Tag Archives: opinion

Looking For REIT ETFs? Only 2 Of These 3 Should Be On Your Watch List

Summary These ETFs offer respectable dividend yields by investing in REITs. I see VNQ as the top ETF in the batch, but if either were to beat VNQ over the long term I think IYR has a better chance of doing. Due to similarity of holdings between VNQ and FRI, it would be difficult for FRI’s underlying assets to outperform VNQ’s assets by enough to cover the expense ratio difference. One of the areas I frequently cover is ETFs. I’ve been a large proponent of investors holding the core of their portfolio in high quality ETFs with very low expense ratios. The same argument can be made for passive mutual funds with very low expense ratios, though there are fewer of those. In this argument I’m doing a quick comparison of a few domestic equity REITs ETFs that investors may be contemplating. Ticker Name Index IYR iShares U.S. Real Estate ETF Dow Jones U.S. Real Estate Index VNQ Vanguard REIT Index ETF MSCI US REIT Index FRI First Trust S&P REIT Index ETF S&P United States REIT Index Dividend Yields I charted the dividend yields from Yahoo Finance for each portfolio. While IYR and VNQ are both yielding a little over 3.65%, the yield on FRI appears substantially lower. Since the yield was so weak I decided to look up the dividend history on Yahoo Finance and manually calculate it. Occasionally this results in a different value than the reported trailing yield. It isn’t common, but I wanted to double check some REITs ETFs will usually have higher dividend yields. There was no mistake that I could find. Expense Ratios The expense ratios run from .12% to .50%: VNQ is one of the cheapest REIT ETFs available. That is the reason I started building my own portfolio’s REIT allocation by buying up shares of VNQ. The combination of a very high yield and a low expense ratio made VNQ a natural choice for my portfolio. Strategy Earlier in the article I referenced which index each ETF would cover, but that doesn’t tell investors a great deal about how the individual allocations are created. Normally I would focus on comparing factors like the sector allocations of each ETF, but that wouldn’t make any sense when each ETF will simply be listed as being 100% invested in real estate. Fact Sheets To learn more about the ETFs, I pulled up the fact sheets for each: IYR’s Strategy Ironically, IYR does not explain their strategy in either the fact sheet or the general page on the ETF . I loaded up the prospectus on the ETF and finally found some answers. The fund managers use “a passive or indexing approach to try to achieve the Fund’s investment objective.” It is helpful to know that the fund is being passively managed, but it makes me wonder about the expense ratio. When the ratios are over .40% I usually expect to see some form of active management either in the portfolio or some rebalancing to follow an index that is changing significantly. The first response not being able to find the information I wanted in any of the three sources might be to look up the Dow Jones U.S. Real Estate Index, so I did that. It turns out that the Dow Jones Real Estate Indices do not include a single index with that precise name. Instead, they include several indexes with similar names. (click to enlarge) Without knowing precisely which of these indexes is being tracked, I don’t see a solid method to enhance the research. VNQ’s Strategy VNQ uses a passively managed, full-replication strategy and their index covers two-thirds of the REIT market. The fund’s management seeks to minimize their net tracking error by having a very low expense ratio. For investors that are not familiar with the net tracking error, it refers to the difference between the results of the ETF and the results of the index. A REIT is only eligible for inclusion in the index if it has a market capitalization of at least $100 million. RFI’s Strategy While the fact sheet does not discuss the strategy of the fund directly, they do discuss the index which gives us some insight. The index is maintained in a manner that includes implementation of daily corporate actions, quarterly updates of significant events, and the portfolio is reconstituted on an annual basis in September. The index appears to be passively managed as over each period the fund is lagging the index by a hair over the expense ratio. (click to