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Vanguard REIT ETF – High Yield, High Risk

Vanguard REIT ETF not one of the better sector offerings at Vanguard


Few, if any, Vanguard funds have put together a string of positive returns like Vanguard REIT ETF (VNQ) did between 2000 and 2006, and few have fallen from grace as ungracefully as it did in 2007 and 2008. Vanguard REIT ETF has since put up another impressive string of returns, up over 200% since the market bottomed in March 2009 — which means Vanguard REIT ETF is the highest performer of all Vanguard sector funds.

But…That Performance Might Not Last

While the yield on this Vanguard REIT ETF and on REITs in general can be sumptuous by comparison to the stock market and an attraction for some investors, this is really a “growth” investment. The yield won’t protect you when investors turn against real estate, as they did with a vengeance in 2008. Despite a reputation for providing portfolio protection and diversification, earned particularly during the 2000-2002 bear market, REITs are no longer living up to their billing.

Although REITs are traditionally considered a “hybrid” security that has characteristics of both stocks and bonds, with financial stocks being whipped around and REITs often bearing much of the brunt of this volatility, this once-placid sector has become much riskier, as the current maximum cumulative loss makes clear. It took 40 months and some rather impressive returns for Vanguard REIT ETF investors to recover from its 68.3% loss.

An Alternative to Vanguard REIT ETF

I have suggested for some time now that using the new Global ex-U.S. Real Estate Index (VGXRX) in tandem with Vanguard REIT ETF would be one way to reduce volatility.

But 2013 hasn’t marked the happiest of three-year anniversaries for Global ex-U.S. Real Estate Index. Investors in the fund, which launched on Nov. 1, 2010, have sacrificed returns when diversifying away from Vanguard REIT ETF — without seeing less risk. That’s not exactly the way diversification is meant to work. Though Global ex-U.S. Real Estate Index is getting a new share class (see the lead story in my November 2013 newsletter issue), the story hasn’t changed much.

Since inception, Global ex-U.S. Real Estate Index has lagged its domestic sibling Vanguard REIT ETF 27.3% vs. 39.5%. Yes, it’s a given that there will be years when U.S. real estate investments outperform those in overseas markets, so that alone isn’t the disappointment.

However, Global ex-U.S. Real Estate Index has also been more volatile. 12-month returns for the global fund have ranged from -16.7% to 41.5%, compared to a range of 0.4% to 32.2% for Vanguard REIT ETF. Another way to look at it is the maximum drawdown since inception. Global ex-U.S. Real Estate Index dropped a full 21.7% between April 2011 and September 2011, while Vanguard REIT ETF’s worst decline over the same period was just -17.5%.

vanguard reit etfBut where Global ex-U.S. Real Estate Index has been most disappointing is as a diversifier. Consider a 50/50 mix of the two real estate funds. As you can see in the graph below, the 50/50 mix underperformed Vanguard REIT ETF because the global fund underperformed. No surprise there. But at the very least, the 50/50 investor might have expected a smoother ride. Alas, that wasn’t the case: The maximum drawdown of the 50/50 portfolio was -19.4%, worse than Vanguard REIT ETF. Additionally, the range of 12-month returns of the 50/50 portfolio, -5.0% to 31.6%, was wider than that of Vanguard REIT ETF, but only on the downside.

Bottom Line

I am not going to write off Global ex-U.S. Real Estate Index yet, though I would note that Vanguard never allocated any money to the fund in the Managed Payout funds, where the stake in Vanguard REIT ETF was chopped in half in May. Yes, when I look at historical returns for the index before the fund’s launch, it appears that adding foreign real estate to a position in Vanguard REIT ETF can reduce risk, though still with some sacrifice to return. In real life, however, the fund has yet to prove itself. Relative performance has improved over the past few months, but investors looking for those diversification benefits will need to be patient. I continue to rate the fund a Hold.

I’d be very careful about putting too much money in either, though. Plus, this is definitely one sector where a number of active managers have outperformed the index over long periods of time. Unfortunately, none of them work for Vanguard.

Senior Editor Dan Wiener and Editor/Research Director Jeffrey DeMaso publish The Independent Adviser for Vanguard Investors, a monthly newsletter that keeps abreast of recent developments at Vanguard, and the annual FFSA Independent Guide to the Vanguard Funds.

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