MSCI MSCI Inc

By Laura Saunders 

A historic change is coming to the S&P 500 and MSCI Inc. indexes on Sept. 16, when publicly traded real-estate investment trusts move out of the financial-services sector and into a sector of their own.

"The average investor has no idea what's going on, but this is a big shift," says Robert Gordon, who heads Twenty-First Securities, a brokerage firm in New York known for its tax strategies.

The REITs moving into their own category had a market value of $609 billion on June 30 and account for about 20% of the financial-services sector of the S&P 500.

Investors who hold financial-sector funds in taxable accounts -- as opposed to tax-sheltered retirement accounts such as IRAs -- should consider two questions ahead of the change, says Mr. Gordon.

The first is whether they will face a surprise tax bill if a financial-sector fund sells its REITs in order to conform to the shift in the index.

In addition, investors should ask what will happen to their current REIT exposure -- will it drop because the fund manager has sold REIT shares in order to stay aligned with the financial-sector index, which has mostly banks, insurers and asset managers? This change could make a difference. REITs averaged a 9.8% return annually since mid-2008, far outstripping the 3.5% returned by bank stocks, according to Morningstar analyst Alex Bryan.

For investors concerned about taxes and future allocations, much depends on how a fund handles details of the shift -- and different funds are taking different approaches.

To some , the change won't matter. Gabe Solomon, who manages T. Rowe Price's $550 million Financial Services fund, says the fund doesn't track the affected benchmarks and plans to make no changes based on them. Recently, about 4% of the fund's assets were in REITs.

Funds that closely track the S&P 500 and MCSI benchmarks must reckon with the change, however. The largest is the $14.5 billion Financial Select Sector SPDR exchange-traded fund, sponsored by State Street Global Advisors.

Given its outsized share of the sector, the fund's managers are working for a smooth transition, says Dave Mazza, head of exchange-traded fund research at SSGA. They plan to split the fund proportionally for holders of record as of Sept. 21. Investors will wind up with two holdings, each mirroring the new S&P benchmarks, and perhaps a small amount of taxable income.

The REIT assets will be paid out via a special dividend consisting of shares in the new REIT ETF on Sept. 22, and this distribution could be largely nontaxable because it counts as a return of capital to investors. The income payment, which will be determined closer to the breakup date and is due to fractional shares and other issues, will be taxable at ordinary rates.

What happens to the investor's cost basis -- the starting point for measuring taxable gain? For the REIT shares, it will be the value on the date they are paid out. Investors' basis in the financial-sector ETF shares will be reduced by that value to account for the distribution of the REIT shares.

Mr. Gordon says this format allows investors both "to keep their allocations intact and avoid a large tax bill on the change."

Other financial-sector funds, including those sponsored by Vanguard Group, Guggenheim Investments, and Fidelity Investments, will be selling their REITs before the index's September change -- so investors who want to maintain REIT exposure will need to replace it with a separate purchase.

A spokesman for Vanguard said the change in its $3.3 billion Vanguard Financials ETF and $3.6 billion Vanguard Financial index fund are "not expected to result in capital-gains distributions."

A spokesman for Guggenheim's S&P 500 Equal Weight Financial ETF, with total assets of $151 million, said it also doesn't expect the sale of the REIT shares to generate capital-gains payouts.

The two Fidelity funds that are rebalancing out of REIT holdings are Fidelity Select Financial Services Portfolio, an open-end fund with $1.1 billion in assets, and the Fidelity MSCI Financials Index ETF, with $245 million in assets. According to a statement from the firm, "it is too early to say exactly what the tax implications will be of any repositioning" but "we manage our products with an eye toward minimizing any tax consequences."

Write to Laura Saunders at laura.saunders@wsj.com

(END) Dow Jones Newswires

July 08, 2016 11:24 ET (15:24 GMT)

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