With more and more investors searching for high yield opportunities to protect their assets from rising inflation, ETFs that offer exposure to Real Estate REITs like Vanguard's Real Estate ETF (NYSEARCA:VNQ) are often proposed as such. As I will discuss in this analysis, however, today's valuation and yield, as well as past performance, indicate that investors should probably look elsewhere for high-quality income-generating investments.
With Assets Under Management (AUM) of $45.57B, VNQ is the largest Real Estate ETF on the market, followed by iShares' U.S. Real Estate ETF (IYR) and Schwab's US REIT ETF (SCHH). Both however have combined AUM that amount to less than a third of VNQ's assets under management.
VNQ holds positions in stocks issued by real estate investment trusts (REITs) and aims to track the MSCI US Investable Market Real Estate 25/50 Index. The Vanguard Real Estate ETF has an MSCI ESG Fund Rating of BBB based on a score of 5.88 out of 10. The fund's 10 largest holdings, as of the 31st of October 2021, are shown below.
While VNQ is often presented as a high-yield choice for income-oriented investors who want some diversification away from stocks, the truth is at current price and yield levels (3.02% TTM) it would be hard to argue for it in that sense. In a rising inflation environment, investors should be searching for higher yields than what the fund has to offer. Many well-known, quality REITs like W.P. Carey (WPC), Realty Income (O), STORE Capital (STOR) and more offer higher yields, while at the same time maintaining diversified tenant/client bases to achieve high occupancy rates.
It is also important to consider that the Real Estate market has recently seen a historic run-up in prices, stretching asset valuations. It is likely that growth rates for ETFs like VNQ will decrease as a possible correction looms.
Vanguard's Real Estate ETF has established itself as the number one choice for investors looking for some exposure in real estate. In this part of the analysis, I will compare VNQ against its two main rivals (IYR and SCHH). Starting with the expense ratio, SCHH is the least costly with an expense ratio of 0.07%, while IYR charges the highest amount at 0.41%. Vanguard's fund is also pretty inexpensive, charging 0.12%. For perhaps the most important metric for a Real Estate ETF, the dividend yield (TTM), VNQ stands ahead of the competition with a 3.02% yield while IYR and SCHH offer 1.72% and 1.94% yields respectively. Dividend growth rates for all three ETFs as well as a few volatility metrics are provided below.
While in terms of volatility all three funds are indistinguishable, VNQ appears to be the winner in terms of dividend performance. Total returns over the last decade once again put VNQ somewhat ahead of its peers, as shown in the chart below.
To determine the performance as well as the volatility effects of including a fund like VNQ in a portfolio, I performed some backtesting in a basic form, using Portfolio Visualizer. For the first simulation, three portfolios were selected and performance/volatility was examined from 2005 onwards. The first portfolio consisted solely of an S&P 500 ETF, SPDR's SPY in our case, the second portfolio included a 20% weight in the VNQ ETF, while the final portfolio was formed using equal weights for both the S&P 500 and the REIT ETFs. A $10,000 beginning balance, dividend reinvestment and annual rebalancing were assumed. As shown below, the addition of the VNQ ETF negatively affected returns, with the CAGR for the entire period dropping from 10.3% when we invest 100% of the capital in the S&P, to 9.5% in a split asset allocation scenario. One thing to note would be that in reality, the performance difference should be a bit wider since VNQ comes with a slightly higher expense ratio as well, a fact that the model does not take into account. Furthermore, while someone would at least expect the addition of the real estate ETF to reduce volatility, this is not the case either. Both in terms of standard deviation and maximum drawdown, the inclusion of VNQ seems to invite more volatility. Finally, risk-adjusted returns as measured by the Sharpe Ratio were the highest in the first portfolio.
After processing the outcomes of the backtesting above, I believe there are (at least) two notes/arguments towards the model that should be made. The first one has to do with volatility. We could argue that a portfolio invested solely in the S&P 500 is very well diversified and there is in fact no more unsystematic risk to do away with. After all, the S&P 500 has on its own some exposure to real estate, and even according to Markowitz's Modern Portfolio Theory 30 stocks should be enough to diversify away unsystematic risk, therefore the S&P 500 fulfills that mission. Maybe adding a REIT ETF to a portfolio that contains a few individual stocks would actually have some volatility-alleviating impact. The second argument involves a more careful observation of the performance chart. It is apparent that the performance gap is established after the Covid-19 crash in 2020, and continues from then on. This period has seen a huge run-up in stocks to what many analysts believe to be overpriced territories. As a result, perhaps the gain in performance might just be an indicator of stocks being currently overvalued and is bound to fade in the future.
While compared to its peers in the Real Estate REIT ETF field, VNQ appears to present a marginally better choice, I remain skeptical of its prospects, at least in the near term. The dividend yield is far lower than what it used to be and performance is expected to lag stock ETFs, especially if assets in Real Estate experience a slowdown in growth, or if inflation rises even higher. I rate the fund as a hold (neutral rating) for now, and advise the search for better alternatives.
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Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. 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.