The Vanguard Real Estate ETF (NYSEARCA:VNQ) is a broad-based U.S. REIT index ETF. The fund provides investors with an easy, convenient, and cheap way to gain exposure to more than a hundred REITs, maximizing diversification, and minimizing risk and volatility. VNQ is an effective fund, but vanilla, with no significant benefits or drawbacks. As such, the fund might make sense for more risk-averse or less knowledgeable investors looking for REIT exposure. More aggressive investors should consider other funds, especially the set of Cohen & Steers REIT CEFs.
Fund Basics
- Sponsor: Vanguard
- Underlying Index: MSCI US Investable Market Real Estate 25/50 Index
- Expense Ratio: 0.12%
- Dividend Yield: 3.23%
- Total Returns CAGR (Inception): 9.02%
Fund and REITs Overview
VNQ is an index ETF administered by Vanguard, the second-largest investment manager in the world, and the pioneers of low-cost index funds. Long-time readers and subscribers know that Vanguard is my favorite index fund provider. This is due to the company's unique corporate structure. Vanguard operates as a mutual company; it is owned by its clients. No shareholders mean no profits, which lowers costs for customers, and ensures no conflict of interest between Vanguard's shareholders and its customers. The structure makes for a sleepy, low-cost company: perfect for index funds.
VNQ itself tracks the MSCI US Investable Market Real Estate 25/50 Index, a broad-based index of U.S. REITs. The index includes all REITs meeting a very basic set of liquidity, trading, size, industry focus, and corporate structure criteria. Said criteria is quite lax, so the index includes most relevant U.S. REITs. It is a capitalization-weighted index, but weights are constrained to ensure a modicum of diversification, and to meet certain regulatory standards. These constraints and weights are constructed using a portfolio optimization framework. Said process is something of a black box, although MSCI is the best in the business, so I feel confident in their approach.
In general terms, I think VNQ's underlying index is reasonable, and besides the aforementioned constraints, nothing stands out.
The resultant index and fund are quite diversified, with VNQ investing in 174 REITs from all relevant industry segments. On the other hand, the fund is quite top-heavy, with the top ten holdings accounting for just under 45% of its value.
(Source: Vanguard and ETF.com)
Diversification serves to reduce portfolio risk and volatility, a strong benefit for the fund and its shareholders.
VNQ's high level of diversification makes the fund an appropriate choice for investors looking for broad U.S. REIT exposure.
Exposure to said industry is appropriate in basically any portfolio for three key reasons.
First, is the fact that the U.S. real estate market is a large, growing market, with a total value greater than $14 trillion. Size alone makes (some) investment in real estates and REITs a no-brainer, and VNQ is a simple way for investors to get said exposure.
Second, is the fact that real estate is one of the best-performing asset classes. In fact, it has been the best-performing asset class these past twenty years, outperforming equities, high-yield bonds, and all other asset classes.
(Source: J.P. Morgan Guide to the Markets)
REITs offer investors strong returns, and so make sense in any investor's portfolio.
Third, is the fact that REITs offer investors some relative value, as REIT prices have lagged equity prices during the ongoing economic recovery. If valuations normalize, expect REITs, including VNQ, to outperform:
Finally, VNQ's 0.12% expense ratio is quite low, and somewhat lower than average. Lower expenses directly increase returns, a significant benefit for the fund and its shareholders. Lower expenses are also one of the only surefire ways of doing so: active-management can fail and alpha might not last, but lower expenses always boost returns.
REITs are a fantastic investment opportunity for effectively all investors, and VNQ is a cheap, simple, and strong way for investors to get exposure to this great asset class. As the fund is quite vanilla, there are few significant strengths and weaknesses, and no possibility of substantial outperformance or underperformance.
There are several other large U.S. REIT ETFs in the market. Let's compare VNQ to some of these.
ETF Comparison
VNQ compares, well, neutrally to its ETF peers, with no significant benefits or drawbacks.
VNQ does have the greatest number of holdings within its peer group, and a slightly lower expense ratio than average, but the differences are quite small. On the other hand, the Schwab U.S. REIT ETF (SCHH) has a comparable number of holdings, and a slightly lower expense ratio as well.
(Source: SeekingAlpha - Chart by author)
VNQ has a slightly higher 3.4% yield and dividend growth track record, a benefit for the fund and its shareholders, but the differences are quite small. At the same time, the Real Estate Select Sector SPDR ETF (XLRE) matches VNQ in these two metrics.
Performance-wise, VNQ is about average, and generally neither outperforms nor underperforms its average peer. This is to be expected, as VNQ is an index fund, and a very broad one at that.
Other time periods show a similar pattern, with VNQ generally posting average performance and returns.
(Source: ETFdb.com)
As should be clear from the above, VNQ is a bland index fund with no significant strengths and weaknesses. As such, and as mentioned previously, the fund might make more sense for risk-averse, less knowledgeable investors looking for real estate exposure. You can never go wrong with a broad index fund, but don't expect outstanding performance from these investments.
Investors looking for more aggressive options should consider the Cohen & Steers REIT CEFs. Let's have a look.
Cohen & Steers Comparison
Cohen & Steers has a set of REIT CEFs with strong yields and even stronger total returns. These are as follows:
- Cohen & Steers Quality Income Realty Fund (RQI)
- Cohen & Steers REIT & Preferred Income Fund (RNP)
- Cohen&Steers Total Return Realty Fund (RFI)
RQI and RNP are leveraged, so they tend to outperform during bull markets, as has been the case these past few three years:
Leverage does mean that these two funds tend to underperform during downturns, especially if discounts widen. This was the case during early 2020:
RQI and RNP both tend to outperform during cycles, as has been the case for the past decade. Long-term performance does somewhat depend on the timing of the investment, the prevalence of downturns, and the discounts of the funds.
Both funds are currently trading with uncharacteristically small discounts:
Finally, both RQI and RNP sport much stronger yields than VNQ:
In my opinion, both RQI and RNP are overall stronger funds than VNQ, but they are also riskier. VNQ might make more sense for more risk-averse investors, looking to maximize diversification and minimize losses during downturns.
RFI is broadly similar to RQI and RNP, but without the use of leverage.
Lack of leverage means that the fund performs in line with VNQ during downturns, at least on a NAV basis. This was the case during early 2020:
At the same time, RFI tends to outperform VNQ on both a price and NAV basis, at least under most long-term time periods, as has been the case the past decade.
As with RQI and RNP, performance is strongly dependent on timing, discounts, and the prevalence of downturns.
RFI also sports a strong 6.6% yield.
Finally, RFI trades with a small, but uncharacteristic, 5.9% premium to NAV.
In my opinion, RFI is slightly stronger than VNQ if bought at NAV or at a discount. At current prices and discounts, VNQ seems like the slightly stronger choice. I also think investors should consider investing in RFI when prices are lower and discounts narrower, and VNQ could function as a stop-gap, temporary fund for these investors.
Conclusion
The Vanguard Real Estate ETF is a broad-based U.S. REIT index ETF. VNQ is a good, simple, cheap fund in this space, but without any significant strengths and weaknesses. It's a buy for me, but more aggressive investors should consider other choices, including the Cohen & Steers REIT CEFs.
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