Tag Archives: marketplace

VNQ: Take The 3.85% Yield; Duplication Is Rarely Worth It

Summary I’ve been getting questions about why investors should choose VNQ over buying largest holdings within VNQ. VNQ offers substantially better diversification than investors can create by replicating the top holdings. The ETF yield is surprisingly similar to the yields across the top holdings. If an investor is committed to a plan of dollar cost averaging, VNQ offers a smart way to minimize trading costs. Vanguard REIT Index ETF (NYSEARCA: VNQ ) offers investors strong distribution yields at a rate of 3.89%. However, some investors are contemplating if they would be better off simply buying the top 5 or 10 holdings of VNQ to avoid the expense ratio and generate more income by concentrating their investments in the REITs with the highest yields. It’s a reasonable idea and it is worth some discussion. I wanted to offer a thorough response on some of the reasons that I believe investing in VNQ is superior to trying to replicate the portfolio through buying the top ten holdings. Holdings I put together a quick chart showing the recent holdings of VNQ based on their most recent market values. (click to enlarge) The top 10 holdings make up about 37% to 38% of the value of the ETF. That is a fairly substantial portion, but not substantial enough that it would make it easy to duplicate the fund by buying the top holdings. An investor that only buys the top 10 would still be missing out on a very substantial amount of diversification from the other 62% or so of the portfolio. Dividend Yields I put together a chart showing the dividend yields on each of the top 10 positions. For the convenience of readers, I kept the holdings in the same order rather than sort them by the highest dividend yields: (click to enlarge) There are certainly a few REITs in this ETF that are paying much higher yields than the main portfolio, but investors focusing on only the highest yield REITs will be putting themselves at risk for slower growth in the pay outs or more risk to the dividend itself. Higher yields are often related to higher levels of risk, so holding only the highest yielding REITs would result in a significantly higher concentration of risk. If you were to take the average yield (equally weighted) of the top 5 REITs, you would have 4.018%. If you take the average yield across the top 10, it is 3.764%. This suggests that all around VNQ is paying a fairly similar level of dividends to what an investor would expect if they focused on buying the top 5 or top 10 holdings by market value in an equally weighted portfolio. Expense ratios are fairly low The Vanguard REIT Index ETF has an expense ratio of only .12%. That does cost shareholders money compared to simply holding all of the underlying securities, but the cost is fairly low compared to the benefits. In exchange for the .12% ratio the investors are able to buy shares in a high liquid ETF with the spread is frequently one cent. On a share price that is floating around $77, that is a very attractive bid ask spread. For comparison, at the time of my checking Simon Property Group, Inc. ( SPG) had a 4 cent bid ask spread on a price around $176 (slightly better larger than VNQ), P ublic Storage (P SA) had a spread of 4 cents on a price around $187, Equity Residential ( EQR) had a spread of 1 cent on shares running around $70 (about equal to VNQ), and Health Care REIT, Inc. ( HCN) had a spread of 2 cents on a price slightly under $70. In short, the Bid-Ask spread on even the largest equity REITs is slightly worse than the spread on VNQ. Granted, if you have an indefinite holding time period the spread is only an issue when purchasing, but it does increase the cost of buying into the position. If an investor has free trading on VNQ (some brokerages do), then their trading cost to buy into positions is limited to crossing the spread. If an investor is simply doing a buy and hold with a 40 year time frame, this isn’t a huge consideration. For the investor with a 40 year time frame that is buying their REITs in one single purchase, it makes sense to replicate the fund. For an investor with a long time frame that intends to continue investing REITs by buying into their position every month or every quarter for dollar cost averaging, it would be better to take advantage of the low spreads and look for a brokerage that is offering no commissions on VNQ. Conclusion While it would be possible to generate higher yields than VNQ by picking the equity REITs with the highest yields, it would also leave an investor facing significantly more diversifiable risk. The extra income may be nice and replicating the portfolio through buying a very large volume of the securities (you’d need more than 10) would make sense for a long term investor that does not plan to be investing new money every month or every quarter. For the investor that is planning to dollar cost average into their investments and builds them up over a period of years, the purchases will be more frequent and the investor may save more on trading commissions and spreads than they lose on the expense ratio. Whether this works or not will depend on the individual investor. My dollar cost averaging strategy puts in place a minimum amount of purchasing activity for REITs, but I will occasionally add to the position when I see share prices fall. Disclosure: The author is long VNQ. (More…) The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article. Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis.

