VNQ: Valuation Risks, Volatility Risks, And Hedging

Oct. 17, 2021 7:14 AM ETVanguard Real Estate ETF (VNQ)7 Comments

Summary

  • My earlier article on the Vanguard Real Estate ETF focused on the near-term risk assessment based on a yield spread analysis.
  • In this article, I will examine its current market valuation and volatility risks. The results show that the valuation is near a historical peak and the fund has shown large volatility risks.
  • The combination of high volatility and high valuation calls for hedging ideas, and this article describes such an idea after analyzing the fund’s fundamentals based on risk-parity and diversification.

REIT. Real estate investment trust. Financial Market. Hand pressing button on screen

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Thesis

The Vanguard Real Estate ETF (NYSEARCA:VNQ) is a popular choice for investors seeking dividends and income from the domestic real estate sector. It features large liquidity, low cost, and excellent diversification. My earlier analyses on the Vanguard Real Estate ETF fund focused on the near-term risk assessment based on a yield spread analysis.

In this article, I will examine its current market valuation and volatility risks. The results show that the valuation is near a historical peak and the fund has shown large volatility risks in the past. Despite the backing of real estate properties, REIT, unfortunately, has suffered significant volatility risks in the past as bad as the overall market. The combination of high volatility and high valuation calls for hedging ideas, and this article describes such an idea after analyzing the fund’s fundamentals based on risk-parity and diversification.

Volatility risks

The details and basics of this fund have been reviewed in my earlier articles and won't be repeated here. Here, we directly go into the discussion of volatility risks.

Many investors believe (or wish) that REITs are safer investments because these companies are backed by real estate properties. But unfortunately, that is not true. REIT businesses have suffered volatility risks in the past as bad as the overall market, as shown in the next chart. As seen, VNQ displayed large volatility risks in terms of standard deviation, maximum drawdown, and worst year performance than the overall market represented by the S&P 500 index. In particular, note that the worst drawdown has been -68%, about 18% worse than the overall market.

Source: Author, with simulator from Portfolio Visualizer, Silicon Cloud Technologies LLC

Valuation risks

In addition to the volatility risks mentioned above, the valuation of the fund is also near the historical peak. I wish I could find the historical price to book ratio or price to FFO ratio for the VNQ fund directly. But I think using the following data from the Whitestone REIT index is accurate enough, because of the very similar indexing methods between the Whitestone index and the VNQ index.

This chart shows the historical price to book ratio values over the last 10 years. The historical average is about 1.0x and the most expensive valuation observed in the past decade is about 1.47x. The current price to book ratio is about 1.2x, i.e., at about 20% premium above the historical average. And such a large premium has only occurred a few times (about 2 or 3 times) in the past decade as you can see.

VNQ price to book value

Source: Whitestone REIT Price to Book Ratio

Another effective way to gauge the valuation risks is to examine the dividend yield. Since REIT funds have to pay out at least 90% of the income as dividends, the dividend yield serves as a very reliable and direct metric for their valuation. As can be seen from the next chart, currently the dividend yield is at a historical low, around 3%. And again, such low yield has only occurred a few times (about 2 or 3 times) in the past decade as you can see.

Such a combination of high volatility and high valuation certainly increases the risk profile of the fund at this current time and calls for some hedging considerations. Therefore, in the next section of this article, we will explore some hedging ideas to tame some of the risks.

VNQ dividend yield

Source: Seeking Alpha

How to hedge some of the volatility and valuation risks?

The above combination of high volatility and high valuation certainly increases the risk profile of the fund at this current time. Therefore, in the remainder of this article, we will explore some hedging strategies to tame some of the risks

First, a little bit more about my overall portfolio management strategy. At the portfolio level, I follow a variation of Dalio’s All Weather Portfolio. And the central idea in my asset allocation is diversification. Therefore, the ideas discussed here will be all along the lines of diversification and risk-parity.

There are not many truly diversified investments (i.e. uncorrelated investments) available to most investors. And as seen from the next chart, VNQ is highly correlated to the overall market as represented by the S&P 500 index. To effectively diversify, we have to look beyond stocks, such as gold and bond.

