The basic idea of buying a broad real estate ETF is to get diversified exposure to the high returns that real estate generates. I strongly support the idea of diversified exposure to real estate in general and particularly in this environment as REITs benefit from inflation and are on the cusp of impressive rental income growth.
However, I think the market is under the false impression that a real estate ETF provides such exposure. It is entirely understandable that one would think the Vanguard Real Estate ETF (NYSEARCA:VNQ) with 164 holdings would be diversified, but there are clear flaws that make it suboptimal in total return performance and overly concentrated in just a few property types.
Vanguard is a respectable and legitimate operator of ETFs. The VNQ cleanly tracks the designated index and has a fairly cheap expense ratio at 12 basis points. My qualm is not with the way the ETF is operated, but rather with the idea of tracking the REIT index in the first place.
There are five critical flaws of the VNQ:
The net result is suboptimal exposure to real estate.
I suspect similar flaws exist in most cap weighted ETFs but I am less privy to their inefficiencies. In studying REITs every day the challenges of the VNQ are readily apparent.
In constructing a passive ETF one typically has to choose either cap weighted or equal weighted. Each method has its problems in that equal weighted results in a substantial overweight to small and micro-cap companies which will cause the ETF to be overly exposed to the risks that come with being subscale.
A market cap weighted ETF such as the VNQ will accurately reflect the publicly traded market. In so doing, it takes on whatever distortions exist in the market. In the case of real estate, the REIT index is quite dissimilar from the real estate market as a whole. The difference lies in the ratio of publicly owned versus privately owned.
Cell towers, for example are a rather small section of the total real estate market, but they are overwhelmingly owned by publicly traded REITs. As such, towers end up being a large portion of the VNQ despite being just a tiny slice of the real estate economy.
The opposite is true of single-family homes which are an enormous part of the real economy but virtually non-existent in the index. Why? Because there are only a couple of REITs that deal in single family homes and their aggregate market cap is not large.
In my eyes this makes the VNQ a non-diversified way of owning real estate. There are two ways to look at diversification in real estate:
Below is the sector breakdown of the VNQ which I think soundly fails both measures of diversification.
To be fair, specialized REITs is a broad bucket category that encapsulates a few property types, namely towers and data centers so no single exposure in the VNQ is 35%. However, there are some 8-12% exposures that are largely a single economic factor.
Thus, despite being a 164-stock portfolio, one is really only getting the diversification of a roughly 10-stock portfolio. Quite simply, when you already own an office REIT, buying a second, third, fourth, and fifth office REIT doesn't really do much in terms of diversification. Maybe it minimizes idiosyncratic single stock risk, but factor exposures are still rather rough.
As seen above, office is now a 7.1% weight in the VNQ, but rewind about five years to before office became the troubled asset class that it is today and it was closer to a 15%-20% weight depending on the quarter in which one looked. Retail was also a massive sector exposure for VNQ back then.
So how did these huge exposures drop to 7.1% and 10.5% respectively?
They performed poorly.
A continual problem with market cap weighted indices is that they chase performance. The exposure will necessarily be at a maximum when a sector is on top of the world and at a minimum when a sector is out of favor. This causes a tendency to be overweight overvalued and underweight that which is undervalued.
Coming out of the financial crisis, Industrial was just a small sliver of the VNQ, but now that industrial is king it is one of the larger sector exposures. As the market continues to flux, the performance chasing inherent in market cap weighting will systematically lead to one having lower levels of exposure on the way up and higher levels of exposure on the way down. That is buy high and sell low. The opposite of what one should be doing.
This problem is not unique to the VNQ, but really the problem with index investing in general. Passive share was much lower back in 2000, but rest assured it would have been chock full of dot-com names right before the bubble burst. This is not speculation on my part. It is just mathematically how it works.
There are 21 real estate property types that are available in publicly traded companies. The VNQ only has meaningful exposure to about 12 of them. Some of the omitted property types also happen to be among the strongest fundamental areas.
The portion of one's portfolio that goes into a given exposure should be based on fundamental strength, not on prevalence within an index.
Most REITs are owned somewhere between 7% and 15% by Vanguard, most of which comes through the VNQ. As an example we can look at Prologis (PLD) which is now the largest REIT.
Vanguard owns 13%.
Once it is in there it is fine but the process of getting in can be quite bumpy. There is a minimum size threshold for a REIT to be included in the VNQ and right now that is approximately $600 million.
As a REIT crosses this threshold it often gets added to the underlying index at the next review period and the VNQ proceeds to buy a large portion of outstanding shares. The influx of buying against the low trading volume of the small cap issue will quite consistently cause it to jump up in price anywhere from 3% to 10% as the VNQ takes in its shares.
As an active trader, I love this because it is one of the most predictable price movements and quite easy to take advantage of.
For a VNQ investor, however, it is a bad thing because it means the VNQ is potentially having to pay 3%-10% above the previous VWAP (volume weighted average price) to get the shares.
While Vanguard has put together an honest and clean instrument for investing in the REIT index, the index itself is flawed. I believe the five critical issues discussed above will cause VNQ to systematically underperform real estate as an asset class.
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