This post is part of a series called Under the Hood, where l take a detailed look at specific Canadian ETFs or index funds.
The fund: Vanguard FTSE Canadian Capped REIT (VRE)
The index: The fund tracks the FTSE Canada All Cap Real Estate Capped 25% Index, which includes large, mid and small-cap companies in the Canadian real estate industry as defined by FTSE. The index is weighted by market cap with a limit of 25% on any single company. It currently has 19 holdings.
The cost: The management fee is 0.35%. Because the fund is less than a year old it has not published its full MER, but expect it to be about 0.40% after adding taxes and incidentals.
The details: Vanguard launched VRE last November and continued its tradition of being a cost leader: its management fee is about 20 basis points lower than its competitors.
VRE is not limited to REITs: some of its holdings are developers and real estate services companies that are not set up as income trusts. But even with this expanded definition, the real estate industry in Canada is extremely small. That makes concentration risk a problem in a cap-weighted fund, as a small number of companies will dominate. VRE’s top holding is the giant RioCan at more than 16%—more than the bottom eight holdings combined—followed by Brookfield Office Properties at almost 13%.
The ETF pays monthly distributions, and the most recent was about $0.04 per share, which works out to an annual yield of less than 2%. That’s unusually low for a REIT fund, so you should expect it to change once the fund has a longer history and its cash flows are smoothed out.
The alternatives: VRE is the newest of three real estate ETFs in Canada. The iShares S&P/TSX Capped REIT (XRE), which is also cap-weighted, is the leader with almost $1.4 billion in assets. The BMO Equal Weight REITs (ZRE) has about $375 million under management. Both ETFs have management fees of 0.55%.
A detailed look at the holdings of these three alternatives turns out to be very revealing:
VRE | XRE | ZRE | |
RioCan REIT | 16.3% | 18.9% | 5.0% |
Brookfield Office Properties Inc. | 12.7 | – | 5.2 |
H&R REIT | 9.4 | 10.9 | 5.0 |
Dundee REIT | 7.2 | 8.7 | 5.2 |
Calloway REIT | 6.2 | 6.8 | 5.2 |
Boardwalk REIT | 6.2 | 6.1 | 5.1 |
Canadian REIT | 5.9 | 7.3 | 5.3 |
Cominar REIT | 5.6 | 6.1 | 5.1 |
Primaris Retail REIT | 5.2 | 6.3 | 5.2 |
Canadian Apartment Properties REIT | 5.1 | 6.0 | 5.3 |
Allied Properties REIT | 4.0 | 5.3 | 5.4 |
Chartwell Seniors Housing REIT | 3.7 | 4.4 | 5.2 |
Artis REIT | 3.4 | 4.2 | 5.2 |
First Capital Realty Inc. | 3.1 | – | – |
Morguard REIT | 1.7 | – | 5.5 |
FirstService Corp. | 1.6 | – | – |
Extendicare Inc. (US) | 1.3 | – | – |
InnVest REIT | 0.8 | – | 5.5 |
Melcor Developments Ltd. | 0.4 | – | – |
Granite REIT | – | 4.3 | – |
Northern Property REIT | – | 2.4 | 5.2 |
Crombie REIT | – | 1.8 | 5.1 |
Pure Indstrial REIT | – | – | 5.7 |
Notice that if you lop off the top and bottom of the list, the holdings are not meaningfully different: the 10 REITs I’ve marked in blue have similar weightings and together make up approximately half of each fund. The truly important difference is in how each fund weights RioCan and Brookfield. The weight assigned to the smaller REITs also varies considerably: VRE includes several very small holdings that will have minimal influence on the fund’s overall performance.
What effect will these differences have? A lot, as it turns out. With a track record of just three months, there is no meaningful performance data for VRE, but FTSE has published index returns for the last five calendar years. Here they are, along with the performance of the indexes tracked by XRE and ZRE:
2008 | 2009 | 2010 | 2011 | 2012 | 5 Yr. | |
FTSE Canada All Cap Real Estate | -42.8 | 46.5 | 31.6 | 8.0 | 16.4 | 6.8 |
S&P/TSX Capped REIT | -38.3 | 55.3 | 22.6 | 21.7 | 17.0 | 10.8 |
Dow Jones Cda Select Eq Weight REIT | -30.7 | 59.1 | 30.7 | 14.5 | 18.9 | 14.4 |
Notice the FTSE index returned just 8% in 2011, dramatically underperforming the other two. I don’t have access to the list of holdings from 2011, but it seems likely this discrepancy was driven by RioCan and Brookfield: the former gained over 23% in 2011, while the latter lost more than 8%. The S&P index has an even greater allocation to RioCan, and it does not include Brookfield at all, which worked out well that year. Meanwhile, the Dow Jones index holds equal amounts of each, so its performance fell between of the other two.