enlarge) This is about how a passively managed fund should look when investors compare the NAV performance of the fund with the underlying index. An actively managed fund would miss by more significant amounts which could be outperforming the index or trailing it. Holding Similarity Since I’m seeing passively managed ETFs with materially different expense ratios, I wanted to determine how reasonable it would be for a substantial difference in performance. I checked the holdings of each ETF. The top holding across all 3 is Simon Property Group (NYSE: SPG ). It ranged from 7% to 8.35% of the holdings depending on which ETF I was looking at. VNQ and F had precisely the same top four holdings in the same order, though the percentage allocations varied slightly. Number two is Public Storage (NYSE: PSA ). Number three is Equity Residential (NYSE: EQR ). Number four is AvalonBay Communities (NYSE: AVB ). When the holdings are similar and the strategy is passive it is difficult to find any reason to expect the underlying portfolios to have materially different returns. IYR on the other hand did offer some different allocations. The second allocation there is American Tower Corp. (NYSE: AMT ) which is a REIT that operates cell phone towers. They are working in an oligopoly as there are only a few major cell phone tower REITs and the leasing structure on their facilities results in enormous economies of scale when they are able to increase the number of customers for each location. AMT is not in the top 10 holdings for either of the other REIT ETFs. Conclusion I tend to favor very passive management which is the trend for each of these ETFs. Without a compelling reason to pick either of the ETFs with a higher expense ratio, I see VNQ as the strongest REIT ETF in this batch. If IYR or FRI were to outperform VNQ over the longer term, I would expect it to be IYR because there appears to be a larger difference in the selection of securities which should reduce the correlation in the long run returns of the ETFs.

As Producers Get Out, You Should Get In: Why I’m Long XLE

Summary WTI crude in the mid-30s is close to the cash operating cost of many high-cost oil producers. As oil trades in the mid-30s, production will be shut in and supply will fall, in theory creating a floor in the price of oil. Continued low oil prices will likely create an underinvestment in oil production, and could create risk to the upside in future oil prices. Investors should consider buying XLE, as it will likely be able to weather the storm, and avoid XOP, as it contains much smaller producers that may not survive. Investors should avoid USO as it is subject to the decay associated with negative roll yield in WTI futures contracts. On December 15th, West Texas Intermediate Crude traded through $35 a barrel. This is close to the variable operating cash cost of many high-cost producers operating out of North America. At these prices, producers potentially stop pumping crude from their wells because it is more expensive to pull it out of the ground than the oil is worth. North American rig counts have already fallen precipitously; at these levels, they are likely set to fall even more. As rig counts fall, supply lessens from this area, and investment in future productive capacity also likely falls. This may set the oil market up for much higher prices in the future, repeating past energy cycles. Investors should consider buying the Energy Select Sector SPDR ETF (NYSEARCA: XLE ), which contains the larger players in the energy sector, to capitalize on this potential for higher oil prices in the future. Investors should avoid buying the SPDR S&P Oil and Gas Exploration and Production ETF (NYSEARCA: XOP ); however, as many of these producers are smaller and may not be able to ride out the storm. Investors should also avoid the United States Oil ETF (NYSEARCA: USO ), as contango will eat away at profits over time. Cash Operating Costs of the Marginal Shale Producer Below is a chart of the estimated cash operating cost of oil production for oil producers globally. “Cash cost” is the variable operating cost of pulling oil out of the ground. These figures are roughly a year old, but are probably still relevant. Note that Canadian oil sands, U.K. producers, and U.S. producers are on the upper end, within a $25-40 barrel cash cost range. As oil prices dip into these