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Summary The portfolio construction of IYR is easy to admire. They took the risk of making the second heaviest weighting an equity REIT with extreme levels of operational leverage. They even incorporate a very small weighting to mREITs which further diversifies the portfolio. A heavy allocation to REITs makes more sense for investors that are weak on bond positions. Investors should be seeking to improve their risk adjusted returns. I’m a big fan of using ETFs to achieve the risk adjusted returns relative to the portfolios that a normal investor can generate for themselves after trading costs. One of the funds that I’m considering is the iShares U.S. Real Estate ETF (NYSEARCA: IYR ). I’ll be performing a substantial portion of my analysis along the lines of modern portfolio theory, so my goal is to find ways to minimize costs while achieving diversification to reduce my risk level. Expense Ratio The expense ratio on IYR is .43%. Compared to other domestic equity funds like the Vanguard REIT Index ETF (NYSEARCA: VNQ ) or the Schwab U.S. REIT ETF (NYSEARCA: SCHH ), that is painfully high. VNQ charges .12% and SCHH charges .07%. Because I love diversification at low costs, I’m holding both VNQ and SCHH in my personal portfolio. Largest Holdings (click to enlarge) A large position to Simon Property Group (NYSE: SPG ) is a fairly normal starting point for most REIT ETFs. The very interesting thing about this portfolio is that they are using American Tower REIT Corp (NYSE: AMT ) as the second holding. For investors that are not familiar with AMT, they are a global telecommunications REIT. When you place a call from your cell phone, you may be using the services AMT provides as they contract with cellular companies to lease usage of their cell phone towers. The REIT has a very weak dividend yield and from most pricing metrics it looks absurdly expensive. The reason investors have kept shares of AMT so expensive is because their structure incorporates an enormous amount of operating leverage. When they go from having one client to two clients for a cell phone tower the variable costs are extremely low while the revenue scales up substantially. This is an interesting play because most holders of a REIT index would be looking to use the position to grab some dividends and AMT has fairly weak dividends. On the other hand, AMT is one of three major companies in their very small sector and there is the potential for excellent returns. This is a play with high risk and high potential returns. The best way to make those kinds of high risk plays is within the context of a diversified portfolio, so it makes sense that it would get a significant allocation within an ETF. Simply put, this strategy makes more sense from a diversification perspective than it does when we are considering why the investor might initially choose to buy a REIT ETF. Sector Exposure This breakdown of the sector exposure reinforces what I was seeing in the initial holdings chart. The heavy position in specialized REITs suggests a goal of using the ETF structure to create a portfolio that is substantially less volatile than the underlying holdings. Overall, I like the strategy in the portfolio construction. While I’d like to see more breakdowns on the “specialized” sector, I have to admit that I really admire seeing the ETF work to incorporate other types of holdings such as mREITs. That sector is highly complex and I spend a great deal of my time explaining it to investors. If investors get their exposure through a very small allocation within a REIT ETF, that would be a solid way to prevent the common investor mistakes of buying high and selling low which seems to be extremely common in the mREIT sector. Building the Portfolio The sample portfolio I ran for this assessment is one that came out feeling a bit awkward. I’ve had some requests to include biotechnology ETFs and I decided it would be wise to also include a the related field of health care for a comparison. Since I wanted to create quite a bit of diversification, I put in 9 ETFs plus the S&P 500. The resulting portfolio is one that I think turned out to be too risky for most investors and certainly too risky for older investors. Despite that weakness, I opted to go with highlighting these ETFs in this manner because I think it is useful to show investors what it looks like when the allocations result in a suboptimal allocation. The weightings for each ETF in the portfolio are a simple 10% which results in 20% of the portfolio going to the combined Health Care and Biotechnology sectors. Outside of that we have one spot each for REITs, high yield bonds, TIPS, emerging market consumer staples, domestic consumer staples, foreign large capitalization firms, and long term bonds. The first thing I want to point out about these allocations are that for any older investor, running only 30% in bonds