[Update: After this post appeared, Vanguard replied: “You’re correct in your reasoning for the relative underperformance in 2011. Until September 2011, non-REIT Real Estate holdings represented  about 41% of the index, with one constituent (Brookfield Asset Management) capped at 25% itself.  However, Brookfield (which was down 14% in 2011) was removed from the index at the September 2011 reconstitution as it was reclassified as a Financial Services company.” Please note Brookfield Asset Management and Brookfield Office Properties are distinct companies, and the latter remains in the FTSE index.]
Bottom line: One of the goals of passive investing is to capture the returns of entire asset class by minimizing the influence of any single security. Real estate has a place in a diversified portfolio because it has historically shown low correlation with equities, not because you want exposure to a couple of specific companies. Cap-weighted indexes are an efficient tool for broad equity markets, but not so for a tiny sector like Canadian real estate.
VRE is the cost leader in this category, but I feel it suffers from the same flaw as XRE: too much concentration.
Does REIT will suffer from a house maket cooling or a raise of interest rate?
@Francis: Most REITs have little exposure to the residential housing market. They could be negatively affected by a rise in interest rates, but that is true of other income stocks like utilities, pipelines, etc. If you believe REITs have a place in a portfolio, they should be a long-term strategic holding, not a tactical one.
@CCP: I am in the recently retired phase of the investment lifetime with a largish portfolio spread evenly between RRSP and non-RRSP. I have avoided real estate completely in my stock/bonds/cash portfolio with the rationale that I have a mid to mid-high value residence in Calgary, and an indirect ownership in a slightly high-end residential apartment in London, UK, and felt that this already constituted an overweighting of Real Estate in my overall investments. With your comment above “Most REITs have little exposure to the residential housing market”, perhaps I should re-think my strategy, and my rationale for omission of REITs. Your comments on this would be very helpful, thanks.
@Oldie: Real estate is highly local, so there is likely zero correlation between the Calgary housing market, the UK apartment market, and commercial/industrial real estate elsewhere in Canada (which is what REITs typically hold).
Dan, could you comment on global REITS such as RWO in your Uber Tuber model portfolio vs a Canadian REIT such as ZRE in your Complete Couch Potato portfolio. I’m assuming having more than one REIT etf in a portfolio would be redundant so what would be the rational to pick ZRE vs RWO? Wouldn’t more diversification with RWO be the better choice than ZRE?
@Louis: The Uber-Tuber was based on strategies used by Dimensional Fund Advisors, and DFA use a global real estate fund that is reasonably close to RWO in its composition. However, in the Complete Couch Potato I chose a Canadian REIT fund to eliminate additional currency risk, transaction costs and withholding taxes. (I should also note that DFA portfolios tend to allocate much less than 10% to REITs.)
If you have a very large portfolio, it would be reasonable to split the real estate component between, say, ZRE and RWO. The two holdings are hardly redundant at all: RWO’s allocation to Canada is very small. But that’s probably slicing and dicing a little too thinly for my tastes.
I definitely concur with your assessment. I was initially quite excited that Vanguard was coming out with a REIT ETF but after looking at the weighting it hardly seems like like 20 basis points are worth it for the loss of diversification. I’m ill at ease when two companies make up a quarter of the holdings of a given ETF. That and the 5 year returns make a pretty compelling case for sticking with ZRE. Why, yes indeed I’ll pay 0.2% for that 7.6%. Will that spread hold up going forward? Who knows, but it’s always safer to bank on diversification.
@David: Just to be clear, I would have been equally concerned if it turned out VRE’s index outperformed its competitors by a wide margin. The overconcentration in a small number of stocks could easily have led to higher returns. The key point is that the performance of one or two companies has a huge influence.
