Thomas Mench is Buying REIT ETFs Again

As chief investment officer for a mutual fund company in the early 1990s, Thomas Mench became intrigued with work by Gary Gastineau and Jay Baker.

At the time, Gastineau and Baker were creating a new financial vehicle for the American Stock Exchange. Those were exchange-traded funds [ETFs]. When the first ETF came out in 1993, the S&P 500-tracking SPDR (AMEX: SPY), Mench jumped at the opportunity.

Since then, he's started his own advisory firm. The Cincinnati, Ohio-based Mench Financial Inc. now serves high net worth and institutional investors across the country. The 13-year-old firm primarily manages separate accounts and portfolios for pension foundations and corporate retirement plans.

"We generally managed ETF-only portfolios," Mench said. "Our style is very low-turnover with a global emphasis."

But along with his staff, Mench reviews fundamental data and applies independent research to different asset classes around the world. In a typical year, he says that will result in one to two roundtrip changes in ETFs.

Lately, Mench has been adjusting his positions in real estate investment trusts. That comes after he moved completely out of REITs in February 2007. The primary ETF he was using was iShares Cohen & Steers Realty Majors (NYSE: ICF).

"Historically, REITs get 80% of their returns from income and 20% from capital appreciation. But as a result of the five-year real estate boom, returns had run up almost 25% compounded annually," Mench said.

By early last year, the average yield on high-quality REIT indexes had dropped below 4%. At the same time, 10-year Treasuries were yielding more than 5%. "Generally over time, REITs' average yield has been at or above 10-year bonds," Mench said.

Investors were obviously chasing price appreciation rather than income. "REITs were never designed to outcompete with the S&P 500 or some stock index," Mench said. "By their very nature, they're primarily income-generating vehicles."

Earlier this month, Mench started buying shares of ICF again. The hysteria that gripped REIT investing has all but died, creating a more traditional market for ETFs such as ICF, Mench says.

"In the course of the last 12 months, the price is down 30% on ICF. And the yield is up to 5.6%," he pointed out. "The third part of the equation is that the new 10-year Treasury was issued two weeks ago at a 3.5% coupon rate."

Mench added: "So now, we're getting 2% more in yield from REITs than 10-year bonds. And with REITs being so oversold at this point, I'm back to expecting at least a 2:1 payback in being in REITs versus a 10-year Treasury note. They're on track to produce total returns of between 7-9% compounded annually over the next three to five years."

Mench still isn't very positive about prospects for bond ETFs at this point. But he's maintaining his clients' core positions in iShares Lehman Aggregate Bond ETF (NYSE: AGG). About 80% of his clients' income-focused portfolios are invested in short-term to intermediate bond ETFs and high-yield currency ETFs.

"Bond yields are still dramatically low," Mench said. "You can pick up 0.5% to 1% more in yield by holding a currency ETF than a bond ETF."

The U.S. dollar's weakness also gives foreign currency ETFs a 2-3% boost in returns. That's due to the fact that most funds are denominated in dollars.

Mench uses iShares Lehman TIPS Bond ETF (NYSE: TIP) and Vanguard Intermediate-Term Bond ETF (AMEX: BIV) for his shorter-term bond allocations.

"With the latest inflation numbers coming out this week, there's a real discussion going on about whether we're in a high-inflation and low-growth stage," he said. "TIP adjusts its income stream to inflation expectations."

BIV is broad-based and keeps investors from the longer end of the yield curve, according to Mench. "Interest rates on 10-year Treasury notes bought right now are likely going to hover around 3.5% or higher 80% of the time over the next decade," he said. "And that's not a good position, both on a relative and absolute return basis. I'd much rather be in high-yield stocks such as REITs or high-yield currencies."

Mench is buying CurrencyShares Euro Trust (NYSE: FXE) and CurrencyShares Mexican Peso Trust (NYSE: FXM).

"We're concentrating on Europe and Mexico in terms of currencies at this point," he said. "Growth is slowing around the world. But we think that international economies will expand at least as much or better than our domestic economy. And we like the valuations on these two ETFs."

Written by Murray Coleman