with 10% of that being high yield bonds is putting yourself in a fairly dangerous position. I will be highlighting the individual ETFs, but I would not endorse this portfolio as a whole. The portfolio assumes frequent rebalancing which would be a problem for short term trading outside of tax advantaged accounts unless the investor was going to rebalance by adding to their positions on a regular basis and allocating the majority of the capital towards whichever portions of the portfolio had been underperforming recently. Because a substantial portion of the yield from this portfolio comes from REITs and interest, I would favor this portfolio as a tax exempt strategy even if the investor was frequently rebalancing by adding new capital. The portfolio allocations can be seen below along with the dividend yields from each investment. Name Ticker Portfolio Weight Yield SPDR S&P 500 Trust ETF SPY 10.00% 2.11% Health Care Select Sect SPDR ETF XLV 10.00% 1.40% SPDR Biotech ETF XBI 10.00% 1.54% iShares U.S. Real Estate ETF IYR 10.00% 3.83% PowerShares Fundamental High Yield Corporate Bond Portfolio ETF PHB 10.00% 4.51% FlexShares iBoxx 3-Year Target Duration TIPS Index ETF TDTT 10.00% 0.16% EGShares Emerging Markets Consumer ETF ECON 10.00% 1.34% Fidelity MSCI Consumer Staples Index ETF FSTA 10.00% 2.99% iShares MSCI EAFE ETF EFA 10.00% 2.89% Vanguard Long-Term Bond ETF BLV 10.00% 4.02% Portfolio 100.00% 2.48% The next chart shows the annualized volatility and beta of the portfolio since October of 2013. (click to enlarge) Risk Contribution The risk contribution category demonstrates the amount of the portfolio’s volatility that can be attributed to that position. You can see immediately since this is a simple “equal weight” portfolio that XBI is by far the most risky ETF from the perspective of what it does to the portfolio’s volatility. You can also see that BLV has a negative total risk impact on the portfolio. When you see negative risk contributions in this kind of assessment it generally means that there will be significantly negative correlations with other asset classes in the portfolio. The position in TDTT is also unique for having a risk contribution of almost nothing. Unfortunately, it also provides a weak yield and weak return with little opportunity for that to change unless yields on TIPS improve substantially. If that happened, it would create a significant loss before the position would start generating meaningful levels of income. A quick rundown of the portfolio I put together the following chart that really simplifies the role of each investment: Name Ticker Role in Portfolio SPDR S&P 500 Trust ETF SPY Core of Portfolio Health Care Select Sect SPDR ETF XLV Hedge Risk of Higher Costs SPDR Biotech ETF XBI Increase Expected Return iShares U.S. Real Estate ETF IYR Diversify Domestic Risk PowerShares Fundamental High Yield Corporate Bond Portfolio ETF PHB Strong Yields on Bond Investments FlexShares iBoxx 3-Year Target Duration TIPS Index ETF TDTT Very Low Volatility EGShares Emerging Markets Consumer ETF ECON Enhance Foreign Exposure Fidelity MSCI Consumer Staples Index ETF FSTA Reduce Portfolio Risk iShares MSCI EAFE ETF EFA Enhance Foreign Exposure Vanguard Long-Term Bond ETF BLV Negative Correlation, Strong Yield Correlation The chart below shows the correlation of each ETF with each other ETF in the portfolio. Blue boxes indicate positive correlations and tan box indicate negative correlations. Generally speaking lower levels of correlation are highly desirable and high levels of correlation substantially reduce the benefits from diversification. (click to enlarge) Conclusion IYR has a great portfolio construction methodology for investors that want some diversified exposure to equity REITs. The dividend yield of 3.83% isn’t mind blowing, but it is higher than the yield on SCHH. Of course, investments in mREITs should help strengthen the dividend yield to make up for REITs like AMT that are priced based on expected future revenue growth combined with exceptional operational leverage. The only thing I really dislike in this ETF is that the expense ratio is just too high. I can’t justify paying that kind of expense ratio for a REIT ETF. If an investor is willing to put up with the huge expense ratio, they should take notice that the fund has a positive correlation with the long term bond portfolio in BLV. That can be difficult because investors would like to be able to use the negative correlations to hammer the portfolio volatility lower. On the other hand, the moderate correlation with the S&P 500 makes it a reasonable option for investors that intend to be running a portfolio that is very heavy on equities. I fall under that category. I run extremely heavy on equities and use a significantly higher allocation to equity REITs than I would if I were running a strong bond allocation. Scalper1 News
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