discretionary; Consumer Staples; Energy; Financials; Health Care; Industrials; Technology; Materials; Telecom; and, Utilities.

The Big Daddies of indices, S&P Dow Jones and MSCI, use these classifications to determine (using an example from a Barron’s article by Chris Dieterich), whether Wal-Mart should be identified as a Consumer Staple, or a Consumer Discretionary stock. With the equity holdings of hundreds of ETFs based on the composition of these ten sectors, definitions matter. So, Wal-Mart (WMT) is a Staple and Home Depot (HD) is a Discretionary. Clear as mud?

The Financials Sector is about to undergo a huge transition on August 31, 2016, when Real Estate Investment Trusts (REIT) get their own sector. REITs are entities that own real estate related investments and often pay sizeable dividends. Owners of shopping malls and strip centers, mini-storage facilities, office buildings, actual mortgages, industrial warehouses, apartment complexes, long-term care facilities, timberland and now buildings occupied by the computers that make-up “The Cloud,” these stocks have often been considered niche investments.

As banks have struggled since the market mayhem of 2008-2009, the Financials Sector has been bolstered by the solid performance – and dividend payouts – of the REITs in their midst (about 20% of the S&P 500 is real estate related stocks). So Financial Sector ETFs like Vanguard’s VFY and State Street’s XLF are likely to see increased price volatility and lower dividend payouts going forward.

And tax ramifications for the holders of these and similar indexed funds benchmarked against the Financials Sector are possible. All ETFs using the Financial Sector as their benchmark will need to remove (sell) REITs, which could have capital gains implications. Additionally, players like Vanguard and State Street will also need to purchase REITs for use in their new REIT Sector ETF offerings. Expect price volatility in REITs over the next couple of months.

With a change to the GICS being made for the first time, the impact on the benchmarked ETFs are uncertain. All Financial Sector ETFs were recently removed from the portfolios I’m responsible for (though not individual REIT stocks). And I’ll be very interested to see what the new REIT Sector ETFs look like.

A caveat: While Invest-Notes has long extolled the virtues of real estate in an investment portfolio, there is an important distinction to make between owning equity REITs, private REITs and a physical structure, like an office building or a vacation home. Equity REITs are stocks and subject to market whims, corporate shenanigans and dividend cuts. Private REITs are typically limited liability partnerships with steady payouts but are extremely risky for investors unfamiliar with this asset class – there can be Hotel California kinds of risk, where you buy-in but can never cash-out. Owning individual physical properties has its own challenges, rewards and tax implications. All three types of investments have long been in my personal asset collection, and also in some managed portfolios, but are definitely not right for many investors.

This entry was posted in Investment. Bookmark the permalink.

1 Response to The difference between banks and buildings

  1. Pingback: ETFs and the 2018 GICS Refresh | Is it time for a change? |

Leave a Reply

Your email address will not be published. Required fields are marked *