July 15, 2005

ETFs Tap Into Real Estate

Do you want to invest in real estate, but are unsure of which stocks to pick? If you buy an exchange-traded fund, those decisions are essentially made for you by indexing experts.

As real estate equities have flourished, so have ETFs based on real estate sector indexes. These relatively new offerings -- funds that are priced throughout the trading day and can be be sold short, like stocks -- offer low fees and a degree of diversification when it comes to geography, business type (REIT or corporation), and property sector (largely office, industrial, warehouse, retail, and multi-family residential).

Four real estate ETFs are now in existence, based on four different indexes. They are largely distinguished from one another by the performance and composition of the indexes they track, and by their costs. Three of the funds are exclusively focused on real estate investment trusts (REITs). Expense ratios range from a high of 0.60% of assets to just 0.12%.

Fund company Cohen & Steers notes that because REITs show low correlation with other asset classes, they can diversify an investment portfolio. The firm calculates that the ratio of correlation between its Realty Majors Index (which holds only REITs) and the S&P 500 is 0.23; between the same index and the NASDAQ, the ratio is only 0.07.

Raymond Mathis, who covers REITs for Standard & Poor's, is most optimistic on lodging and retail REITs. He notes that their fundamentals have improved in the past few quarters, and he expects them to continue to improve. "I'm more cautious on apartment REITs -- which isn't to say that they haven't done well -- they have, with condo values raising the value of the apartment buildings," he said. "But that's not a fundamental issue of supply and demand. It could be a temporary blip."

Mathis notes that when it comes to REIT funds, there's not a hotel or office REIT ETF. Instead, investors end up getting a "little bit of everything." Not only are there not that many REIT stocks out there to begin with, smaller-cap issues tend to be underrepresented since larger funds typically can't buy very much of them.

Several REITs that are heavily weighted in the indexes figure into each ETF's top 10 holdings. They include Simon Property Group (SPG) , Vornado Realty Trust (VNO) , General Growth Properties (GGP), and Equity Office Properties Trust (EOP). Even so, there are important differences among the real estate indexes which the current group of real estate ETFs track.

Dow Jones U.S. Real Estate Index

The Dow Jones U.S. Real Estate index seeks to provide a broad measure of the U.S. real estate securities market. The index currently has 84 components, which make up the real estate portion of the Dow Jones U.S. Total Market Index.

Though the U.S. Real Estate Index consists predominately of REITs, it also includes real estate operating companies (REOCs). To be listed on the index, a company must be based in the U.S., must trade on one of the three major exchanges, and cannot have had more than 10 days of inactive trading during a prior quarter.

The fund based on the index, iShares Dow Jones US Real Estate Index (IYR), was launched in June 2000, making it the oldest real-estate equity sector ETF. As of June 30, portfolio turnover was 20.0%, versus an average of 108.4% for equity funds that invest in real estate.

Dow Jones Wilshire REIT Index

The Dow Jones Wilshire REIT Index is a subset of the Dow Jones Real Estate Securities Index and includes only REITs. Its objective is to provide a broad measure of publicly traded REITs.

The index held 93 components as of March 31. The fund based on the index, streetTRACKS Wilshire REIT Fund (RWR), had negligible turnover of 5.0% as of June 30.

Cohen & Steers Realty Majors Index

Another REIT-focused index is the Cohen & Steers Realty Majors Index, which tracks the performance of large, actively traded U.S. real estate investment trusts. The fund based on the index, iShares Cohen and Steers Realty Majors Fund (ICF), held 31 components as of June 30.

Diversified by both geographic region and property type, the fund's largest holdings as of March 31 were in the Pacific region (California, Oregon, Washington; 26%) and the South Atlantic (Maryland, Delaware, Virginia, West Virginia Washington, D.C., North Carolina, South Carolina, Georgia, Florida; 20%), and the Mid-Atlantic (New York, Pennsylvania, New Jersey; 14%). The top five property classes were office (21%), regional malls (17%), apartments (17%), shopping centers (14T), and industrial (11%).