REITs are 10% of the Complete Couch Potato and if you used VRE or XRE, RioCan would be the biggest individual holding in the entire portfolio. This would be less of an issue if real estate were a smaller percentage of the portfolio.
How does the market cap with a limit of 25% compare to other non-canadian REIT?
Would it be better to invest in a non-canadian REIT to have more distributed holdings?
@Tommy: A global REIT fund would have better diversification, but it would also be more expensive to trade (denominated in USD), entail currency risk, and be subject to withholding taxes.
I sort of think of currency risk as a ‘feature’ not a ‘bug’ of investing internationally.
Would distributions from a US REIT ETF held in an RRSP be exempt from US withholding tax, as with US dividends?
PS: +1 for Andrew F’s comment. I do not understand how Canadians, who rely so heavily on imported goods, can consider exposure to foreign currencies a risk. On top of that, retired Canadians who are relatively well off tend to spend half their time in the US or Mexico.
@Andrew F and Owen B: I have long argued for currency diversification in a portfolio. The question is, how much? The Complete Couch Potato already includes 40% in foreign currency. Using global REITs would raise that to 50%, and if you wanted a lower bond allocation the proportion would go up even more. I’m not sure what the optimal level of foreign currency exposure is, but I’d suggest it’s lower than 50%.
Re: withholding taxes on global REITs, see this blog by Justin Bender.
That yield does seem very low for real estate especially when you consider RioCan pays more then 5%
@Mandy: The yield on a new ETF is pretty much meaningless, because yield is calculated over trailing 12-month periods. This fund is less than four months old.
I don’t understand why REIT ETFs have such relatively high MERs. They’re all holding less than 20 stocks; other broad equity and bond ETFs hold hundreds of securities and have MERs less than 0.2%. ZRE seems particularly expensive given that it’s not even following an index so there is no fee paid to an index provider. Buying the individual stocks as discussed in a post last year seems more attractive.
@Smithson: Sector ETFs in general tend to be more expensive than broad-market ETFs. Part of the reason is likely that some of the stocks tend to be smaller and less liquid (though that doesn’t explain why XFN is charges 0.55% to hold all the big banks). I suspect market makers also find it more work to maintain them.
For the record, ZRE does track a Dow Jones index.
Unbundling a small ETF like ZRE is a reasonable possibility, but I would certainly spend some time doing the math to see whether it’s really worth it.
https://canadiancouchpotato.com/2012/10/10/ask-the-spud-should-i-unbundle-my-etf/
I was hoping you could weigh in on 2 questions, one being a general ETF question, and the other being specific to a listing.
1. Why do ETFs seem to not capture the capital growth of the underlying equities they contain? The 52-week spreads seem consistently narrow. Is it just a law of averages kind of thing? I’m finding myself investigating and rejecting scores of ETFs because they don’t seem to really have any purpose at all – most offer extremely low capital growth and pitiful yields (1-3%). I’m in my twenties and I want capital growth – my appetite for risk is very high.
2. For ETFs like FIE, where in 2011 the fund distributed more in Return of Capital than from Dividends, is it just me or is that totally insane? Why would anyone ever hold this? And for the privilege of their brilliant investing strategy of holding some other iShares ETFs and some no-brainer Canadian Bank preferred’s, and returning your own damn money back to you, they charge a 1% MER?! I don’t get it.
Appreciate the work you do here – cheers!
@Andrew: I have to confess I don’t understand your first question. ETFs capture all the gains of their underlying holdings, minus their fee, of course. What data are you looking it? If you can provide an example I might be able to offer some insight.
As for return of capital, I tend to agree with you. If you’re an investor who is living off the income from your portfolio and you are fully aware that ROC is the same as spending your principal, then it’s fine. However, many yield-hungry investors are not aware that ROC is not an investment return: as you say, it is simply giving you back your own money. You see this a lot in the popularity of monthly income funds, which entice people with high “yields.” These same investors would be aghast at the idea of selling a few units of their fund every month to generate income, but it’s exactly the same thing. I wrote about this recently in MoneySense:
http://www.moneysense.ca/2012/09/14/the-income-illusion/
@ CCP re: my #1 question
Maybe it comes from my never having paid much attention to indices as a whole, which I realize the ETFs tend to track pretty well. I guess my goal isn’t to really track the performance of an index but to capture gains in sectors that are undervalued at any given point. My central point is that I’ll look at the unit prices of an ETF and they’ll have X variance over 12 or 36 months or whatever timeframe, and I’ll look at some of the top Canadian blue chips it holds (e.g. low risk equities), and they tend to have larger capital growth. To my mind the ETF game is sometimes a big mediocrity play and I’m struggling to understand the benefit of parking the majority of one’s long term savings in these instruments.
