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Financial Overexposure Cripples Real Estate ETFs

Posted: Aug 14, 2008 15:03 PM by Gregory S. Davis

Tickers in this Article: REZ, FRI, DRW, TAO, REM, NLY, EQR, PSA, BXP

All real estate exchange-traded funds are not created equally. The iShares NAREIT Residential ETF (PSE:REZ) has managed to stay in positive territory through the first half of the year, but real estate ETFs focused on emerging markets or mortgages have lost nearly one-third of their value. Investors building their real estate investments during the current down cycle must weigh the risk versus return before investing.

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Let's have a look at some of the industry's carnage that proves overexposure in one area can cripple a fund. (To learn how to avoid the mistakes of the fund's below, check out Solutions For Concentrated Positions.)

Over exposure to Asia-Pacific/European Financials
The WisdomTree International Real Estate (AMEX:DRW) is down 28% since the beginning of the year. The fund pays a decent yield of 5.46%. Its overweight exposure to financial services companies in Australia, Hong Kong and France left the fund at the mercy of tightening global credit markets.

Over exposure to Asian Financials
The Claymore/AlphaShares China Real Estate (PSE:TAO) is down 35 % for the year. With $26 million in assets under management the fund is small relative to the $118 million in the WisdomTree ETF. TAO's over exposure to financials in Hong Kong, China and Singapore led to an even worse performance

Over exposure to U.S. Financials
The iShares FTSE NAREIT Mortgage REITs (PSE:REM) is down 28.91% over the same time frame due to its 100% exposure to U.S. based financial services companies. The fund reports an extremely high yield of 17.49%, but with less than $28 million in assets under management, the future of the ETF is uncertain.

MBS Exposure
Annaly Capital Management (NYSE:NLY) makes up more than one quarter of REM's portfolio. Annaly is organized as a REIT and generates revenue primarily by investing in mortgage backed securities. Given continued concern over the stability of credit markets, having NLY as the funds largest holding is a heavy risk to bear. (To learn about this unique income security, read What Are REITs?

Remove the Guesswork
The First Trust S&P REIT (AMEX:FRI) is composed of 100 companies on the S&P REIT composite index. The fund is up 3.71% for the year on the performance of top holdings including Equity Residential (NYSE:EQR), Public Storage (NYSE:PSA) and Boston Properties (NYSE:BXP). Note that the fund only has $3 million in AUM after its inception in May of last year.

Final Thoughts
If you have experience as a mortgage broker, then it may make sense for you to exploit your expertise when looking for a real estate investment focused on mortgage finance. For everyone else without industry knowledge, seeking out an ETF that tracks an index is probably the best investment path to take.

Read more on real estate, and other sector ETFs in our related article Singling Out Sector ETFs.

By Gregory S. Davis

Gregory S. Davis is an investment writer and consultant for his company G.Davis Capital Inc. His core methodology for choosing investments include patience, diversification and asset due diligence. Gregory is a graduate of the Wharton School of Business. He is also a board member of StoriesWork, a non-profit organization based in Durham, NC that uses storytelling to empower youth and individuals to utilize alternative dispute resolution tactics.

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