As of June 30, the index fund experienced turnover of 15.0%.

Morgan Stanley US REIT Index

The Morgan Stanley US REIT Index aims to achieve broad and fair representation of the equity REIT investment universe. It comprises REITs that are included in the MSCI US Investable Market 2500 Index, excluding specialty equity REITs that do not generate a majority of their revenue and income from real estate rental and leasing operations.

The MSCI US REIT index excludes mortgage and hybrid REITs and companies classified under the Global Industry Classification Standard (GICS) "Real Estate Management & Development" subindustry. However, unlike the two Wilshire real estate indices, the index includes health care REITs. As of July 1, it held 110 securities.

The fund based on this index is Vanguard REIT VIPER (VNQ), is the newest real estate ETF, established in September 2004.

Sector ETFs: A Few Caveats

Though sector funds can offer industry exposure, investors should bear in mind that they can be highly volatile. The average U.S. equity real estate mutual fund has a three-year annualized standard deviation of 15.4%, a measure of volatility, versus 13.9% for the S&P 500. While higher, that number is low compared to technology funds (28.4%), and precious metals funds (30.5%).

Another thing to keep in mind is that real estate stocks have had strong gains the past five years, and could be due for a breather. In other words, investors shouldn't necessarily expect a repeat of the performance, and might consider rebalancing at this stage. (Please see Real Estate Funds: Beyond the Bubble, also under the Research & Insights section of Fund Advisor.)

Standard & Poor's analysts give the REIT subindustry an investment ranking of 3.1 STARS. (A 1 STAR ranking is a Strong Sell recommendation; 3 STARS is a Hold; and 5 STARS is a Strong Buy.) "This indicates that while there are some companies out there that we like, we're neutral on the subindustry," said Mathis. "A number of companies are 4 and 5 Stars, and a number are 2 Stars."

At the same time, the subindustry's relative strength ranking is 4 out of 5, putting it in the top 70% to 90% of all others in the S&P Composite 1500 Index. While this measure of trailing 12-month price-change rankings is backward-looking, it also has forward-looking implications, notes Sam Stovall, Standard & Poor's Chief Investment Strategist, who calculates the rankings.

Real Estate ETFs

Fund Name

June Returns(%)

YTD Return Through 6/30/05 (%)

Three-Year Annualized Returns Through 6/30/05 (%)

Portfolio Characteristics

Expense Ratio (%)

iShares Cohen and Steers Realty Majors Fund (ICF) 4.5 35.3 21.5 Index: Cohen & Steers Realty Majors Index. Components in Fund: 30 (as of 3/31/05).Top 10 Holdings as percent of total: 59.7% (3/31/05). Dividend Yield: 4.13% Total Assets: $1.58 billion 0.35
streetTRACKS Wilshire REIT Fund (RWR) 5.2 33.6 20.5 Index: Dow Jones Wilshire REIT Index. Components in Fund: 95 (6/30/05). Top 10 Holdings as percent of total: 40.3% (5/31/05). Dividend Yield: 4.27% Total Assets: $659.2 million 0.26
iShares Dow Jones US Real Estate Index (IYR) 4.5 31.4 19.5 Index: Dow Jones U.S. Real Estate Index. Components in Fund: 84 (7/14/05). Top 10 Holdings as percent of total: 34.8% (6/29/05) Dividend Yield: 4.01% Total Assets: $1.21 billion. 0.60
Vanguard REIT VIPER (VNQ) 3.8 5.1 N/A Index: MSCI US REIT Index. Components in Fund: 126 (5/31/05). Top 10 Holdings as percent of total: 35.1% (5/31/05). Dividend Yield: N/A Total Assets: $318.3 million. 0.12

SOURCE: Standard & Poor's. Total returns are in U.S. dollars and include reinvested dividends.

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