*shrug*
Maybe what I really want is another 2008, now that I have capital to invest haha.
@Andrew: Well, this comes down to the age-old question: do you want to invest in the market as a whole, or do you think you can choose the individual sectors or stocks that will outperform over the long run? I’ll refer you to the list of books on my Resources page.
@CCP: Can you please elaborate on your comments about currency risk, and the items to consider when looking at your % of foreign currency, and deciding the ideal amount.
I am having a hard time understanding how you take your arguments in this post to choose ZRE over VRE or XRE, but then easily decide that a Canadian REIT is better than a Global one.
For example, even when you combine the addition foreign withholding taxes with the lower MER of VNQI you are still lower than the Canadian REITS MER and considerately more diversified with a lot “less concentration”. Combine VNQ to mix and the total MER drops even more, and no withholding taxes if held in an RRSP. If you are already converting CAD to USD with VTI & VXUS, why not buy some US REIT ETFs as well.
Side note, do you know where Justin Bender found the foreign withholding taxes for RWO in your link you posted?
100% of the distributions of a foreign ETF (including REIT ETFs) would be taxed as ‘foreign income’ at your MTR in a taxable account, whereas a Canadian ETF might distribute some capital gains, return of capital and (possibly) dividends, along with the ‘other income’.
@Que: I didn’t mean to suggest Canadian REITs were categorically better than global REITs. I simply meant one should consider how much of their overall portfolio is exposed to foreign currency risk. If a portfolio is 60% Canadian bonds and 40% equities, then it might be fine to use a global REIT fund instead of a Canadian one. But if your portfolio was mostly equities and you already had, say, a 20% allocation to US equities and 20% to international equities, I would think twice about adding another 10% allocation to foreign REITs. I don’t think there’s a magic number for currency risk, but I would be a bot concerned about going over 50%. Some advisers I respect recommend no more than 20%. It really depends on your individual needs.
Justin’s numbers for RWO come from the fund’s annual report, page 309:
https://www.spdrs.com/library-content/public/SPDR%20Index%20Shares%20Annual%20Report%2009.30.12.pdf
@Andrew: (to quote your statement)
” To my mind the ETF game is sometimes a big mediocrity play”
The whole point of the Couch Potato strategy is that the (index) ETF (invested in a passive, long-term strategic, market-timing-agnostic manner) game should ALWAYS be a big mediocrity play (with the footnote that mediocrity, the attribute of corresponding to an average value, is not necessarily a bad thing).
That is the fundamental premise of the Couch Potato (passive index) investment philosophy — that you should ideally aim to track the chosen index as exactly as possible, minus the anticipated costs, which, obviously should be a low as possible, while still allowing you to achieve your goal. For most people this can be a surprisingly difficult concept to accept as a good thing. The resources that Don has linked to are not particularly difficult, but need to be read through before you can say whether or not you disagree. Personally speaking, they have converted me from being a skeptic to a true Couch Potato believer, and therefore reading this blog is merely a guide as to the transition from theory to practice.
@Andrew:
“…and I’m struggling to understand the benefit of parking the majority of one’s long term savings in these instruments.”
Just read the resources. Please, please, please, please just read the resources.
I’m struggling to find the words, without sounding like a decrepit senile loser, to persuade you to take the advice that I’m sure will speak for itself once you start reading. I wish I had read these same materials when I was in my twenties like you are, instead of just 8 months ago; but that is just water under the bridge. As it is, I count myself lucky that I just happened to learn the lessons of frugal living early in life, and that I entrusted the resultant enhanced savings to a reasonable institution with a very modest percentage extraction considering that they were in the very large majority of investment advisors who believed that their actively managed mutual funds were a good deal; and due to disciplined regular contributions I have wound up with enough to work on (CCP-wise) for the retirement I have just started.