levels, independent producers will begin to shut-in production as it stops making economic sense to continue producing. This, in theory, should create a floor on the price of oil, as the price-determining marginal supply from these producers diminishes. Note that as the price dips as low as $30, almost 30% of producers are operating at levels that don’t make sense to continue. (click to enlarge) Source: Morgan Stanley and Business Insider Falling North American Rig Count Rig counts have fallen dramatically since last year as oil has collapsed and oil producers have cut back CAPEX in the face of a deteriorating credit market in the oil and gas sector. New rigs that would be too expensive to operate at low oil prices are not coming online, and old rigs being phased out are not getting replaced. Per Baker Hughes, North American rig counts have collapsed from a high of 2,300 rigs to 883 today, or a decline of 61% in one year. North American Rig Count through Time (click to enlarge) Source: Baker Hughes and Bloomberg Given that many producers have cash costs of oil in the $30-40 range, rig count is likely to decline further with oil breaching $35 a barrel, in my opinion. As rig count falls, the industry as a whole sets itself up for stronger oil in the future. The effect is twofold; supply of oil falls initially, stabilizing prices, but then the ensuing underinvestment in oil infrastructure creates a situation where oil prices could increase dramatically as underinvested producers are less able to quickly increase production in response to higher oil. We could see a repeat of the underinvestment of the late 1990s that led to the boom in oil prices in the mid-2000s. Buy XLE, Avoid XOP and USO Investors should consider XLE, as it contains very large producers such as Exxon Mobil (NYSE: XOM ), Chevron (NYSE: CVX ), and Schlumberger (NYSE: SLB ) that have the ability to weather the storm of lower oil prices for a long time. Investors should avoid XOP, as it contains a higher concentration of smaller capitalization companies that may not be able to survive mid-30s oil for a long time. I could imagine a situation where oil remains in the mid-30s, and XOP continues to tank, as smaller producers come under increasing financial pressure. See below for the breakdown of top holdings of XLE and XOP; note that some of the largest concentrations in XOP are in stocks with market caps of less than 4BN: Source: Bloomberg Investors should also avoid USO, as it is long oil futures contracts, and is therefore subject to the negative roll yields associated with contango. Oil contracts trade for future delivery at specified points in time. Currently, the market is in contango, meaning that contracts further into the future are more expensive than contracts expiring closer to the present. Contango in WTI Crude (click to enlarge) Source: Bloomberg USO owns short-dated contracts, and as those contracts expire, it sells them and buys contracts further into the future. With today’s prices, for example, USO would sell the Jan. 16 expiries at 37.11 and buy the Feb. 16 expiries at 38.27, creating a 37.11/38.27-1= -3.03% yield in just one month. A rough annualization of that yield means that USO is currently losing 36.4% annually! It is better to own the producers themselves who sell their production forward in the futures market than to own a fund exposed to the cost of maintaining a long position in futures, as the price performance between XLE and USO over the past five years has shown. Shorting $1 of USO and buying $1 of XLE, price performance over past five years, excluding dividends: Source: Bloomberg Conclusion Oil in the mid-30s is approaching the cash operating costs of many North American oil producers. As oil falls, they will shut in production, theoretically creating a floor in the price of oil in this range. Underinvestment in oil production in the future due to low oil prices today may also one day contribute to strong future oil prices. Investors looking to take advantage of this potential floor should look to buy XLE, as it contains some of the largest oil-producing companies in the world, and should be able to weather the supply glut in oil, and avoid XOP, as it has smaller producers that may not be able to survive lower oil. Investors should avoid USO as it is subject to negative roll yields associated with contango in WTI futures markets.

