What About Passively Managed REIT Funds?

In the short history of this young-but-venerable REIT blog, I have already expressed a few positions that form the cornerstones of my investing philosophy: (1.) REITs are pretty great. (2.) Diversification is pretty great. (3.) Index funds are pretty great. So it would stand to reason, then, that I must love passively managed, low-cost REIT funds, right? Well… yes and no.

I probably wouldn’t have even bothered to write this blog 5 years ago because the answer, in my mind at the time, would have been totally obvious: Don’t fool around trying to pick individual REITs; just buy Vanguard’s passively managed REIT ETF (VNQ) and call it a day. (In fact, I actually didn’t bother to write this blog 5 years ago, although the reason for that was less the awesome primacy of VNQ and more that I was too busy hanging out and being The Dude. REIT blogging is, it seems, a (slightly) older man’s game.) I want to use this post to answer three questions: (1.) What is VNQ? (2.) What’s awesome about VNQ? (3.) Why is VNQ perhaps less awesome than it was just a few years ago?

What is VNQ? VNQ is the ticker symbol for an exchange-traded fund (ETF) called the Vanguard Real Estate Index Fund ETF Shares. An exchange-traded fund or “ETF” is just a mutual fund that trades on an exchange like a stock. This means you can easily buy and sell ETFs from your brokerage account just by typing in the ticker symbol just as you would with any other stock purchase. VNQ is a passively managed fund which tracks a particular index of REITs. The fund summary provides as follows:

The investment seeks to provide a high level of income and moderate long-term capital appreciation by tracking the performance of the MSCI US Investable Market Real Estate 25/50 Index that measures the performance of publicly traded equity REITs and other real estate-related investments. The advisor attempts to track the index by investing all, or substantially all, of its assets-either directly or indirectly through a wholly owned subsidiary, which is itself a registered investment company-in the stocks that make up the index, holding each stock in approximately the same proportion as its weighting in the index. The fund is non-diversified.

– Fund summary from Yahoo! Finance

In other words, when you buy one share of VNQ, you’re basically buying an interest in a whole bunch of REITs at one time. For the price of one VNQ share (about $95 as of this writing) you get instant diversification across the REIT spectrum. In exchange for this instant diversification, you have to pay Vanguard for the service of setting up and maintaining the ETF. This payment comes in the form of an “expense ratio” which is, as of this writing, 0.12%. (Note that I am only discussing Vanguard’s REIT fund instead of other competing REIT funds because when it comes to mutual funds my belief is that you pretty much want to go Vanguard or go home if at all possible. Vanguard is a great, investor-focused company with a long track record of keeping fees low and not releasing dumb gimmicky products.) That means that for every $1,000 you invest in VNQ, the annual expense charged will be roughly $1.20. It’s always important to keep fees low when you are buying mutual funds because the effect of fees on investment performance can be profound over long periods of time, but 0.12% is pretty danged good.

What REITs are you actually getting when you buy VNQ? You can get more information on the MSCI US Investable Market Real Estate 25/50 Index (the index corresponding to VNQ) here. What you will notice, among other things, is that about a third of the index is comprised of the top-10 holdings, all of which are well-known, large-cap REITs like American Tower Corp., Prologis, and Equity Residential.

What’s Awesome About VNQ? Instant diversification for a low price. For a mere 12 basis points you get a whole slew of REITs. If one of those REITs falls on hard times, well, that’s not a very big deal, because you are exposed to plenty of others. If one of them cuts its dividend, you’re still going to be getting a dividend from VNQ that looks pretty much like it did before the cut. Diversification (as a general rule) reduces risk. This benefit isn’t free, but at 0.12%, it’s pretty cheap. (Note that this pretty-cheap-ness is really limited, in my view, to VNQ. Once you get outside of Vanguard fund fees can spiral up in a real hurry. Make sure that you carefully check all of the fees before you purchase any ETF or mutual fund.) The Dude is not long VNQ at this time, but he has owned it in the past and probably will again at some point in the future. If you just want to easily and conveniently add some REITs to your portfolio and don’t feel like spending a bunch of time doing research, I would be hard-pressed to come up with a better choice than VNQ.

