The Biggest Financials Sector ETF Undergoes a Makeover

With nearly $15 billion in assets under management,

First There Were Changes to GICS On Nov. 10, 2014, index providers S&P Dow Jones Indices and MSCI announced the result of their annual review of the GICS structure. (GICS is an industry classification system jointly developed by the two firms, which was first introduced in 1999.) The most meaningful change springing forth from this review was the creation of a stand-alone real estate sector. According to SPDJI and MSCI, this was largely driven by investor input. In the press release announcing real estate's graduation to sector status, Remy Briand, managing director and global head of equity research at MSCI, stated, "Investors told us that there are significant differences between public real estate and financial companies and therefore real estate deserves a dedicated GICS sector." Thus, the eleventh GICS sector was born.

Then Came Two New SPDRs On Sept. 2, 2015, SPDJI announced the launch of the Real Estate Select Sector and Financial Services Select Sector indexes. The benchmarks were licensed to State Street Global Advisors and now underlie Real Estate Select Sector SPDR XLRE and Financial Services Select Sector SPDR XLFS, which began trading on Oct. 8, 2015. At that point the plan was to leave XLF alone. In the press release announcing the launch of XLRE and XLFS, James Ross, executive vice president and global head of SPDR exchange-traded funds at SSgA, shared "For those looking to maintain broad-based exposure to financials, our existing Financial Select Sector SPDR XLF, which provides the most liquid exposure to the broader financial sector, will remain unchanged."

But Now XLF's Bogy Is Changing On June 7, SPDJI issued a press release stating that the Financial Select Sector Index--XLF's current benchmark--will be dropping all real estate companies effective as of the close of business on Sept. 16. XLF must now change, too. On June 8, SSgA issued its own press release outlining the mechanics of this transition.

A Special Kind of Special Dividend XLF will be shedding its current real estate holdings in the form of a special dividend, which will be paid to XLF shareholders in shares of XLRE, as well as a small cash residual that will solve for the fact that fractional shares in XLRE cannot be issued. The ex-date for XLF is Sept. 19, 2016. Buyers of XLF on that date will not be entitled to the special dividend. On Sept. 19, XLF's share price will drop by an amount that will approximate the value of the special dividend. The record date for the dividend will be Sept. 21 and the pay date Sept. 22.

As of Sept. 16--the effective date for the changes to the Financial Select Sector Index--XLF's real estate holdings were transferred on an in-kind basis to XLRE, thus creating new shares of XLRE. In an effort to mitigate the cost of implementation, SSgA waived XLRE's fee until Sept. 16. This has resulted in the creation of $3 billion worth of new XLRE shares; these will be held by XLF until they are ultimately paid out to XLF shareholders as a special dividend on Sept. 22. According to SSgA, the estimated distribution for the special dividend will be 0.14 shares of XLRE or approximately $4.47 per share of XLF as of Sept. 9, 2016.

So Now What? Long-term investors that are glad to maintain the exposure they've obtained by investing in XLF should be largely indifferent to all of this, as the sum of XLRE and the new-look XLF's portfolios is identical to the "old" XLF. SSgA had vetted other means of executing these changes and ultimately opted for this route given that the firm believes it will minimize market impact, as well as the costs borne by investors, and best allow fund shareholders to maintain seamless exposure to XLF (in its current form).

As for tax consequences, SSgA has shared the following with respect to the tax treatment of this special dividend:

The dividend distribution may be characterized as both return of capital and income for tax purposes. As of Sept. 9, 2016, the amount of the dividend that will be treated as return of capital is estimated to be between 70% and 80%; the remaining 20%-30% is expected to be taxed as ordinary income. The amount of return of capital is an estimate and subject to change based upon multiple factors including fund performance, shareholder activity, and general market movement up until the payable date of the distribution.

As always, investors should consult a tax advisor to better understand the tax implications of this dividend.