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Investment implications of the changes in the GICS sector structure

Investments, Investment Views

Posted by James Yang

Sep 8, 2016 1:40:17 PM

Investments Products Manager
Empire Life Investments Inc.
Gestionnaire, Produits de placement
Placements Empire Vie

The Global Industry Classification Standards (GICS) just went through its first significant structural change since its inception in 1999. After the market close on August 31, 2016, Real Estate (formerly an industry group within Financials) was promoted to its own sector. The new GICS structure now consists of eleven sectors. GICS is the foundation for equity index structures and investment portfolio positioning. This change may have a significant impact on not only sector characteristics but also asset allocation decisions across the entire investment industry.

In the Canadian equity market, the change results in Real Estate becoming the 8th largest sector in the S&P/TSX Composite Index, larger than Information Technology, Utilities, and Health Care by market weight.

By carving out Real Estate from the Financials sector in the S&P/TSX Composite Index, we are able to examine the historical characteristics of a simulated Real Estate sector and the Financials sector without Real Estate.

Cumulative Growth (%) between Feb. 2003 and Jul. 2016

Source: Bloomberg Feb. 2003 and Jul. 2016

Impact on the Financial Sector:

By moving out almost half of the total number of constituents, the new Financials sector is only about 3% smaller in total market cap, which means it has a much larger average market cap with a lower dividend (The removed REITs have a much higher dividend yield in general).

Real Estate Investment Trusts (REITs) have been particularly strong in recent years benefiting from historically low interest rates and a relatively stable commercial real estate cycle. Real Estate outperformed the S&P/TSX Composite Index leading up to the 2007/2008 peak and then became more vulnerable and suffered a more severe crash during the 2008/2009 financial crisis.

Source: Bloomberg Feb. 2003 and Jul. 2016

Excluding real estate, the new Financials sector appears to have a higher absolute risk resulting from less diversification. As a result, we can expect a higher variance of the expected return from the new Financials sector going forward, suggesting a wilder swing in future performance, with not only stronger upside potential but also more downside risks.

Source: Bloomberg Feb. 2003 and Jul. 2016

The new Financials sector may also have a higher Beta, reinforcing the less diversified and more sensitive sector characteristics than the old one. Excluding real estate, the new Financials sector appears to have a higher absolute risk resulting from less diversification.

Implications of the New Real Estate Sector:

The new Real Estate sector will be almost entirely driven by the REITs (20 of the 21 new sector members are REITs), which tend to have a lower correlation and less sensitivity than the newly-defined Financials sector, when measured against the broader market.

Source: Bloomberg Feb. 2003 and Jul. 2016

Source: Bloomberg Feb. 2003 and Jul. 2016

Even though real estate is not necessarily as defensive as Consumer Staples or Utilities, it has demonstrated less market sensitivity recently, making it a potential low-beta tool for investors seeking to increase diversification benefits and reduce portfolio volatility.

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