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

When ETFs came on the scene 15 years ago, they brought a brave new world of efficient markets with low operating expenses and minimal tax liability. While the largest funds like DIA and SPY are designed in the spirit of the original ETFs, to track the large indexes, most of the newer ones do not even come close to this original purpose.

If the Efficient Market Hypothesis (EMH) is correct, then only two ETFs are needed at most, a world stock index such as the Vanguard Total World Stock Index (VT) and a bond index like the Vanguard Total Bond Market ETF (BND), in a ratio that fits your risk tolerance. Anything more, if we are to be philosophically true to the EMH, tips into the realm of active investing.
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