Index providers MSCI and S&P Dow Jones Indices have created a new sector for real estate within the Global Industry Classification Standard (GICS) framework, elevating its position from an Industry Group within the Financials sector. The creation of this new sector will affect investors in financials sector ETFs, with changes scheduled for 16 September.

MSCI and S&P Dow Jones Indices have created a new sector for real estate within the Global Industry Classification Standard (GICS) framework.

The upgrade of real estate means there are now 11 GICS sectors instead of 10, the first time they have been altered since inception in 1999, and more than two years after the GICS consultation started in 2014.

“This change will elevate its position from under the Financial Sector, recognizing Real Estate as a distinct asset class and a foundational building block of a modern portfolio,” read a statement on the MSCI website.

Real estate, the least correlated group within financials, represented just 0.6% of the financial sector in 2001. In 2016 they accounted for 20%, according to ETF.com data.

When real estate becomes its own sector, it will be bigger than either the materials or the telecommunications sectors in terms of market capitalisation.

ETF issuers are dealing with the switch in different ways, which affects financials sector ETFs linked to S&P Dow Jones and MSCI indices across all geographic regions – US, Europe, Asia, World etc.

For the largest financials ETF, State Street Global Advisors‘ $15.7bn Financial Select Sector SPDR ETF (NYSE ARCA: XLF), real estate stocks (about 20% of the fund) will be spun off into a separate SPDR ETF – the $114m Real Estate Sector SPDR ETF (NYSE ARCA: XLRE), with investors receiving shares in-kind. Investors will therefore not change their exposure, but they will own two separate funds – XLF and XLRE.

In Europe, however, SSGA is taking a different approach with its SPDR S&P US Financials Select Sector UCITS ETF (LON: XLSF). The absence of a locally listed equivalent US real estate sector ETF means the issuer is treating the index reclassification as a re-balance. It will therefore trade out of the “ejected” real estate stocks and reinvest the proceeds into the remaining financials stocks in line with the reconstitution of the index.

A similar approach is being taken by Source with its $700m Source Financials S&P US Select Sector UCITS ETF (LON: XLFS). This swap-based ETF will effectively treat the reclassification as a re-balance, with the swap referenced to the ongoing financials ex real estate index. Source does offer an ETF linked to the GICS real estate sector – the Source Real Estate S&P US Select Sector UCITS ETF (LON: XRES) – so investors could maintain their real estate exposure by trading a proportion of their holding out of XLFS and into XRES, but they will need to carry out this transaction themselves.

The re-balance approach is also being adopted by Vanguard. Its $3.6bn Vanguard Financials ETF (NYSE ARCA: VFH) , which is linked to the MSCI US Investable Market Index (IMI)/Financials 25/50, will simply sell the real estate holdings and reallocate to the remaining constituents. Investors’ exposure will therefore change come 19 September, as they will no longer own those real estate holdings.

Another fund affected by the new sector is the US-listed $145m Guggenheim S&P 500 Equal Weight Financials ETF (NYSE ARCA: RYF). This fund is taking the SPDR US approach and reallocating its real estate holdings –  just over 29% of the fund – into the $2.7m Guggenheim S&P 500 Equal Weight Real Estate ETF (NYSE ARCA: EWRE). Investors will receive an in-kind distribution of shares of EWRE, plus a small amount of cash for fractional shares

All these changes will impact the funds’ performance numbers going forward, as the two sectors have, and do, perform differently. Indeed, thus far in 2016 real estate has outperformed financials; the MSCI-based iShares US Financials ETF (NYSE ARCA: IYF) has returned over 4% year to date, while the iShares US Real Estate ETF (NYSE ARCA: IYR) is up more than 12% in the same period, both in USD terms. According to Fidelity, with the removal of real estate, the financials sector may become more volatile, with positive exposure to long-term interest rates.

Investors are being advised to check what each issuer’s process is if they own an ETF that tracks a financials index from S&P or MSCI. The changes do not apply to other index providers, which have their own classification systems. FTSE Russell has the Industry Classification Benchmark (ICB), for example.

So what about the new GICS real estate sector? It contains two sub-industries: equity real estate investment trusts (REITs) and real estate development and management companies. REITs are legally mandated to pay dividends, which is important for income-seeking investors, said David Blitzer, Managing Director and Chairman of the Index Committee at S&P Dow Jones Indices in a recent video for MSCI

REITs will by far outnumber real estate development and management companies. For example, 37 out of 39 mid-cap real estate stocks will be REITS. The real estate sector is likely to be relatively low beta, with high correlations to defensive sectors such as utilities and health care.

Mortgage REITs will remain in the financial sector, which is composed of “diversified financials” as well as banks and insurance.