Todd Rosenbluth is director of ETF and mutual fund research at CFRA.
Location, location, location. Just like with a house or an apartment—where you have put money to work in real estate—securities can make a big difference.
The S&P 500 Real Estate sector was up 8.2% year-to-date through August, but popular Vanguard sector funds are lagging behind. While the lack of exposure to strong-performing specialty REITs have hurt Vanguard, the firm is likely to begin a move to a new, more inclusive index in 2018.
Given the $65 billion in assets in the Vanguard mutual funds and ETF classes, such a move could have a significant impact.
In July, Vanguard filed a preliminary proxy statement with the SEC seeking shareholder approval to change the investment objective for the Vanguard REIT Index Fund, which would result in a change in its benchmark.
Expanding The Investable Universe
“The proposed changes to the investment objective and benchmark will expand the investable universe beyond REITs, thereby broadening investors’ exposure to the real estate sector,” explained Jon Cleborne, principal at Vanguard Portfolio Review Group. “This will ensure long-term accessibility to investors, and aligning the REIT fund with Vanguard’s other sector funds.”
The future benchmark is the MSCI US Investable Market Real Estate 25/50 Index, which includes real estate services and development companies in addition to REITs. Certain prominent specialty REITs not in the current MSCI US REIT Index are in the proposed index. Following shareholder approval, Vanguard would begin using a transition index, likely in early 2018, for the subsequent six months to reduce the transaction cost impact.
The change will align the Vanguard REIT Index with the updated GICS [Global Industry Classification Standard] methodology for classifying global market sectors used by S&P and MSCI. Vanguard’s 10 other sector index funds, such as the Vanguard Financials ETF (VFH), currently seek to track MSCI benchmarks under this methodology; MSCI carved out REITs from its financial sector indices in September 2016.
The Vanguard REIT ETF (VNQ) has $34 billion in assets, significantly more than the $2.5 billion in the Real Estate Select Sector SPDR Fund (XLRE), which tracks the aforementioned S&P 500 sector index and the approximately $400 million Fidelity MSCI Real Estate Index ETF (FREL); however, VNQ’s 3.6% total return was below the gains for XLRE (8.6%) and FREL (6.8%).
Holdings Differences Impacting Reit ETF Records
Source: CFRA’s MarketScope Advisor
Under The Roof
Meanwhile, the year-to-date gain for the Vanguard REIT Index Fund, Admiral Shares (VGSLX) through Sept. 1 was in line with its Lipper real estate mutual fund peer average’s, while the actively managed Invesco Real Estate Fund (IARAX) was more than 2% stronger in the same period.
For XLRE, FREL and IARAX, specialty REITs American Tower (AMT), Crown Castle International (CCI) and Weyerhaeuser (WY) were among the biggest positions. Yet those wireless-telecom or timber-driven REITs are not inside the index that VNQ currently tracks, though they are currently part of the proposed index.
At the end of the second quarter, AMT was the largest constituent, at a 5.5% weighting, while CCI was the third largest, at 3.5%. In addition, WY and SBAC Communications were 2.4% and 1.6%, respectively.
Based on the combined $65 billion in assets tied to Vanguard REIT index products—including multiple mutual fund and ETF shares classes—Vanguard’s exposure consisted of $3.6 billion of AMT, $2.3 billion of CCI, $1.6 billion of WY and $1.0 billion of SBAC. This is equal to approximately 6% of the market capitalization of these specialty REITs as of the end of August.
Other real estate companies not inside Vanguard’s REIT funds but inside the index Vanguard seeks to track and peer REIT funds include real estate services companies CBRE Group and Jones Lang LaSalle, real estate developer The Howard Hughes Corp. and specialty REITs Lamar Advertising and Rayonier.
The current MSCI US REIT Index had 155 holdings, less than the proposed MSCI US Investable Market Real Estate 25/50 Index, with 181 holdings at the end of June 2017. Relative to Vanguard’s current index, the future one had a slightly lower dividend yield, but an in-line median market capitalization at the midyear point.
CFRA does not believe the impact of the Vanguard proposed index changes have fully resonated in the investment community. For example, CFRA Equity Analyst Angelo Zino, CFA, who covers AMT, CCI and SBAC, notes neither company managements nor fellow analysts on the second-quarter earnings call discussed the impact of the potential move.
Zino has a buy recommendation on AMT, but downgraded CCI and SBAC to hold recommendations in March 2017, citing some valuation concerns. In addition, he believes both CCI and SBAC would be more negatively impacted by any potential Sprint/T-Mobile combination. AMT, CCI and SBAC have all climbed in value in 2017, helping FREL’s relatively strong performance record.
Index Changes Wagging The Tail
Further proof that planned index changes can cause stocks to move higher, SBAC rose 2.7% on Friday, August 25, following the news the specialty REIT would soon be added to the S&P 500; AMT and CCI were up 2.4% less on the same day.
In addition to XLRE, other S&P index-based funds such as the SPDR S&P 500 ETF Trust (SPY), the iShares S&P 500 ETF (IVV) and the Vanguard 500 Index (VFINX), would add SBAC as a constituent following the index inclusion. CFRA thinks some active investors seek to get ahead of index changes, while managers of index funds can make purchases in preparation of an addition.
Yet Vanguard’s addition of all of these new real estate stocks for its REIT funds would occur regardless of the stocks’ valuation. These Vanguard ETF and mutual funds passively track the chosen benchmark.
In contrast, actively managed IARAX reduced exposure to office and health care REITs in the second quarter of 2017 due in part to its belief of less favorable valuations.
What’s Changing In Vanguard Funds
|Name||Ticker||Index Weight (Current)||Index Weight (Proposed)|
|Simon Property Group||SPG||6.1%||5.0%|
Source: Vanguard. As of June 30, 2017
To make room for the future additions to the funds, Vanguard’s stakes in other stocks are expected to be reduced. Equinix, Prologis, Public Storage, Simon Property and Welltower are examples of current top-10 holdings of VNQ. These REITs have lower weightings in the new index and could likely be negatively impacted as new neighbors moved in.
CFRA believes REIT-focused investors, regardless if they are using funds or directly owning shares, should understand the impact of Vanguard’s planned index change. We think what’s inside a fund matters a lot, and in ranking VNQ and VGSLX, we incorporate CFRA’s equity analyst valuation and risk opinions.
At the time of writing, neither the author nor his firm held any of the securities mentioned. Todd Rosenbluth is director of ETF and mutual fund research at CFRA, an independent research firm that acquired S&P Global Market Intelligence's equity and fund business in October 2016. He can be reached at [email protected]. Follow him at @ToddCFRA.