The fact that I now know I could have done much better myself is neither here nor there. You, on the other hand, now have in your hands a golden educational opportunity to radically transform your financial lifetime while you are still at the front end. Don’t squander it.
Re: Oldie’s comments – time limited at the moment, will come back to your comments :)
Re: Return of Capital
A family member who was suggesting FIE said this when I noted that I was cautious with the fund because it distributed more in Return of Capital than in Dividends.
> Return of Capital is just another way of classifying Capital Gain (your no. of units remain constant so distributions lower your Cost base). Here’s an old article from Globe and Mail (Q2) which explains this in detail:
http://www.theglobeandmail.com/globe-investor/investor-education/the-abcs-of-dividend-etfs/article1373200/
> In a non-registered a/c, Capital Gain has a more preferential tax treatment than dividends or interest since you’re taxed only on 50% of the gain and only when you sell your units. You can further reduce tax by offsetting your gains w/ capital losses on other investments.
Thoughts?
@Andrew: It’s true that capital gains can be more tax-advantaged than dividends, though it depends on your tax bracket: for low-income earners, dividends are taxed more favourably. It’s also true that ROC lowers the that adjusted cost base of the fund, which can lead to a capital gain when the fund is sold at some future date.
As long as you understand all of this, ROC is fine. It’s only a problem when people think of it as true “yield.”
Hi Dan,
Could I ask why you seem to have more faith that REIT’s will maintain their low correlation with equities, but you seem to have more reservations that commodities won’t?
@Robert: I don’t recall expressing that opinion about commodities. My concern with commodities in a portfolio is more practical than theoretical. They probably are a good diversifier, but it’s difficult and expensive to get exposure to this asset class.
I was taking a look at VRE’s holdings. They have the standard large Canadian REITs (RIOCAN, CanREIT etc.)
However, instead of holding the TSX listed REITS, they hold the US OTC Pink Sheet version of these REITs. E.g. RIOCF instead of REI.UN.
If interested, you can see their holdings by going here and downloading the spreadsheet.
https://www.vanguardcanada.ca/institutional/investments/etfs-detail-characteristics.htm?portId=9559#HoldingsEquityHeader
I was trying to figure out why they might hold the REITs in this manner, as well as whether this should affect my decision to buy VRE instead of XRE (iShares Canadian REIT). I had decided to get VRE because of the lower management fee, better management (I like Vanguard’s investor-first philosophy), and because I get VRE for no commission through ScotiaiTrade.
@hoopy: I checked this out with Vanguard and it’s just a mistake on their website. They have assured me it will be correct very soon.
Hey Dan,
Just wondering if you’d consider writing a bit about the absolute beating REITs are taking at the moment. From some superficial research I understand there is an inverse relationship between interest rates and REIT performance; that being said, bonds also have the same relationship but they haven’t fallen quite so hard, and seem to have flattened out recently. ZRE is just getting clobbered, and I’m interested to know a little bit more about what is doing the clobbering.
Thanks for considering
matt
@Matt: I’m not sure I can explain the specific reasons for the bad year REITs are enduring. The interest rate hikes are no doubt one factor, but real estate is a cyclical industry, and like any stocks, REITs can fall in value considerably. Let’s remember that they have enjoyed an enormous run since March 2009 and it would have been naive to expect it to continue forever. That’s why we diversify.
Of course, we could make forecasts like this one. :)
http://business.financialpost.com/2013/01/15/stay-invested-in-reits-the-word-according-to-raymond-james/
@CCP, I am still a bit perplexed about the continued low yield of VRE, currently 2.22%. The ETF has been around about a year now and I saw the comments about waiting for the cash flows to be smoothed out before increasing distributions… but I am not entirely if there will be one large distribution a the end of the year or if investors are losing out in some way.
@Michael: Someone else mentioned this recently, so I will check it out with Vanguard and report back.
Reit ETF vs owning one or two individual reits in an RSP account.
