What are the investment implications of the change?
In terms of the investment merit of REITs and the decision of how much of them you should own, we do not believe the reclassification should matter. REITs have been part of the S&P 500 index (arguably the most well known and invested stock index in the world) for a long time, and their popularity among the investment public has already exploded in recent years. Being promoted to sector status may contribute to marginally boost the popularity of REITs further, but it is unlikely to be a game changer from this perspective. Moreover, while some observers have pointed out the millions of dollars that are expected to ‘flow’ into REITs as a result of the creation of new mutual funds and ETFs investing in REITs as a result of the reclassification, they seem to have forgotten about the likely commensurate amount of money that will ‘flow’ out of REITs as a result of forced selling from mutual funds and ETFs investing in the Financial sector. The bottom line is, if you liked (or did not like) REITs as an investment prior to the reclassification, the reclassification is unlikely to change that, so you should probably sit tight and stay the course.
What are the tax implications of the change?
However, the reclassification of REITs may have some tax implications that investors should be aware of. As previously mentioned, mutual funds and ETFs investing in the Financial sector will be forced to make changes to their portfolio in order to get rid of their exposure to REITs. Different funds may choose a different way to approach the transition, which will likely have different tax consequences for investors in these funds.
For instance, State Street Global Advisors is making this transition in the hugely popular $16 billion Financial Select Sector SPDR Fund (XLF) through a special dividend in the form of shares of the Real Estate Select Sector SPDR Fund (XLRE). Investors in XLF will effectively end up with the same overall exposure as prior to the transition, but divided in two securities: one (XLF) representing the newly-defined Financial sector (i.e. excluding REITs) and one (XLRE) representing REITs. State Street is planning to execute the transition using an in-kind transaction. This should minimize costs for investors, since it will not involve any buying and selling of securities. Moreover, it should have a limited impact on the investors’ tax liability, since the greater majority (estimated around 70-80%) of the special dividend should be treated as a return of capital, with only the remainder being treated as income.
Meanwhile, Vanguard is planning on going a different route with its $3.6 billion Vanguard Financials Index Fund (VFH). Unlike State Street, Vanguard’s plan is to simply rebalance the portfolio by selling the underlying securities that no longer belong in the newly-defined Financial sector. This means VFH will be selling the entire section of the ETF allocated to REITs (except for mortgage REITs) and reinvest the proceeds proportionally in the remaining securities (i.e. mostly banks, diversified financials, and insurance). As a result, investors wishing to retain the same exposure as prior to the transition will have to sell a portion of their VFH position and invest the proceeds in REITs, thus effectively undoing Vanguard’s trade. As of July 31st, 2016 VFH allocated around 25% to REITs. While in theory the selling of REITs by VFH should be a taxable event, Vanguard claims the turnover resulting from the transition should be minimal, and is hoping there will be no capital gains distributions stemming from the transition. Vanguard did not elaborate on specific estimates of turnover, transaction costs, or capital gains/losses.
Investors in these funds wishing to avoid the event altogether have the option of selling the funds before the transition occurs. Last year, State Street launched a new ETF, the Financial Services Select Sector SPDR Fund (XLFS), which has been tracking the newly-defined Financial sector, meaning that once the transition occurs, XLF and XLFS will be identical in terms of the underlying securities. For investors wishing to avoid the event by selling XLF while retaining the same underlying exposure, XLFS is a viable option. The right combination of XLFS and any REITs ETF (e.g. XLRE) should provide the same underlying exposure as XLF while allowing the investor to dodge the special dividend. However, investors considering this option should carefully evaluate the cost and tax consequences of selling their entire position in XLF, and compare that with the cost and tax consequences of continuing to hold XLF and receiving the special dividend. While the performance of the overall Financial sector has been trailing the performance of the S&P 500 in recent years, the sector still experienced fairly strong gains: as of August 31st, 2016, XLF has a five-year cumulative gain of 101.2% and a three-year cumulative gain of 33.6%. The fund has gained “only” 7.2% over the last twelve months, but has gained 17.7% over the last six months. Therefore, it is likely that XLF investors who have been holding the security for some time would be facing a significant tax liability from realizing capital gains in case of a sale. Our tax team estimates that XLF investors with unrealized gains of around 10-15% or more should be better off holding XLF through the payment of the special dividend as opposed to selling XLF and realizing those gains. Therefore, barring any specific individual circumstances that would change such conclusion, our general recommendation to Pinnacle Advisory Group clients is to continue to hold XLF.
Conclusions
The biggest consequence of the reclassification of REITs as their own sector is that index providers S&P Dow Jones Indices and MSCI should be able to earn licensing fees from funds tracking the indices. If you currently judge REITs to be a good (or poor) investment, your opinion should not be affected by the reclassification. If you own any mutual funds or ETFs that may be affected (chiefly, funds with the primary objective of investing in the Financial sector), make sure you fully appreciate how the transition could impact your tax bill.