The S&P 500's new sector could be a really big deal

The S&P 500 is about to undergo a landmark change, and it could have interesting and important developments for investors.

Since 1999, the index of large-cap stocks has been cut into 10 broad sectors, with the distinctions critical for investors trying to create diversified portfolios. Now, they're getting company — an 11th sector dedicated to real estate that will be taken out of the broader financials group starting Sept. 1.

The move matters on a number of fronts, but in particular because portfolios will need to be rebalanced to account for the new group. Financials now will account for a smaller portion of the index, possibly triggering substantial reallocation of resources, while the new sector, and real estate investment trusts in particular, could attract even more investor capital.

The REIT carve-out will take about a fifth of the value from financials and comprise about 3.1 percent of the total index, making it larger than the materials, telecom and utilities sectors.

"It's an enormous sector," said Christopher Whalen, senior managing director and head of research at Kroll Bond Rating Agency. "Given the size, I think it's appropriate to break it out. It makes a lot of sense. It should have happened a long time ago."

Indeed, REITs have accumulated about $1.1 trillion in total market capitalization, according to the National Association of Real Estate Investment Trusts, and have become an increasingly popular tool in a yield-hungry investment world. On the S&P 500 alone, REITs have close to $600 billion in market cap.

An aerial view of a retirement community in Central Florida
Carlo Allegri | Reuters
An aerial view of a retirement community in Central Florida

Essentially, they are vehicles that allow investors to buy into real estate and receive special tax considerations. (Mortgage REITs will be excluded from the new sector.) REITs also traditionally boast high-dividend payouts. They trade as individual and through index funds on the major exchanges.

The breakout from the broader financials sector acknowledges how far REITs have come after decades at the fringes of the investing world.

"It's an exciting development," said Steven N. Violin, portfolio manager at F.L.Putnam Investment Management. "I've been tracking REITs since the late '90s and early 2000s when they were completely ignored. This is the culmination of 20 years of increasing acceptance from the investment community."

While the attention is being directed toward the industry as a whole, Violin believes investor cash ultimately will be pushed to specific plays rather than broad sector moves found with exchange-traded funds.

In particular, his firm favors Highwoods Properties, a $5.2 billion market cap office REIT that focuses on high-quality investments in mostly suburban and secondary urban markets.

However, ETF buyers have been drawn to the sector as well. Despite warnings from Goldman Sachs and others that a rising rate environment could hamper returns on financial-related stocks, REITs are attracting cash, perhaps in anticipation that the Fed will be hiking at a much slower pace than anticipated earlier this year.

Real estate funds have attracted a whopping $6.8 billion in fresh investor cash this year, good for ninth overall in about 500 different ETF sector classifications, according to FactSet. The biggest draw by far in the group is the Vanguard REIT Index Fund, which has pulled in $4.6 billion and is up 11.5 percent this year as of Monday afternoon, crushing the S&P 500's 6.8 percent gain.

Investment pros are closely watching what effect carving out the new sector will have on financials.

As a whole, financials are up just 0.3 percent year to date, the worst-performing market sector and one that would be doing even worse without the comparatively strong performance of REITs, which are up 6.7 percent as a group.

The new sector also will result in a reduction of index cap weight for financials — currently about 15.9 percent of the total index but expected to drop to about 12.4 percent, according to Howard Silverblatt, senior index analyst at S&P Dow Jones Indices. The new allocation could come into play as investors figure out how to balance their portfolios with the 11th sector in play.

Without REITs, financials would be down about 1.9 percent this year, Silverblatt said.

"Watch out for the 'old' financials, since so many notable portfolio managers have no REIT exposure right now," cautioned Nick Colas, chief market strategist at Convergex. "This means they are essentially overweight — and dramatically so — banks, brokers and insurance companies (non-REIT Financials). The reweighting caused by the ... sector change will bring this positioning into stark relief."