ETF investors should take a look into the real estate sector as an alternative asset to diversify a fixed-income portfolio.
On the recent webcast, Real Estate ETFs: Where to Start?, Kevin Davis, Chief Growth Officer for Vident Financial, explained that real estate is an important component of any diversified portfolio due to its low correlation with other asset classes and potential to provide diversification benefits, inflation protection dividend income, high returns, high growth and tax advantages.
Real estate has historically exhibited low correlation to stocks, bonds and commodities, which makes the asset a great source of diversification. The FTSE NEREIT All Equity REITs Index has exhibited a 0.552 correlation to the S&P 500, a 0.115 correlation to commodities, a 0.475 correlation to the MSCI EAFE Index, a 0.352 correlation to the emerging markets, 0.198 correlation to the Barclays U.S. AGG Index and 0.052 correlation to U.S. Treasuries.
The sector has a strong track record as an inflation hedge and long-term store of value. Davis pointed out that rental income generally increases with inflation, and standard leas terms protect landlords from cost inflation since tenants are usually responsible for operating costs such as utilities, insurance and maintenance. From 1978 through 2011, REITs have shown a 65.8% inflation protection success rate, compared to 60.8% for stocks, 53.8% for Treasury Inflation Protected Securities and 43.2% for gold.
Real estate investors also enjoy attractive dividend yield-generation, which provides an alternative to bonds as a source of income. The sector offers yields that exceed sovereign and corporate investment bonds. Unlike bond coupons, real estate dividends can grow over time, which is invaluable in periods of high growth and inflationary environments. Additionally, due to real estate’s long-term leases, they provide a more reliable source of dividends than other equities.
Davis also underscored the historical outperformance of real estate assets. The returns in high growth periods have shown the potential to be competitive with equities and fixed-income investments. Meanwhile, real estate is better positioned for low growth environments when compared to most equities due to the stable dividend potential.
As a way to help investors access the real estate segment, Vident Financial has come out with the U.S. Diversified Real Estate ETF (NYSE Arca: PPTY). Fred Stoops, Head of Real Estate at Vident Financial, highlighted the four main factors that the PPTY portfolio follows, including location, property type, leverage and governance.
The location factor refers to a key driver of real estate performance. Stable targets are used to diversify geographic exposure while favoring dynamic, high-growth locations. Jerry Bowyer, Chief Economist at Vident Financial, also pointed out that PPTY’s geographic targets increase exposure to relatively attractive retail locations such as New York City, Washington, D.C., and Los Angeles.
Property type is based off the fact that differences between property types matter, so fixed allocations seek to ensure diversification and balance. A traditional market-cap weighted indexing methodology focuses on retail, followed by communication, whereas PPTY’s more balanced approach takes an overweight position to residential, office space and industrial REITs.
“Unlike other indices, PPTY allocates to companies deriving their revenues from real estate as opposed to other businesses,” Andrew Alden, Head of Quantitative Research at WeatherStorm Capital, said.
The leverage factor corresponds to responsible use of leverage to enhance returns, but excessive debt creates unnecessary risk, especially during economic downturns. PPTY seeks to reduce allocations to companies with high debt in favor of firms with strong balance sheets.
Lastly, governance covers companies with significant governance risks, which are excluded from the portfolio. The index utilizes two criteria: external management and low free float percentage.
Financial advisors who are interested in learning more about the real estate sector can watch the webcast here on demand.