Currently, Global Industry Classification Standard (GICS) classifies all major public companies in the MSCI and Dow Jones indexes as belonging to one of 10 sectors: consumer discretionary, consumer staples, energy, financials, health care, industrials, information technology, materials, telecommunication services, and utilities. With the elevation of real estate from within financials, the new framework will consist of 11 sectors after the market closes on August 31, 2016.
The classification of sectors affects many aspects of sector-based investing, including the analysis of a wide variety of investing strategies and vehicles. Investors who use sectors for specific purposes—to reduce portfolio exposure to market volatility, for example, or to take advantage of a sector’s relatively high dispersion of returns (e.g., the average price performance difference between a grouping of stocks and its individual components)—will need to take into account the changed nature of the financials sector after real estate is removed from it, as well as the diversification and investing opportunities that will open up with the creation of the new real estate sector.
Financials may become more volatile
Investors using the financials sector as a portfolio building block may find that the removal of real estate means they are now exposed to a slightly less diversified, potentially more volatile sector with positive exposure to long-term interest rates.
Based on sector performance correlations during the past three years, the new financials sector appears likely to experience lower correlations with eight other sectors. Correlation refers to how closely related two data points are, such as two different stocks or sectors. Lower correlation implies potentially greater diversification benefits and higher correlation implies potentially lower diversification benefits. However, correlations would decline most sharply against utilities, telecommunication services, consumer staples, and health care—traditionally the more defensive sectors.
These recent sector correlation trends suggest that financials, minus real estate investment trusts (REITs), may become more correlated with the economically sensitive sectors of the equity market. However, it is important to keep in mind that while REITs have been particularly steady during the past four years, given low interest rates and a relatively stable commercial real estate cycle, they have not always performed in exactly the same way, and have been more cyclical at various points in their history.
The new financials sector, without real estate, would have higher absolute risk as well as higher beta (e.g., a measure of sensitivity to broad market returns), compared with the current sector (see "Performance correlations" chart). Note that financials’ absolute risk and beta remain in the middle of the pack compared with other sectors. The new financials sector also would have a larger average market capitalization, as smaller-cap real estate companies are moved out, shifting the average toward larger-cap banks and diversified financial services companies. It would have a lower dividend yield, given the removal of REITs, which are required to distribute at least 90% of their taxable income in the form of dividends.
The revised sector also would have greater positive exposure to long-term interest rates and more negative exposure to short-term rates. Despite general investor concern about rising interest rates, higher long-term rates have positive implications for banks, which would become a larger portion of the sector after the removal of real estate. Banks borrow capital at short-term rates (e.g., the rates they pay for deposits) and lend it out at longer-term rates, a spread known as net interest margin. When long-term interest rates rise relative to short-term rates, net interest margin expands, a situation that can benefit bank earnings.
New real estate sector: low correlations, modest volatility
Meanwhile, real estate as a standalone sector would be driven almost entirely by REITs (an estimated 97% of the new sector’s capitalization).2 The real estate sector would have a fairly low correlation to other sectors, giving investors another lever to consider at the sector level for portfolio exposure. Interestingly, the new sector would have a higher historical performance correlation to seven other sectors than to financials, its former parent sector, underscoring the differences between them. Its lowest correlations would be to energy and information technology, and its highest would be to the relatively defensive utilities and health care sectors.
The new real estate sector also would have moderate market sensitivity, with beta that matches health care and is higher than only two sectors, consumer staples and utilities (see "Beta" chart). This could make it a potentially useful additional tool for investors seeking to reduce portfolio volatility while maintaining exposure to equities.
However, it is important to remember that real estate has not historically been “defensive” in the way the consumer staples, utilities, and health care sectors are. Even during an economic downturn, consumers generally will continue to buy toothpaste and soap, pay the electric bill, and find funds for necessary health care treatment. The commercial real estate business, on the other hand, can be dependent on supply and demand for real estate, employment rates, interest rates, cost of capital, and other factors.
Based on recent trends, we see several potential investment implications in the new GICS framework. For one, removing real estate—the industry with the least correlation to the other components of the financials sector—will make financials a more focused tool for investors using sectors to diversify risk or capture alpha. In becoming less diversified, the financials sector likely will have more upside potential, but also more downside risk. This could provide investors with a sharper tool to use in sector allocation strategies.
Meanwhile, the new real estate sector may provide a new lower-beta tool for investors seeking to diversify risk or reduce their exposure to market volatility. Given that many investors have been underweight to REITs, they may want to take a closer look at their exposure to determine whether it is adequate given their investment objectives.
Past performance is no guarantee of future results.
Earnings yield, dividend yield, and size exposure were analyzed using the MSCI Barra U.S. Equity Long-Term Model (USE3L). The Barra earnings yield, dividend yield, and size exposure is the weighted average of the index constituents’ exposure to the selected Barra factor.
The S&P 500® Index is a market capitalization–weighted index of 500 common stocks chosen for market size, liquidity, and industry group representation to represent U.S. equity performance. S&P 500® is a registered service mark of Standard & Poor’s Financial Services LLC. Sectors and industries are defined by the Global Industry Classification Standard (GICS®).
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