Many people think of the stock market as a pie divided into slices, called sectors. For many years, a major classification system has divided the market into 10 sectors, but that’s about to change: Beginning September 1, real estate will become the 11th sector.
Why should investors care? Well, if you invest in sector-specific exchange-traded funds (ETFs), you may see some market volatility as ETF managers adjust their holdings to account for the fact that real estate will be migrating to its own sector. You may want to check your own portfolio allocation, as well, and rebalance if necessary.
Why are sectors changing?
Some background: Since its inception in 1999, the Global Industry Classification Standard (GICS®), published by Standard & Poor’s and MSCI, has divided all publicly traded companies into 10 sectors: consumer discretionary, consumer staples, energy, financials, health care, industrials, information technology, materials, telecommunication services and utilities.
Up to now, real estate has been part of the financials sector. But the two companies that developed GICS have announced they will spin off real estate into a separate sector in response to the growing importance of real estate in global equity markets. The number of companies won’t change—they’ll just be divided differently.
What will the new sector include?
The new real estate sector will mostly be made up of equity real estate investment trusts (REITs), with some real estate development companies included. Equity REITs own physical property—such as apartment buildings, office property or shopping malls—and typically receive rental income. (Mortgage REITs, which own mortgages instead of physical property, will remain in the financials sector.)
Equity REITs have done well in recent years. Low interest rates have allowed them to obtain cheap financing. At the same time, their relatively high dividend yields have attracted investors frustrated by low interest rates on other types of investments, such as bonds. REITs have also benefited from a recovering economy, while strong demand for apartments in the years after the housing market crash has led to higher apartment rents.
REITs face some challenges, however. If U.S. interest rates rise, it could make REITs less attractive. Apartment rent increases may slow as people grow more confident about the housing market. A trend toward online shopping could hurt traditional mall-based retailers, making it difficult for malls to demand higher rents from retail tenants.
How will ETFs react?
ETFs that aim to track the financials sector will have to remove REITs and real estate development company stocks from their portfolios. This selling could lead to higher fund volatility in the days surrounding the GICS change.
Meanwhile, ETFs forced to sell securities that have risen in value may generate capital gains, on which their shareholders will owe taxes. Usually, ETFs sell holdings only when their benchmarks change, which doesn’t happen very often—that’s one of the reasons ETFs typically offer shareholders a lower capital gains tax bill compared with mutual funds. Many investors don’t expect to pay much in capital gains tax unless they sell their ETF shares, so the higher tax bill may be an unwelcome surprise.
Finally, some investors may want to adjust their portfolio allocation to account for the change. If you hold a diversified mutual fund or a broad equity index ETF—one that tracks the S&P 500® index, for example—the fund manager will make the adjustment for you. However, if you hold sector-specific funds, you may want to take steps to adjust your exposure to real estate.
Diversification and rebalancing
Bottom line, if you’ve built a well-diversified portfolio, there’s not much urgency to react to the GICS change. However, given that markets are always evolving, it’s a good idea to rebalance your portfolio on a regular basis, to help keep it aligned with your risk tolerance and target allocation.