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During the 2008 crash, Oppenheimer Rochester National Muni A (ORNAX ) lost over 50% of its worth. It was one of the very worst performers. Before that it had been one of the best. Investors were clearly not expecting that type of drawdown that fast. In an article our firm wrote near the end of 2008, we discussed the oft-misunderstood tobacco revenue bonds, which made up a substantial portion of ORNAX’s bond purchases. The uncertainty of these bonds, coupled with investors’ general misunderstanding of them, led them to be mispriced and under-appreciated. These bonds are still mispriced and under-appreciated today. And they still make up the largest of ORNAX’s holdings, at around 22%. However, when we recently looked under ORNAX’s hood, we found something more interesting. Management has decided on a philosophy that could lead them to enter the property management business, a move that should concern any investor.

First: some things never change. The crowd continues to be wrong. In 2008, ORNAX lost because the credit markets were imperiled and its holdings were relatively illiquid. Poor pricing led to an investor outflow causing more selling of illiquid bonds. This has a similar effect as a run on a bank, exacerbating the impact of the market. At the bottom, investors began to chase yield and value, which ORNAX had in abundance after the fall. Then the opposite problem occurred: there were not enough good, high-yield municipal bonds to go around. When this happens, the fund has to buy new bonds at higher prices along side the investor inflow and thus reducing the yield for all investors.

So what has changed? Ron Fielding until just over a year ago managed ORNAX. Fielding’s single-minded purpose for the fund was to buy the highest yielding municipal bonds anywhere. At the time he left, the management continued to follow Fielding’s idea and model. Through all the funds past volatility, it was always guided by Ron Fielding’s vision. However, the current managers have decided that things may change. During a conference call on June 8 Troy Willis and Scott Cottier revealed that the fund is no longer simply looking to buy the highest yielding municipal paper, but that it has broken away from Fielding’s idea to begin a new life in property management.

This trailblazing move is a response to the large number of dirt bonds that are being defaulted on, primarily in Florida. Of ORNAX’s roughly 21% exposure to dirt bonds, 10-13% are Florida dirt bonds that have defaulted. But not to worry—the fund’s managers see this as a great opportunity. They figure that these bonds were for the cost of developments on the property and that now, when they foreclose, the fund will receive both the land and the developments. Consequently, ORNAX has decided that they will become the first bond fund to actually go through the prolonged legal procedures necessary to repossess these properties, which amount to about 2.5% of their total holdings.

When it comes to high-yield bonds (“junk bonds” as they used to be called), some of them will lose their value entirely. When junk bonds are bought, the buyer understands this possibility (or at least they should have been told this from the person selling them!). Investors accept it because the cash flow from the bonds is so high—the buyer gets paid for taking on that level of risk. ORNAX used to understand that. Investors who bought ORNAX expected the uncertainty and volatility that comes with that risk. Currently, the non-accrual rate for the fund is at 4.8%. Those familiar with junk bonds understand that this rate may vary significantly over time and that the value of ORNAX might fluctuate plenty, even as much as the S&P 500. But investors will still buy, so long as that plentiful stream of tax-free income continues to flow. Put it this way, it took a 50% drawdown in 2008 to get investors to really freak out and start selling.

However, instead of remaining a junk bond buying fund, simply seeking out the highest-yielding municipal bonds, ORNAX’s managers have decided that it may now repossess and manage these foreclosed properties. The bond managers have many ideas about what to do with their newly acquired holdings. Now investors are expected to trust these fund managers to competently manage property that was received from bad bonds. These managers are paid to buy junk bonds. Why should investors believe that ORNAX would do a better job managing the properties than the owners who are foreclosing on them? Realistically, they will probably hire a third party to manage the real estate transactions, but you still have to wonder about a management team that is going outside their core competency of analyzing credit.

Although the Florida dirt bond problem concerns only 2.5% of ORNAX’s assets at this time, what if the problem spreads? What if Obama decides not to back up municipalities? What if Congress determines that they ran out of checks this week or next? Will ORNAX end up owning and managing a significant amount of property? Will this former junk bond fund become a REIT? Probably not, but it seems like unforeseen black swan events are growing by the day.

In the conference call, these managers revealed that they have altered ORNAX’s philosophy from that established by Ron Fielding. While the cash flow and performance of the fund have been impressive, it is no longer the same beast. And who knows how it will act in the future?

Enterprising investors should realize that, though the uncertainty of ORNAX’s changing philosophy leads to a greater risk that is not accounted for in its current price, it could seed an incredible opportunity in the future. If the Florida dirt bond mess spreads and the fund decides to continue to repossess properties, then it will go from holding relatively illiquid municipal bonds to extremely illiquid real estate. This change could cause an exodus from the fund. Considerable investor outflow, together with the challenge of valuing illiquid property in this ‘40 Act NAV mutual fund, could once again cause tremendous opportunity to buy ORNAX at a much lower valuation. Enterprising investors should put ORNAX on their radar—and beware.

