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Question of the Week - August 29, 2016

Question of the Week - August 29, 2016

Guest Post - Monday, August 29, 2016

What is the impact of real estate becoming its own sector?

As we mentioned in passing a few months ago, real estate is being carved off into a separate S&P GICS (Global Industry Classification Standard) equity category as of August 31—being carved out of its current home in financials. This will be the first new 'sector' in several decades since the present lineup was laid out, expanding the list of sectors from 10 to 11.

Firstly, what are the 'GICS'? (Due to the similarity in acronyms, it can be confused with 'GIPS', which is a set of global investment performance standards and is a different animal completely.) Back in 1999, S&P and MSCI agreed on a method of categorizing companies into industry groups by their principal business activity. For most firms, these industry descriptions are fairly straightforward, but of course, they aren't perfect, especially in the modern era when there are firms that can described as 'multi-sector', often straddling the definitions of healthcare/technology, materials/industrials, etc.—these more diversified companies tend to be placed in different buckets by different classification systems. The GICS are divided into 156 sub-industries, then grouped into 67 industries, then 24 industry groups and, finally, 10 (now 11) sectors.

This isn't as big a change as it first appears, since real estate only represents 3% of the overall S&P 500—on par with materials, utilities and telecom in terms of sector size. With the real estate piece being carved off, this will shrink the financial services sector pro rata from around 16% of the S&P to approximately 13%. The financial sector is a bit unique anyway, comprising national banks, regional banks, insurance companies, brokers/investment managers and a few other diversified firms that dabble in a variety of miscellaneous investment activities, like private equity. This change is an acknowledgement of real estate's growth over the past several decades as well as the fact that its characteristics are unique enough from other financial companies to deserve its own bucket. What it might do is continue to enhance the 'profile' of REITs in the marketplace and, in turn, expand the demand for these securities from managers seeking to reduce tracking error to indexes and so forth. Whether or not it results in a flood of investment assets towards REITs by those who wouldn't otherwise be interested remains to be seen, but the general thinking is that this change is a positive for the group from a sentiment standpoint.

Operationally, these types of changes affect those attempting to precisely replicate a particular index or sub-index, which include index funds/exchange-traded funds, sector-based ETFs, portfolio managers monitoring sector weightings versus their benchmarks, as well as for reporting functions like attribution (the performance analysis process of dividing up return results by sector component, stock selection component, etc.). So, all equity investors will be affected to some degree over time.

This also relates to the deeper discussion of how to classify REITs in a portfolio. Since public REITs are technically common stocks, they've been included in broader stock indexes for some time. Due to their smaller market cap size and fundamental characteristics, they've primarily fallen into the 'mid-cap value' style bucket, which has been either a blessing or a curse for mid-cap managers depending on their philosophy and specific interest in the sector. Traditionally, though, due to the 'real asset' nature of the real estate business, many fund families and asset allocators have tended to treat it as a completely separate asset class from a portfolio construction standpoint (as we do) and utilize specific real estate mandates as opposed to allowing weightings to be dictated by default through index classifications. More diversified asset allocations also tend to assign higher weightings to real estate than do more basic index-like stock/bond combinations. This is borne out by the special characteristics that real estate provides in a portfolio—namely, historical lower volatility than equities, higher yields and other non-correlation/diversification benefits, particularly during periods of inflation that tend to reward the holding of physical assets.

Read our Weekly Review for August 29, 2016.

Read the previous Question of the Week for August 15, 2016.

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