If you had 12000 to use in an RSP account and the only asset class that was missing in a portolio was the REIT sector…..would it be wise to select 2 Reits or just 1 or best to get one of the etf’s. (and am wondering what is the preferred ETF strategy right now…capped or equal weighted) This would be for a long term hold with DRIPS. I am trying to decide if a pie with many pieces and MER fees is better than just 2 pieces with no fees apart from buying the initial REIT. In the bigger picture this would not represent more than 4% of a portfolio. I’m looking for income with a high yielding equity. Any suggestions would be appreciated and understand you can’t offer specific advice. Thanks, Sue
@Sue: Holding just one or two REITs does not provide adequate diversification. The goal should always be to eliminate single-security risk form a portfolio.
This may also be of interest:
https://canadiancouchpotato.com/2012/10/10/ask-the-spud-should-i-unbundle-my-etf/
@CCP: Checking the holdings of VRE today, I find that RioCan REIT constitutes 18% and H&R REIT constitutes about 14% of VRE; the next highest component is below 7%.
Remembering that one can unbundle an ETF and purchase the underlying stocks, I wondered if there was any way one could start in the reverse order and purchase VRE, and somehow “unbuy” about 13% worth of RioCan REIT and 9% worth of H&R REIT using some sort of futures transaction to end up with, in effect, VRE with the top two holdings trimmed to about 5% of the total ETF worth.
I have no idea if this is possible, let alone practical, but if the cost was reasonable, it might be an alternative to buying ZRE (assuming this would be used in an RRSP or TFSA).
Why is the yield still at a low 2%? I thought the excuse was that it was a new fund, but it is exactly 2 years old as of today. Is it because of a lack of ROC? If so, then I’m all for it. I can sell my stocks myself. The truth is that I hold it in my TFSA anyway and don’t want to sell for a very long time.
@Luxerus: Great question and the answer is, yes, the low yield on VRE is due to Vanguard’s decision not to boost it with return of capital. Investors have different opinions on ROC, but I tend to agree with you that the less ROC, the better. (Total return is unchanged.)
Thanks for this article. Your website is a continually useful source of information!
I’ve decided I want to hold ZRE in my portfolio (5%). What are the benefits/drawbacks of holding ZRE in TFSA vs. RRSP? If limited contribution isn’t an issue in either case, is one a smarter option than the other?
Let’s assume I’ll make more money in retirement than I do now (currently 30 years old making $85k, will have pension), if that makes any difference.
@Sarah: I think we need to separate these to decisions. The first is whether you should prioritize TFSAs over RRSPs. If you are in a relatively low tax bracket now, then that probably makes sense. After you have made that decision, the next question is whether ZRE has any advantage in one account over the other, and the answer to that is no. :)
Hi, I’ve read your post and all the comments, just want to be sure I’m understanding the difference between yield on the VRE and ZRE. You say that Vanguard decided not to use ROC to boost returns on VRE so I checked ZRE and didn’t see any mention of ROC on the website. Maybe I missed it. If ROC isn’t involved, then I’m assuming the difference in the distribution and yield comes down to the different indices and weightings. Is that right?
@Laura: Click the “Distributions” tab on ZRE’s web page and then scroll to the bottom to see the breakdown of ROC and other income types:
http://www.etfs.bmo.com/bmo-etfs/distribution?fundId=80001
It looks like they have not posted 2014 numbers yet, but in 2013 the fund paid about $0.24 in ROC on a total distribution of $0.97 per share.
Thanks, I only checked the 2014 numbers.
Another difference I have noticed after reviewing the tax breakdown on the CDS website is that ZRE distributes capital gains as cash, while VRE reinvests them. The cash+non-cash “yields” for the whole year are not very different.
I just checked ZRE and VRE holding list , there is no Brookfield. Not sure why?
http://www.etfs.bmo.com/bmo-etfs/holdings?fundId=80001#
https://www.vanguardcanada.ca/institutional/mvc/detail/etf/overview?portId=9559&assetCode=EQUITY##portfoliodata
@P: Brookfield Office Properties was purchased by Brookfield Property Partners in March 2014 and removed from the indexes tracked by these ETFs.
http://www.theglobeandmail.com/globe-investor/news-sources/?mid=cnw.20140320.C6308
@CCP
Hi, I remember this website could notify me by email when someone replied my post .
But I don’t see the notifying email today , I hope you didn’t remove that feature.
It saves my time to check my post. Tks!