Sources:

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We set out to compare two broad-based and heavily traded REIT ETFs in order to discover if they have different compositions and how any differences effect long-term performance. After a basic review of the holdings a few things stood out. The difference in performance could be attributed either to the inclusion of mortgage REIT’s into IYR’s composition or to the heavier weight of VNQ’s top sector positions within the category. We did not find enough differences between the compositions of the two ETF’s over time to warrant a strong opinion either way. In the end, long-term cost structure and trading liquidity appear to have the greatest impact.

General Overview

VNQ and IYR are two ETF’s composed of a collection of REITs (Real Estate Investment Trusts). VNQ is issued by Vanguard Group, Inc. and is designed to track the MSCI (Morgan Stanley Capital International) U.S. REIT Index. IYR is issued by iShares Funds and is designed to track the Dow Jones U.S. Real Estate Index. Both indices aim to be benchmarks that measure the performance of publicly traded REITs. VNQ only trades in equity REITs, while IYR also trades in mortgage REITs.

Composition Comparison

There are currently 134 publicly traded REITs in the United States. Of these, 111 are equity REITs. VNQ is comprised of 98 REITs, all equity REITs—73% of all REITs and 88% of all equity REITs. IYR is composed of a total of 76 REITs, 57% of all REITs. IYR’s 71 equity REITs comprise 68% of the equity REITs on the U.S. market.

The two funds are composed largely of the same holdings. 61 REITs are shared by both (92% of those in Vanguard’s fund and 83% of iShares’s). Though Vanguard’s fund has more unique holdings, these make up only 7.31% its NAV, whereas 18.85% of iShares’s NAV are unique holdings. Most of this difference is due to iShares’s inclusion of mortgage REITs, which total 7.41% NAV. The rest of the equity difference between unique holdings of the two funds is due to iShares’s greater focus on specialty REITs, which compose 5.20% of its NAV, but only 1.03% NAV of Vanguard’s ETF.

The table below shows the difference in composition between the funds, organized by type[1]

Vanguard’s fund is more diversified by individual holding, with 37 unique holdings, but iShares’s is more balanced between different types. iShares includes two types Vanguard does not that make up a significant portion of its portfolio (10.07% NAV). In general, Vanguard invests more equity in the larger REIT types, while iShares distributes its investments more evenly amongst the different types. Vanguard’s ETF is therefore more susceptible to changes in a single type of REITs than is iShares’s.

Of the largest individual holdings in each, the only significant difference between the ETF’s is with those holdings that are unique to the iShares fund. Of the top ten largest REIT holdings, only one is held uniquely and in significantly differing amounts, a mortgage REIT held by iShares (Annaly Capital Management (NLY); 4.42% IYR’s NAV). Of the holdings that compose over 1% NAV of the ETF’s, Vanguard has no unique holdings, whereas 8 of iShares’s holdings are unique and in total compose 15.28% NAV. In general, iShares has a greater concentration of equity in individual holdings, where Vanguard is invested in a greater total number of REITs. Overall, iShares’s fund is less concentrated both in types of REITs and in individual stocks than is Vanguard’s.

The two funds have roughly the same 5-year annualized turnover rates, Vanguard’s at 13% and iShares’s at 18%. However, iShares’s fund’s turnover rate varies widely, from only 7% in 2008 to a full 29% in 2007. Vanguard’s fund, on the other hand, only varies between 10-17%.

Performance Comparison

Neither funds’ performance differs significantly from its underlying index in a given year. However, due to differences in fees, Vanguard’s fund slightly outperforms the MSCI U.S. Real Estate Index whereas iShares’s fund slightly underperforms the Dow Jones U.S. Real Estate Index. These slight annual differences result in Vanguard outperforming its index by .54% in a five-year period when iShares underperformed its by 1.32% in the same period. Vanguard’s fund has an annual fee of only .15% compared to iShares’s of .48%. Supposing a 5% annual return, this difference in fees adds up to 1.58% over a 5-year period. It was curious that dividend yield did not have a consistent effect of the differences in year-to-year total return.

Yearly pre-tax return, dividend yield, & turnover rate of VNQ, IYR since 2005.

One could conclude that over time both ETF’s have done a fine job of tracking the overall REIT market for a low cost. However, at this point with the uncertainty of interest rate markets and government intervention of mortgage paper, VNQ may be a better alternative with its lack of direct mortgage exposure. Ultimately, it is a coin toss. For trading purposes IYR has superior liquidity when tight spreads and fast execution are needed. Going forward it may come down to relative differences in yield that could become a deciding factor. For cash flow oriented portfolios a higher yield would be more beneficial if, over the longer term, total return remained constant. This may be the focus of follow up studies on these two investment vehicles.

Sources

us.ishares.com/home.htm

www.djindexes.com/mdsidx/index.cfm?event…

www.google.com/finance?q=NYSE:VNQ

www.morningstar.com

www.reit.com

www.vanguard.com

*Individual investment results will vary depending upon buy and sell dates.