S&P Sector Split Illustrates How Real Estate and Financials Are So Different

A month after the S&P 500 spawned a real estate sector, the new grouping is charting its own course.

For the first half of 2016, when real estate companies were still lumped into the financials sector, they were some of the year’s best performing stocks, climbing 8.7% even as the full sector fell 4.2%. But that began to shift in the second half, and since the new sector was created on Sept. 16, it has fallen 1.2% while financials have climbed 2%.

The reversal in performance illustrates just how different real estate stocks are from the financials category from which they were separated. It shows that in some respects, the stocks are polar opposites of each other.

“Real estate has a distinctive set of characteristics and deserves a seat at the allocation table,” said analysts at Wells Fargo Investment Institute, led by Chris Haverland, in a research note.

On the face of it, the decision to add an 11th sector to the S&P 500may seem like little more than an administrative shift. The newest stock grouping in the benchmark index, and the first one to be created since 1999, makes up just 3% of its market value.

But creating a new real estate sector–and products to invest in it–allows investors to more cheaply and easily invest directly in those groups of stocks. Exchange-traded fund providers including Fidelity Investments and State Street Global Advisors offer ETFs tied to the sector.

One way to see the differences between the sectors is through correlations. Financials, excluding real estate, have had a 0.84 correlation with the broader S&P since 1990, meaning the two move closely together, according to Wells Fargo Investment Institute. Real estate, by comparison, had a much lower 0.55 correlation with the benchmark, the second lowest correlation after the utilities sector.

A correlation of 1 means they move by the same proportion in the same direction, while a correlation of zero means the two share no relationship at all.

ENLARGE

The differing performance between the two sectors has largely beendriven by the outlook on interest rates. As rates fell for much of the beginning of the year, high-dividend stocks like real estate firms out-performed because they offered comparably high annual income. Financials suffered because they were seen to be squeezed by lower interest margins from falling rates.

But in recent weeks, particularly since the sector split, investor expectations of a Federal Reserve rate increase this year are on the rise, sending benchmark bond yields higher. Financials have benefited while real estate has suffered.

Real estate includes real estate investment trusts and real estate management companies. Because REITS have special tax status, they are required to give at least 90% of their taxable income to shareholders. They often have higher dividend yields than the average stock. Wells Fargo describes the sector has having “traits of both equities and fixed income investments.”

Financials, on the other hand,  includes firms like banks, brokers, and insurance companies. Mortgage REITs are still included in the sector.

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