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Rise of the REITs: Big changes on tap for S&P 500

Written By | Jul 11, 2016

WASHINGTON, July 11, 2016 – The Maven is back in town after wearing his theater review hat over the long weekend, taking in the five new or nearly new plays of this year’s Contemporary American Theater Festival (CATF) in nearby Shepherdstown, West Virginia. (Rolling reviews will be going up all week over at CDN’s Entertainment Section.)

Meanwhile, although connectivity was occasionally poor in West Virginia’s Eastern Panhandle (or at least rather slow), the Maven attempted to catch up with potential market action this past weekend, but was still a bit surprised to see the market up nicely today, Monday, which in recent history has tended to be an awful day for the bulls. Yet as of 3:30 p.m. today, half an hour before the market’s closing bell, all three major averages are up half a percent or more, still running off the allegedly high Friday employment figures.

Meanwhile, gold is slightly off, oil a little more, and silver is still catching a bid.

But the increasingly big market news has been hiding in the shadows all summer and could provide an interesting investment and/or trade for investors interested in the income side of stock market investing. So, rather than provide our always-sterling political and economic stock market analysis in today’s column, let’s go right into the Maven’s…

Trading diary

Something profound, yet subtle, has been going on beneath the surface of 2016’s roller coaster market action. Some background first.

While most individual investors who’ve been around for a while are well aware of the unique composition of the three major stock averages—the Dow Jones Industrials (DJ or DJI), the S&P 500 (S&P) and the NASDAQ (full name: National Association of Securities Dealers Automated Quotation system)—they’re not often acquainted with the sub-categories within these averages.

For example, the DJI is really a sub-category in and of itself. The range of Dow Jones averages also includes the Transportation Index (DJT)—until present times often nicknamed the “trannies,” something that’s probably become politically incorrect—and the Utilities Index (DJU). The S&P 500 is even broader, consisting of America’s 500 biggest companies, subcategorized for now into 10 different sectors.

Individuals are probably most acquainted with the DJI, since that’s the index most often trumpeted by popular pundits and TV news blow-dries who usually know nothing about the meaning of the data they trumpet during their rip-and-read broadcasts. However, the S&P 500 is obviously more broadly based and is the general index that professional investors follow most closely.

Until now, the S&P 500 has included 10 sub-categories or “sectors.” That’s why some of the better reports will often refer to things like the “industrial sector,” the “financial sector,” and so forth as a way of pinching in on how each facet of American business might be doing, financially, within a given period of time.

Loads of mutual funds, index funds and ETFs are geared to track not only the S&P 500 in general—the ETF that’s traded under the symbol SPY, for example—but also to trade individual S&P 500 sectors. XLU and FXU (utilities), IYZ and VOX (Telecommunications) and many others are examples of ETFs that track S&P 500 sectors.

To more or less track the actual sectors, each of these funds and/or ETFs must invest in a generally capital-weighted average of the securities contained in each sector. Companies move in and out of the S&P and its sectors every so often, meaning old companies can be jettisoned while new companies can be added, and the funds and ETFs must do likewise to represent the underlying indexes.

Bottom line: Given all the index-driven investments that have become so popular with the public right now, any security contained within one of these sub-categories or sectors is going to get a lot more buying and selling action than a security that’s not included in the list.

Well, here’s where we’re going with all this. For the first time in a long time, the S&P folks have decided to actually ADD a new component to their List of 10 sectors: real estate. That sector, to the extent it’s been represented in the S&P, has lived under the financial sector. But now it’s being broken out into its own sector, the S&P’s 11th.

Precisely what will be contained in the new S&P real estate sector is not known at this time to the Maven, nor does he really care. The important thing to note is that the biggest companies in this sector are real estate investment trusts, or “REITs,” a (usually) high-income investment long favored by the Maven for adding extra income to 21st century portfolios that are generally starved of it, due to the nearly negative interest rate returns in our current environment.