MORT: An ETF Yielding 10% That Is Worthy Of Replicating

Summary MORT offers investors exposure to several mREITs, but the portfolio only holds 25 total mREITs. An investor planning on a long term investment could find significantly better performance by negotiating with a brokerage for free trades. If I were building an ETF for mREITs, I would make some major changes to the allocation. If you’re contemplating investing in the mREIT industry, you should know that there are significant benefits to diversification as each mREIT has a different strategy. One way for investors to achieve that level of diversification is to buy the Market Vectors Mortgage REIT Income ETF (NYSEARCA: MORT ). The ETF offers investors a fairly solid dividend yield and some diversification between mREITs, but as an mREIT analyst I’m not blown away with the investment opportunity. Challenges for MORT The first challenge is that the ETF is trading at a premium of about .4% to the NAV. That’s a large enough premium for investors to be wary of investing. Since inception, the average premium to NAV has been .06%. I don’t see any reason for investors paying a .4% premium to believe that they will recoup the premium when they sell shares. The second challenge is that investors planning to hold shares indefinitely have a superior option. The ETF only holds 25 securities. If investors are dedicated to building an income portfolio from mREITs, they can contact a few brokerage firms and arrange an offer to receive a substantial volume of free trades for opening an account there or moving an existing account to the brokerage. If the investor puts in the time to arrange an account with free trades, they have the opportunity to buy up the holdings without paying the .4% premium. Of course, investors may recognize that the work required to set up the new account would be substantial and the return on their time wouldn’t be that attractive. The return on time wouldn’t be that bad If investors are serious about building a large mREIT portfolio and holding it for a long time, the work of managing the portfolio is fairly simple. The investors would simply need to determine if they wanted dividends reinvested or not and check the appropriate box. There would be no other need to manage the portfolio, which makes it very desirable for long term investors to avoid the substantial expense ratio. The expense ratio The Market Vectors Mortgage REIT Income ETF charges investors a net expense ratio of .41%, but has a gross expense ratio of .60%. Some analysts will tell investors that they should only be concerned with the net expense ratio of an ETF. In the short term, it is reasonable to assume that the costs that are relevant to investors are the costs they are paying to have the ETF managed. For investors looking for a long term holding, the gross expense ratio provides an indication of where the expense ratio might go in the future. I checked the prospectus to look at the terms for maintaining the net expense ratio. The expense ratio is contracted through September 1st, 2015. After that point, it is expected to continue at .41% until the Fund’s Board of Trustees acts to discontinue all or part of the limitation to the expense ratio. That gives me confidence that the expense ratio will be limited to .41% until it ceases to be. Basically, the expense ratio is stuck at .41% until it changes. Let’s say the returns on the mREIT industry are actually decent over the next 20 years and we see values (with dividends reinvested) rising by a 9% annual growth rate. An investor holding the individual stocks with no expense ratio would see their investment climb to 560.44% of the starting value. The investor paying the expense ratio of .41% per year would have their portfolio value climb to 519.75% of the starting value. In my opinion, that is a fairly substantial difference in the ending values of the portfolio. While saving .4% on the initial investment may not be worth negotiating a deal for free trades may not be worth it to save .4%, it should be worth it when the ending portfolio value is growing by over 7.8%. My views You can put me down for bearish if I’m comparing the performance of MORT to the performance of the mREIT industry. You can put me down for thoroughly bullish if I’m comparing the investment to holding cash for a decade. Returns should be positive, but I would expect them to fall short of a reasonable index for measuring the performance due to the expenses. Holdings The following chart shows the top 10 holdings of the portfolio by market value. They represent over 72% of the total value of the ETF. (click to enlarge) If I were building a mortgage ETF, I would lower the weight on Annaly Capital Management (NYSE: NLY ). I would still include it for diversification, but weighting the mREITs by market cap is far from an optimal strategy and doesn’t produce the highest risk adjusted returns. The best weighting system possible for the mREITs would be to have a portfolio manager that is extremely familiar with the mREITs going through each mREIT and considering their exposure to interest rate and credit risk factors. Then an entire portfolio of mREIT companies could be designed to avoid excessive concentration of risk factors that could have been effectively diversified. That would require an enormous amount of work, but would be worthwhile for an enormous ETF tracking mREITs. That may be part of the problem; a market cap of $116 million leaves MORT substantially less liquid than many of the mREITs it is holding. It also means the .41% expense ratio is only providing gross fees of under $500,000. Given that the ETFs will have administrative and trading costs in management, it may be difficult for a fund to provide returns to the sponsor while also paying an expert to design the exposures and to reevaluate those exposures on an annual basis. If a major producer of ETFs like Vanguard or Schwab decided to get into this space, I believe they could put together that combination of mREITs and generate a large enough volume of assets under management to provide a suitable return. Comparing MORT to REM Another option for investors in this space is the iShares Mortgage Real Estate Capped ETF (NYSEARCA: REM ). My views on REM are not substantially different from my views on MORT. REM is offering investors a .48% expense ratio on both gross and net, so higher than MORT currently but without a scheduled increase. It should be noted that the scheduled increases are often delayed, so it is unclear which ETF will have a lower expense ratio a year from now. When it comes to the holdings of the two mREITs, I would consider REM’s portfolio to be slightly more attractive because it holds 38 companies (relative to 25 for MORT) and it has a lower allocation to the top equities. At the present time, I think the ETFs that are available may be superior to investor blindly picking a single holding. However, the high expense ratios and concentration in the largest mREITs make each ETF less desirable as a long term holding. Investors planning on a very long term holding should become familiar with the industry and build their own portfolio. Conclusion I would expect positive total returns for shareholders of MORT over a long time period, but I would expect dramatically better performance by an investor that focused on buying and holding positions in the underlying stocks. If I was designing this portfolio, I would probably overweight holdings like Blackstone Mortgage Trust (NYSE: BXMT ) since their portfolio has substantial diversification benefits . Then I would overweight Dynex Capital (NYSE: DX ) and CYS Investments (NYSE: CYS ) for having internal management teams that are better aligned with shareholder interests. I’d keep American Capital Agency (NASDAQ: AGNC ) as a heavy weight despite the external management structure because the team has a solid track record of success. I wouldn’t overweight Annaly Capital Management despite the large market cap because the mREIT combines an external management agreement with a CEO that has a short track record at the helm and negative returns over the few years she has been leading the mREIT. Disclosure: The author is long DX. (More…) The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article. Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis.