VNQ Vs. IWM: Cash Flow Or Profits?

 |  Includes: IWM, IYR, VNQ
by: Lee Eugene Munson, CFA

It is widely believed that diversifying across all financial sectors is the holy grail of investing. Most people know something is wrong with this as many investors ignore this advice. Why is it that you must invest in everything just because a broker wants to insure no mutual fund manager is left behind? For some so-called advisors in my field along with investors, there is a false sense of safety in numbers. This is only half wrong. We don't want to put all our eggs in one basket, but becoming a mutual fund collector is a sign you don't know what you are doing. This article illuminates why my firms current core ETF lineup doesn't have a dedicated small cap equity allocation. Yes, small cap stocks are in our universe, but are allocation to it for the past two years has been 0%. We will discuss what that really means, why we decided to do it, and what would cause us to change our minds.

Do you know what small cap means? Most would define it as a firm with a total market cap of under 1 billion. Some people may take that threshold all the way up to 10 billion. Who cares? For starters, there is ample evidence that during certain periods of time smaller companies will outperform larger companies. Don't bother with trying to find a complex reason why. Strip it down to the basics. Our global trading oriented markets see smaller firms as more risky and larger firms less so. When capital wants to add risk, smaller names will collect the money flow. For individual investors, the question becomes: do you get paid for the risk?

This is core question investors need to be concerned with, not simple rules of thumb based on the past. Does a certain group of companies give you the return that matches the risk took on? If so, measure it, keep looking at it, and throw it under a bus when it stops doing it.

In early 2010, our firm was deciding if we wanted small cap exposure as represented by the Russell 2000 index. We looked at IWM to represent the index. There was a fundamental concern that smaller firms may not be able to pull out of what has been a mediocre market if financing was questionable and consumer spending was in jeopardy. Was increased government spending going to trickle to the biggest well-connected firms or the smaller fish? Plus, after the rebound in 2009, we wanted to look at alternatives that were cheap, somewhat hated, and with a hedge. What was the hedge? Cash flow. Because we were in a low rate environment, looking at a sector that had a higher percentage of total return that came from dividends versus capital appreciation was important. We were even willing to make less total gain if a bird in the hand got paid each quarter. However, we still wanted to keep a similar amount of risk in the portfolio. How does it benefit investors to gain exposure to an alternative proxy to the small cap index if the risk is higher? Going from small cap stocks to CD's is not long-term thinking; that only changes your long-term risk, which can screw up any portfolio. We found a decent substitute in the REIT sector. We focused on VNQ, a cheap ETF that tracks 106 publicly traded REITs. Why VNQ? Check out our analysis that compares it to another popular REIT ETF, IYR here on Seeking Alpha.

REITs were unloved going into 2010 (has that changed in the past year?). In fact, at the time I was one of the only people who would show his face on CNBC discussing the positive performance of the group. Our firm didn't think it was a great place, but simply undervalued, a similar risk, and still diversified. Let's look at some numbers over the past two years to see if this idea has paid off.

So, we have similar volatility with a lot better performance than the small cap index. We even get decent returns against the SPX when you adjust for the extra risk. What about correlation?

You get no real diversification by investing in REITs. Sure, long-term there have been better numbers, but right here right now all you get is higher cash flow, similar risk to small caps, and similar movements to the broad markets. If cash flow is king, what was the total contribution to performance from that cash flow?

In the end, we see that even with the extra capital appreciation from VNQ, it still had a higher percentage of total return from cash flow to investors than IWM. SPY, an ETF that can capture the SPX performance and cash flow, is a perfect example of when dividends count, with the least return of the three but the highest contribution from dividends. So, while dividends are irrelevant if you don't have positive returns, they still count on some level. What we don't want to do is seek out high dividends without some overriding reason why. When the economy picks up, pure profit will take pole position and those that are perma-dividend fans will feel the pain.

The question is, when will this end? I don't know, but it will someday. Mostly likely, we will see a time when the fundamental growth of our economy will pick up and the innovators will lead the pack. Looking at the high level of cash public companies hold suggests we are not there yet. My point is simple. You don't have to buy everything just because a pie chart told you to. You do, however, need to look at the risk you take and see if there is a reasonable payoff. Everything decays if it is working. Change rules, that is our motto.

Disclosure: I am long VNQ, SPY.