If VNQ is so awesome, then why doesn’t the Dude own any? There are two primary reasons why I am a little bit less enthusiastic about VNQ (or any comparable fund) than I was just a few years ago: (1.) Brokerage costs have changed and (2.) technological changes have impacted the marketplace dramatically.

First, brokerage costs have decreased markedly between 2015 and the present. I personally use TDAmeritrade for my non-retirement investing. (This isn’t an endorsement or anything, I just happened to have a Scottrade account and TDAmeritrade bought them out.) Ever since I first opened the Scottrade account in roughly 2006, each trade cost a flat fee of $7. The $7 charge created an incentive to buy as much as I could with each purchase in order to reduce the percentage of each transaction being eaten up by fees. To illustrate the point, when each trade costs $7, you can buy $14 worth of stock and pay 50% in fees or you can buy $700 worth of stock and pay 1%. At $7 per trade, unless you are dealing with very large amounts of money (which, 5 years ago or even today, the Dude was and is not), diversification gets expensive quickly, which makes index funds look all the more appealing.

Suppose that you wanted to buy a diversified basket of REITs. You did your research and picked out 15 favorites for investment. You gathered up $1,500 to invest and were ready to get started. In order to buy shares in all 15 REITs, you would need to pay 15 different $7 purchase fees for a total of $105, leaving only $1,395 actually invested in your REITs. (And if you ever sold, that $7 fee would rear its ugly head again.) Relative to your $1,395 investment, you’d have paid more than 7.5% in fees. That’s a spicy meatball, and it’s also a hell of a lot worse than paying one $7 fee plus a 0.12% expense ratio to buy VNQ.

Things are different now. Within the past year, most major brokerages (including TDAmeritrade) have switched to a zero-commission model where you can buy and sell stocks willy nilly for free. This means that instead of paying 7.5% to invest $1,500 in 15 different REITs you are actually paying nothing, zip, zero, nada, zilch. Suddenly VNQ’s 0.12% expense ratio, while still low as those things go, doesn’t look so good by comparison. The elimination of commissions in online brokerage accounts means that diversification just got a whole lot cheaper, and as a result index funds with a fee, however low that fee, are less appealing.

As far as technological changes go, this is a bit more speculative, but it is no secret that Amazon has been absolutely crushing the retail sector in recent years. Brick-and-mortar retail is on the decline (for now at least), and I don’t see that reversing. Neither I nor anyone I know has been to a mall more than once in the last 2-3 years, and even then it’s usually just to get an Apple product repaired. Buying things online is just an easier, better, more convenient, and often cheaper experience. I could be wrong about this, but I don’t see the trend of consolidation in the physical retail space reversing for a long time, if ever. While not as dramatic as the contraction in retail, we may also begin to see a reduction in the demand for commercial office properties as more and more employees take advantage of improving network technology to telecommute (and as telecommuting grows more socially acceptable for employers.) As a general matter (and there are certainly exceptions which will be the subject of future posts here on this very REIT blog) I want to stay away from retail and I’m leery about commercial in general. According to MSCI, the index tracked by VNQ consists of 9.44% office properties and 11.41% retail properties. Meaning that roughly 20% of what you’re buying with VNQ is stuff I’m nervous about. Maybe I am wrong (the Dude has been wrong before, will be wrong again, and mostly just hopes to be right occasionally), but since diversification is free now, I prefer to chart my own course between the Scylla of strip malls and the Charybdis of off-the-freeway exurban office towers. Plus it’s just fun to research individual REITs (or at least it is for the Dude who, quite possibly, needs hobbies.)

Published by reitdude

I am an attorney and dividend investor from California with a particular interest in REITs. My fantasy football opinions may well be better than my investing opinions.

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