5 Critical Flaws Of The Vanguard Real Estate ETF

May 05, 2022 2:13 PM ETVanguard Real Estate ETF (VNQ)AMH, ARE, ELS, INVH, LAND, PLD, SUN, UMH72 Comments


  • While REITs are opportunistic right now, VNQ is not the right way to buy them.
  • This article discusses problems inherent with VNQ.
  • I think it will systematically underperform real estate as an asset class.
  • Looking for a helping hand in the market? Members of Portfolio Income Solutions get exclusive ideas and guidance to navigate any climate. Learn More »

Text Real Estate Investment Trust on new house background

Vladimir Zakharov/iStock via Getty Images

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.

VNQ - The Sell And Replace Thesis

There are five critical flaws of the VNQ:

  1. Not representative of the actual real estate economy
  2. Not a diversified exposure
  3. Adverse purchase and sale activity based on momentum
  4. Entirely omits key property types
  5. Incidental market distortion upon inclusion

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.

Market Cap Weighting

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:

  1. Matching the exposures of the real economy such that if real estate as an entire asset class does well you will do well.
  2. Minimizing exposure to any single factor such that no single failure can result in large losses.

Below is the sector breakdown of the VNQ which I think soundly fails both measures of diversification.

Chart, pie chart Description automatically generated


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.

Omission By Insignificant Weight In Key Property Types

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.

  • Manufactured housing is the fastest growing sector as measured by organic same store NOI growth yet it is less than 2% of the VNQ as of 3/31/22 - 1.13% Sun Communities (SUN) 0.74% Equity Lifestyle (ELS) and 0.07% UMH Properties (UMH).
  • Farmland is a $2.6 trillion asset class in the U.S yet only a 0.07% exposure in the VNQ via Gladstone Land (LAND)
  • Single family homes are the largest portion of real estate by value yet only 2% of the VNQ - 1.33% Invitation Homes (INVH) and 0.67% American Homes for Rent (AMH).
  • Life science labs are in high demand, experiencing rent rollups of around 30% yet the VNQ only has a 1.64% exposure via Alexandria (ARE)

The portion of one's portfolio that goes into a given exposure should be based on fundamental strength, not on prevalence within an index.

Incidental Market Distortion From Inclusion

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.

Graphical user interface, table Description automatically generated

S&P Global Market Intelligence

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.

Wrapping It Up

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.

I would like to present a better way to invest in REITs.  Use my research to guide you into a diversified group of REITs, each hand-selected for its outperformance potential.  Right now, you can access all of my picks, analytics, spreadsheets, REIT data sets and my expertise on Portfolio Income Solutions at a discounted price.  

Why the discount?  Because the market is cheap right now and I like the idea of you getting in at an opportunistic time.  The sale ends after this article so grab your free trial today!

This article was written by

Dane Bowler profile picture
Access professional analysis and a curated high yield portfolio

2nd Market Capital Advisory specializes in the analysis and trading of real estate securities. Through a selective process and consideration of market dynamics, we aim to construct portfolios for rising streams of dividend income and capital appreciation.

Our Portfolio Income Solutions Marketplace service provides stock picks, extensive analysis and data sheets to help enhance the returns of do-it-yourself investors.

Investment Advisory Services

We now offer a way to directly invest in our Proprietary Investment Portfolio Strategy via REIT Total Return, which replicates our activity in client accounts. Total Return client’s brokerage accounts are automatically invested simultaneously and at the same price when we make a trade in the REIT Total Return Portfolio (also known as 2CHYP).

Learn more about our REIT Total Return Portfolio.

Dane Bowler, along with fellow SA contributors Simon Bowler and Ross Bowler, is an investment advisory representative of 2nd Market Capital Advisory Corporation (2MCAC). As a state registered investment advisor, 2MCAC is a fiduciary to our advisory clients.

Full Disclosure. All content is published and provided as an information source for investors capable of making their own investment decisions. None of the information offered should be construed to be advice or a recommendation that any particular security, portfolio of securities, transaction, or investment strategy is suitable for any specific person. The information offered is impersonal and not tailored to the investment needs of the specific person. Please see our SA Disclosure Statement for our Full Disclaimer.

Disclosure: I/we have a beneficial long position in the shares of UMH, ARE 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.

Additional disclosure: Important Notes and Disclosure
All articles are published and provided as an information source for investors capable of making their own investment decisions. None of the information offered should be construed to be advice or a recommendation that any particular security, portfolio of securities, transaction, or investment strategy is suitable for any specific person.
The information offered is impersonal and not tailored to the investment needs of any specific person. Readers should verify all claims and do their own due diligence before investing in any securities, including those mentioned in the article. NEVER make an investment decision based solely on the information provided in our articles.
It should not be assumed that any of the securities transactions or holdings discussed were profitable or will prove to be profitable. Past Performance does not guarantee future results. Investing in publicly held securities is speculative and involves risk, including the possible loss of principal. Historical returns should not be used as the primary basis for investment decisions.
Commentary may contain forward looking statements which are by definition uncertain. Actual results may differ materially from our forecasts or estimations, and 2MC and its affiliates cannot be held liable for the use of and reliance upon the opinions, estimates, forecasts, and findings in this article.
S&P Global Market Intelligence LLC. Contains copyrighted material distributed under license from S&P
2nd Market Capital Advisory Corporation (2MCAC) is a Wisconsin registered investment advisor. Dane Bowler is an investment advisor representative of 2nd Market Capital Advisory Corporation.

Recommended For You

Comments (72)

To ensure this doesn’t happen in the future, please enable Javascript and cookies in your browser.
Is this happening to you frequently? Please report it on our feedback forum.
If you have an ad-blocker enabled you may be blocked from proceeding. Please disable your ad-blocker and refresh.