REITs are so named because, under federal law, they must pay out at least 90 percent of their earnings each year to shareholders, resulting in outsized returns. REITs are not, to be frank, foolproof investments. They tend, due to their mega-bond type yields, to move inversely against prevailing interest rates, which is why they got hit in early 2016 (fear of the Fed) and got demolished during the most intense phase (2008-2009) of the Great Recession which, in and of itself, was largely precipitated by real estate lending fraud on a massive scale.

But REITs and other such investments have become so large an element in today’s securities trade that they are finally being acknowledged by at least one firm—S&P—as being worthy of their own investment sector category, something set to happen on September 16, 2016.*

Which means that all mutual funds, hedge funds, ETFs, etc., will be required to add to or augment their real estate and/or REIT holdings rather considerably when the new sector designation becomes effective. For this reason, investors should now consider adding one or more REITs or similar investments to their portfolios in advance of this move.

No guarantees, of course, and much of the buying by institutional investors is probably well underway. But, given that many REITs are relatively thinly-traded, this should start narrowing bid-ask spreads and aiding in the over all trade of these unique investments.

The Maven currently holds two REITs—New Residential (NRZ) and Two Harbors (TWO) in his portfolios, and is considering adding to this list in the coming days, buying on nasty market dips:

  • RNP (Cohen & Steers REIT and preferred income fund), a hybrid closed-end fund that contains a basket of REITs and preferred stocks, an investment the Maven also favors currently)
  • SCHH (the Charles Schwab REIT ETF, which can be bought and sold by Schwab customers without commission)
  • VNQ (the Vanguard REIT ETF, long-known for its consistency and decent yield)
  • REM (another REIT-like investment that invests in a basket of high-yielding REITs to pay, at this point, a roughly 10 percent dividend)
  • AGNC (a suburban DC-based REIT noted for its high-yield, which is paid monthly—a big plus for income-oriented investors who wish their quarterly-dividend-paying REIT holdings would do the same)
  • TWO (Two Harbors, a very respectable, high-yielding REIT that’s spread out its risk by entering into side-businesses like the lucrative mortgage servicing business)
  • NRZ (New Residential, a REIT whose activities are similar to those of TWO, with an added kicker or two we’ll explain in a future article)
  • BXMT (A relatively recent REIT that is, however, underwritten by the mega-giant Blackstone financial colossus and carries a nifty rate of return)
  • Also on most professionals’ lists is Realty Income Corp. (O), a long-established and much-loved REIT famous as the “monthly dividend company” for self-explanatory reasons. After a period of doldrums, however, this REIT took off like a rocket last fall and may very well be too pricey to consider as a new investment at the moment. But any precipitous drop in price here that’s not based on fundamentals could be taken advantage of.

Again, all the above are not really recommendations. Timing is all when it comes to picking up REITS, and some even now are a bit overpriced, probably due to the pending new S&P category. But over time, buying these generally high-yielding REITs judiciously and at the right time (when they’re being decimated) can help stabilize individual portfolios in a volatile trading environment.

We’ll have more to say on this new category as it develops into August and beyond. And, as we mentioned a bit earlier, we may pick up a few shares in the above-mentioned categories if the price is right.

*An earlier version of this article erroneously cited the month of August.

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Terry Ponick

Biographical Note: Dateline Award-winning music and theater critic for The Connection Newspapers and the Reston-Fairfax Times, Terry was the music critic for the Washington Times print edition (1994-2010) and online Communities (2010-2014). Since 2014, he has been the Senior Business and Entertainment Editor for Communities Digital News (CDN). A former stockbroker and a writer and editor with many interests, he served as editor under contract from the White House Office of Science and Technology Policy (OSTP) and continues to write on science and business topics. He is a graduate of Georgetown University (BA, MA) and the University of South Carolina where he was awarded a Ph.D. in English and American Literature and co-founded one of the earliest Writing Labs in the country. Twitter: @terryp17