A change in S&P Dow Jones investment classifications has the potential to change the makeup of some dividend-focused ETFs.
Last month MSCI and S&P Dow Jones Indices announced that their Global Industry Classification System (GICS) will soon count real estate -- and, therefore, many REITS -- as a separate investment category rather than as a subset of financials.
The change, which effectively creates an 11th sector, takes effect after Aug. 31, 2015. It does not affect mortgage REITs, which will remain part of the financials.
That matters to investors because equity REITs have to date been lumped in with financials in any sector analysis -- which has been particularly challenging in the wake of the financial crisis.
TAINTED BY BANKS
Here's the backstory: Until the debacle of 2008, financials were a cornerstone of funds and ETFs that concentrated on dividends. But when the bottom fell out, many banks slashed their dividends; that slashed the income of investors who depended on them.
Some banks have yet to raise their payments to shareholders, in part because of regulatory pressures. Meanwhile, many investors continue to avoid financials because of fear that regulators have not done enough to restrain some of the excesses that caused the financial crisis in the first place.
Yet other financials were tainted by the banks' problems as well. The sector also includes asset managers and insurance companies, among others, many of which had little to do with causing the crisis. And equity REITs, by virtue of their inclusion in the financials sector, were painted with the same brush.
In fact, REITs did tumble sharply in the market decline. But the value of the properties underlying those REITs -- particularly the commercial property trusts -- proved to be much more stable.
IMPACT ON ETF HOLDINGS
The domestic dividend ETF that is likely to face the biggest change when the new classification of REITs goes into effect next summer is WisdomTree's $12.5 billion Dividend Ex-Financials Fund (DTN).
Two key reasons: The ETF was created to appeal to investors who fear holding bank stocks; it also uses the GICS classifications. Once REITs are no longer part of the suspect sector, WisdomTree will be able to include them in a portfolio that avoids banks and other mainstays of the financial world.
But many of the other big dividend ETFs will show minimal impact. The following table lists the four biggest domestic dividend ETFs, along with the percentage of financials in their current portfolios.
Perception of the SPDR S&P Dividend ETF (SDY) will clearly benefit from the establishment of a separate real estate sector. The ETF currently has 21.11% of holdings in financials and is based on an index that categorizes stocks using the GICS methodology. REITs are 4.25% of the fund's holdings, meaning that under the new classification system, SDY would have 16.86% in financials -- and therefore will appear less risky to investors fearful of financials exposure.
The makeup of the fund is unlikely to change immediately, however: Since the rules of the index upon which SDY is based require 20 consecutive years of dividend increases, the reclassification will have no effect on eligibility of particular REITs for future inclusion.
But the other three are unlikely to be affected: Not only do they not use the GICS system, but they also avoid REITS by design, because of the rules governing their underlying indexes.
The two dividend-focused Vanguard ETFs (VIG and VYM) use FTSE's Industry Classification Benchmark system, which still includes REITs in the broader financials sector. But it's irrelevant anyway: Both funds' underlying indexes -- the Nasdaq U.S. Dividend Achievers Select Index, which VIG is based upon, and the FTSE High Yield Dividend Index, which underlies VYM -- exclude REITs.
The iShares Select Dividend ETF (DVY), despite being based on an index from S&P Dow Jones, also eschews the GICS system for that same FTSE system. In addition, the rules governing the Dow Jones U.S. Select Dividend Index exclude REITs.
The iShares fund might choose to include REITS in the future, however, because S&P Dow Jones co-owns GICS and could in theory change both the classification system and the index methodology.
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