VNQ correlation results

Source: Author, with simulator from Portfolio Visualizer, Silicon Cloud Technologies LLC

Historically, REIT fund has been negatively correlated to long-term treasury bonds in the past and showed no correlation with gold. Given such a negative correlation or lack of correlation, it is possible to set up a combined portfolio consisting of two or three of these negatively correlated assets for hedging. The following example illustrates the simple use of two assets by two example portfolios:

  • Portfolio 1: 100% VNQ
  • Portfolio 1: 90% VNQ + 10% TLT with a quarterly rebalance

As can be seen in the next chart in this section, with the addition of 10% EDV, the combined portfolio significantly reduced the volatility, in terms of the standard deviation, the worst year performance, and the maximum drawdown. Even the total return is slightly improved, but not by that much.

Also, as you can see from the next chart, the addition of a bit of treasury bond as hedging does not impact the current income either. It actually increased their income a little bit in some of the years such as 2020.

VNQ portfolio growth

Source: Author, with simulator from Portfolio Visualizer, Silicon Cloud Technologies LLC

VNQ portfolio income

Source: Author, with simulator from Portfolio Visualizer, Silicon Cloud Technologies LLC

For me, I care more about the reduced volatility risks than the little return and/or income enhancement. As seen, the maximum drawdown has been improved by about 6% by the addition of a little bit of treasury bond. And the worst year performance has been improved by about 7%. Seeing a 2/3 shrink of your TOTAL portfolio shrink can be very stressful, and a 6-7% improvement is a LOT – both in economic and emotional terms.

The reduction of volatility risks can be better appreciated by the following chart when we compare the underwater time and the recovery time. As seen, the addition of a little bit of treasury bond as hedging not only reduces the degree of drawdowns as aforementioned, it also significantly shortened the recovery time and underwater time. During a crisis like that of 2008, the VQN fund suffered an underwater period of ~5.5 years in the recovery time of ~3.4 years. Adding a little treasury bond as a hedge reduced the recovery time and underwater time by more than a year. That is A WHOLE YEAR less economic and emotional stress!

Drawdowns forVNQ

Source: Author, with simulator from Portfolio Visualizer, Silicon Cloud Technologies LLC

Conclusions and final thoughts

The Vanguard Real Estate ETF offers an excellent choice for exposure to the REIT space. However, there are disadvantages to be considered too, such as its larger volatility than the overall market

Furthermore, the current overall market valuation is at or near historical high both in terms of price to book value multiples and dividend yield. The combination of high volatility and high valuation calls for hedging ideas, and this article describes such an idea after analyzing the fund’s fundamentals.

And this article describes such an idea after analyzing its fundamentals based on diversification to hedge the risks. The method also slightly improved the total return. But the reduced volatility is more important for conservative investors like myself.

The addition of a little bit of Treasury bond as hedging not only reduces the degree of drawdowns, it also significantly shortens the recovery time and underwater time. More specifically, the method improved the maximum drawdown by about 6~7% at the worst of the times in the past and shortened the recovery time and underwater time by more than a year. Seeing a more than 50% shrink of your total portfolio shrink can be very stressful during the worst times, and a 6~7% improvement and a WHOLE year less of being underwater is a lot – both in economic and emotional terms.

This article was written by

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** Disclosure: I am associated with Sensor Unlimited.

** Master of Science, 2004, Stanford University, Stanford, CA 

Department of Management Science and Engineering, with concentration in quantitative investment 

** PhD,  2006, Stanford University, Stanford, CA 

Department of Mechanical Engineering, with concentration in  advanced and renewable energy solutions

** 15 years of investment management experiences 

Since 2006, have been actively analyzing stocks and the overall market, managing various portfolios and accounts and providing investment counseling to many relatives and friends.

** Diverse background and holistic approach 

Combined with Sensor Unlimited, we provide more than 3 decades of hands-on experience in high-tech R&D and consulting, housing market, credit market, and actual portfolio management. We monitor several asset classes for tactical opportunities. Examples include less-covered stocks ideas (such as our past holdings like CRUS and FL), the credit and REIT market, short-term and long-term bond trade opportunities, and gold-silver trade opportunities. 

I also take a holistic view and watch out on aspects (both dangers and opportunities) often neglected – such as tax considerations (always a large chunk of return), fitness with the rest of holdings (no holding is good or bad until it is examined under the context of what we already hold), and allocation across asset classes.

Above all, like many SA readers and writers, I am a curious investor – I look forward to constantly learn, re-learn, and de-learn with this wonderful community.

Disclosure: I/we have a beneficial long position in the shares of VNQ either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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