Mutual funds are about to get much more real.
A big change is coming in how stock indexes measure the market, one that’s likely to push tens of billions of dollars into real-estate investments, according to estimates. All that cash could drive further gains for a group of stocks that’s already done quite well since the financial crisis. Critics say it could also make an area of the market that they call overvalued even more so.
The deluge of cash is the result of a re-think by index providers about how they see the market’s construction. The Standard & Poor’s 500 and other indexes have long split the market into 10 main sectors, such as technology companies or utilities or industrials. After the market closes on Aug. 31, S&P Dow Jones Indices and MSCI will carve out real estate to become the 11th sector.
For investors who own only broad index funds, the change won’t mean much. Real-estate investment trusts, which own apartments, office buildings and shopping malls, will still make up about 3 percent of the S&P 500, and they’ll make up the same percentage of S&P 500 index funds.
The change is much more than housekeeping for actively managed mutual funds, which still control more dollars than their index-fund rivals.
It’s a stock picker’s job to be different from the index. That’s why they charge more in expenses than S&P 500 funds, for the opportunity to do better than the index. Even so, active managers pay close attention to how indexes are constructed. If their portfolios are very different, they’ll need to explain why to their investors.
Many mutual funds have nothing at all invested in real estate. Nearly 40 percent of large-cap core fund managers have zilch, according to a review by Goldman Sachs strategists. But that’s not obvious from a quick glance at funds’ marketing materials, which generally show how much is invested in each of the 10 big sectors.
REITs are currently categorized as part of the financial sector. So an actively managed fund could have 16 percent of its investments in financial stocks, the same as the S&P 500, but with no real estate. At first glance, such a fund could look like it’s built similarly to the S&P 500 index. But come September, that same fund would suddenly appear as if it’s optimistic about banks, insurers and other financial companies — and pessimistic about real estate — because it will hold more financials and less REITs than the index.
THE WAVE HAS ALREADY BEGUN
Estimates vary widely on how much REIT buying the index changes will drive, but most are big. They range from about $10 billion to 10 times that.
“It’s a tsunami,” says Mike Underhill, portfolio manager at the RidgeWorth Capital Innovations Global Resources and Infrastructure fund, which owns several REITs. And he says the buying has already started.
He’s recently noticed prices doing better than he’d typically expect for REITs that operate in areas where renters are falling behind on rents. He attributes that to mutual funds buying REITs in advance of the index shift.
ALREADY STRONG PERFORMANCE
The expected jump in demand could help keep REIT prices high, even after their strong performance both this year and since the stock market bottomed in March 2009. An index of REITs by MSCI has returned a cumulative 434 percent since March 9, 2009, versus 265 percent for the S&P 500.
Investors have been buying REITs in part because they offer relatively big dividends. Bond yields are low, so investors have gone searching elsewhere for yield. And REITs can avoid taxes if they pass on 90 percent of their profit to shareholders as dividends.
That’s drawn investors to REITs like Simon Property Group, which owns shopping malls around the country, or Public Storage, which runs self-storage units.
The jump for REITs mean they make up about 3 percent of the S&P 500 index now, up from 0.1 percent in 2003, according to Goldman Sachs. When it becomes the 11th sector, real estate will be roughly the same size as the utilities, raw materials and telecom services sectors. The largest component in the S&P 500 is technology, which makes up 21 percent of the index.
WORRIES AND CONSEQUENCES
All the demand for REITs in recent years, though, means their prices have climbed not only on an absolute level but also relative to how much cash their businesses are producing. The jumps have been big enough that some investors call REITs overly expensive, while others say they’re fairly valued. Most fund managers agree that REITs are no longer cheap.
The index changes could have particularly big impacts on investors with funds that focus on just financial stocks, which control a total of about $39 billion in assets.
The largest such exchange-traded fund, the Financial Select Sector SPDR fund, has already laid out its plans. It will pay out a special dividend to investors in September, one made up entirely of shares of an ETF created in October that focuses exclusively on REITs.
But the index shifts will likely reverberate across the market. S&P Dow Jones Indices and MSCI say they’re upgrading real estate to stand-alone “sector” status because they want to acknowledge its importance to the global economy. That may push lay investors to give the sector a closer look.