High Dividend Yield ETFs Deserve Further Inspection

Summary These four dividend ETFs include 3 with extremely high dividend yields for an equity fund without REITs. SDOG comes up as my favorite after I looked through the allocation strategies each fund was using. FVD reports a net expense ratio of .65% in their fact sheet. Yahoo reports a .70% net ratio for the fund. With the exception of SDOG, the ETFs currently have very high allocations to the consumer defensive sector and the utility sector. One of the areas I frequently cover is ETFs. I’ve been a large proponent of investors holding the core of their portfolio in high quality ETFs with very low expense ratios. The same argument can be made for passive mutual funds with very low expense ratios, though there are fewer of those. In this argument I’m doing a quick comparison of several of the ETFs I have covered and explaining what I like and don’t like about each in the current environment. Ticker Name Index SDOG ALPS Sector Dividend Dogs ETF S-Network® Sector Dividend Dogs Index FDL First Trust Morningstar Dividend Leaders Index ETF Morningstar Dividend Leaders Index PEY PowerShares High Yield Equity Dividend Achievers Portfolio ETF NASDAQ US Dividend Achievers® 50 Index FVD First Trust Value Line Dividend ETF Value Line(R) Dividend Index By covering several of these ETFs in the same article I hope to provide some clarity on the relative attractiveness of the ETFs. One reason investors may struggle to reconcile positions is that investments must be compared on a relative basis and the market is constantly changing which will increase and decrease the relative attractiveness. Dividend Yields I charted the dividend yields from Yahoo Finance for each portfolio. The First Trust Value Line Dividend ETF is the weakest of the batch on dividend yields. The yield isn’t weak overall, but it is lower than I would have expected. (click to enlarge) Expense Ratios The expense ratios run from .40% to .70% according to Yahoo Finance. (click to enlarge) I thought the expense ratio for FVD seemed a little too high at .70% so I decided to pull up their Fact Sheet through MorningStar which indicates a net expense ratio of .65%. For consistency sake I’ve stuck with the values reported by Yahoo in the chart, but it appears the fund is reporting a lower net expense ratio. I also checked the ETF through Charles Schwab and saw a .65% ratio there. Sector I built a fairly nice table for comparing the sector allocations across dividend ETFs to make it substantially easier to get a quick feel for the risk factors: (click to enlarge) First Glance FDL and PEY get some immediate respect from me for their very high allocations to the consumer defensive sector. It is also notable that FLD, PEY, and FVD all use heavy allocations to utilities. While several dividend ETFs include at least some allocation to real estate, there was a 0% allocation for the first 3 ETFs. As we get into ETFs with higher expense ratios, it is worth noting that many may have more complicated weighing structures that will materially vary over time and therefore the investor needs to either buy in completely to the strategy of the fund or keep an eye on the sector allocations or both to prevent becoming overweight on specific sectors. SDOG SDOG uses the most even allocation strategy out of all the funds. I have to admit that I like that part of their strategy. I wondered if that was random chance or if the company was doing it intentionally, so I pulled up the quarterly factsheet . It turns out that this is an intentional choice and that the portfolio is designed to maintain that allocation: “SDOG provides high dividend exposure across all 10 sectors of the market by selecting the five highest yielding securities in each sector and equally weighting them. This provides diversification at both the stock and sector level.” FDL The allocations for FDL feel pretty heavy on communication services to me, but each fund here changes their positions materially over time. The process for building the index includes a “Proprietary multi-step screening process”. There are a couple other comments, but in general it seems the system is designed to create a bit of a black box. Investors that want to read further into it can check out the fact sheet . PEY PEY is based on the NASDAQ U.S. Dividend Achievers 50 Index. Both the fund and index are reconstituted each year in March and the positions are rebalanced on a quarterly basis. Again, it is possible for the sector allocations to change materially which makes it important to look into the positions regularly. I appreciate funds that opt for a strategy with more rationality behind it than “the portfolio is market-cap weighted, we don’t do anything”. On the other hand, when the fund does not appear to be using strict sector weight limits it creates some risk of having more concentration than I would want in the portfolio. The yield is great and I really like the current allocations, but there is a material risk of the portfolio changing significantly in March. On the positive side, since the index is only reconstituted once in March each year investors can take a look at which securities were selected and decide if they feel comfortable holding that portfolio. If the investor believes in rebalancing, then the expense ratio on the fund may be significantly cheaper than the commissions the trader would incur. FVD The allocation process for FVD is also fairly complex. The index is based on whittling down the available universe of stock securities based on their Value Line® Safety Rating. After the available universe has been screened, the fund picks the companies with dividend yields that are higher than average for the S&P 500. To avoid allocation to smaller companies, anything with a market cap below $1 billion is removed from consideration. What do You Think? After looking through the allocation strategy for each fund, I think SDOG is my favorite of the batch. Which dividend ETF makes the most sense for you?