5 Critical Flaws Of The Vanguard Real Estate ETF (NYSEARCA:VNQ) | Ezine Daddy

Vladimir Zakharov/iStock via Getty Images

The basic idea of ​​buying a broad real estate ETF is to gain diversified exposure to the high returns that real estate generates. I strongly support the idea of ​​diversified exposure to real estate in general and especially in this environment as REITs are benefiting from inflation and are on the cusp of impressive rental income growth.

However, I believe the market has the wrong impression that a real estate ETF offers such exposure. It is quite understandable that the Vanguard Real Estate ETF (NYSEARCA:VNQ) at 164 positions would be diversified, but there are clear flaws that mean total returns are subpar and overly concentrated in just a few property types.

Vanguard is a reputable and legitimate operator of ETFs. The VNQ tracks the designated index cleanly and has a fairly favorable expense ratio of 12 basis points. My concern is not with the way the ETF is operated, but primarily with the idea of ​​replicating the REIT index.

VNQ – The Sell and Replace Thesis

There are five critical flaws of the VNQ:

  1. Not representative of the current real estate industry
  2. No diversified exposure
  3. Adverse buying and selling activity based on momentum
  4. Omits key property types entirely
  5. Random market distortion upon inclusion

The net result is subpar exposure to real estate.

I suspect there are similar flaws in most cap-weighted ETFs, but I’m less privy to their inefficiencies. When studying REITs on a daily basis, the challenges of the VNQ become clear.

market capitalization

When constructing a passive ETF, one usually has to choose between cap-weighted or equally weighted. Each method has its problems, as equal weighting results in a significant overweight to small and micro-cap companies, leaving the ETF overly exposed to the risks associated with undervaluation.

A market cap-weighted ETF like the VNQ accurately reflects the publicly traded market. In doing so, it takes on any market distortions. When it comes to real estate, the REIT index differs significantly from the real estate market as a whole. The difference lies in the ratio of public to private ownership.

Cell towers, for example, are a rather small part of the overall real estate market, but they’re overwhelmingly owned by public REITs. Therefore, towers end up making up a large part of the VNQ even though they are only a tiny part of the real estate economy.

The opposite is true for single-family homes, which account for a huge proportion of the real economy but are virtually non-existent in the index. Why? Because there are few REITs that deal in single-family homes and their total market cap isn’t large.

In my view, this makes the VNQ a non-diversified way of owning real estate. There are two ways to look at real estate diversification:

  1. Match exposures to the real economy so that when real estate performs well as an overall asset class, you do well.
  2. Minimizing exposure to a single factor so that no single failure can result in large losses.

Below is the sector breakdown of the VNQ, which I think falls well short of both diversification measures.

Diagram, pie chart description generated automatically

vanguard

To be fair, specialty REITs are a broad category that includes a few property types, namely towers and data centers, so no single exposure to the VNQ is 35%. However, there are around 8-12% exposures that are mostly a single economic factor.

So even though it’s a 164-stock portfolio, you really only get the diversification of a roughly 10-stock portfolio. It’s simple: If you already own an office REIT, buying a second, third, fourth, and fifth office REIT doesn’t really add much in terms of diversification. Maybe it minimizes idiosyncratic single stock risk, but factor exposures are still pretty crude.

As seen above, Office is now 7.1% weight in the VNQ, but some five years before Office became the troubled asset class it is today, and closer to a 15% to 20% weight depending on the quarter % lay you saw. Retail was also a massive industry commitment for VNQ at the time.

How did those huge exposures drop to 7.1% and 10.5% respectively?

You did badly.

A constant problem with market-cap weighted indices is that they chase performance. Engagement is necessarily maximum when a sector is world-leading and minimum when a sector is unpopular. This leads to a tendency to overweight the overvalued and underweight the undervalued.

After the financial crisis, Industrial was just a small part of the VNQ, but now that Industrial is king, it’s one of the larger sector exposures. As the market moves, the hunt for performance associated with market cap weighting systematically results in having less exposure on the way up and more exposure on the way down. That is, buy high and sell low. The opposite of what one should do.

This problem is not unique to the VNQ, it really is the problem with index investing in general. The passive share was much lower in 2000, but rest assured it would have been chock full of dot-com names just before the bubble burst. This is not speculation on my part. It’s just mathematical how it works.

Omission due to insignificant weight in key property types

There are 21 property types available in publicly traded companies. The VNQ only has significant involvement with about 12 of them. Some of the omitted trait types also happen to be among the strongest fundamental domains.

  • Manufactured housing is the fastest growing sector in terms of same-business organic NOI growth, but is less than 2% of 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 US but only 0.07% exposure to the VNQ via Gladstone Land (LAND).
  • Single-family homes make up the bulk of real estate by value, but make up just 2% of the VNQ — 1.33% Invitation Homes (INVH) and 0.67% American Homes for Rent (AMH).
  • Life science labs are in high demand, seeing rent increases of around 30%, yet the VNQ only has a 1.64% stake through Alexandria (ARE).

The portion of one’s portfolio that invests in a particular exposure should be based on fundamental strength, not prevalence within an index.

Random market distortion by inclusion

Most REITs are owned between 7% and 15% by Vanguard, most of which comes through the VNQ. As an example, we can consider Prologis (PLD), which is now the largest REIT.

Graphical user interface, table description generated automatically

S&P Global Market Intelligence

Vanguard owns 13%.

Once in, it’s fine, but the process of getting in can be pretty bumpy. There is a minimum size for a REIT to be included in the VNQ, and currently it’s around $600 million.

When a REIT breaks this threshold, it is often added to the underlying index in the next reporting period, and the VNQ buys a large chunk of the outstanding shares. The influx of buying against the small-cap issue’s low trading volume will fairly consistently see the price rise between 3% and 10% as VNQ takes over its shares.

As an active trader, I love this because it’s one of the most predictable price movements and it’s pretty easy to use.

However, for a VNQ investor, this is a bad thing as the VNQ may have to pay 3% to 10% above the previous VWAP (volume weighted average price) to get the shares.

packaging

While Vanguard has put together an honest and clean tool for investing in the REIT index, the index itself is flawed. I believe that the five critical points discussed above will cause VNQ to systematically underperform real estate as an asset class.

Leave a Comment