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Choosing The ‘Best’ REIT ETF

Summary Over the past 8 years, REZ has outperformed the other REIT ETFs. REITs are generally more volatile than the S&P 500. REIT ETFs help diversify a S&P 500 focused portfolio but are highly correlated among themselves. As a retiree looking for income, I am a fan of Real Estate Investment Trusts (REITs). I own some individual REITs, but for diversification, I tend to gravitate to REIT funds, especially Closed-End Funds (CEFs) or Exchange Traded Funds (ETFs). In July, I wrote an article on how to choose the “best” REIT CEF and selected the Cohen and Steers REIT and Preferred Income Fund (NYSE: RNP ) as my favorite. This article focuses on selecting the “best” ETF and also compares the performance of these ETFs with RNP. There are many ways to define “best.” Some investors may use total return as a metric, but as a retiree, risk is as important to me as return. Therefore, I define “best” as the fund that provides the most reward for a given level of risk and I measure risk by the volatility. Please note that I am not advocating that this is the way everyone should define “best”; I am just saying that this is the definition that works for me. For those that have not read my previous articles, I will quickly summarize some of the characteristics of REITs. In 1960, Congress created a new type of security called REITs that allowed real estate investments to be traded as a stock. The objective of this landmark legislation was to provide a way for small investors to participate in the income from large scale real estate projects. A REIT is a company that specializes in real estate, either through properties or mortgages. There are two major types of REITs: Equity REITs purchase and operate real estate properties. Income usually comes through the collection of rents. About 90% of REITs are equity REITs. Mortgage REITs invest in mortgages or mortgage-backed securities. Income is generated primarily from the interest that is earned on mortgage loans. The risks and rewards associated with mortgage REITs are very different than those associated with equity REITs. This article will only consider equity REITs. One of the reasons REITs are so popular is that they receive special tax treatment, and as a result, are required to distribute at least 90% of their taxable income each year. This usually translates into relatively large yields. But because REITs must pay out 90% of their income, they rely on debt for growth. This means that REITs are sensitive to interest rates. If the interest rates rise, the cost of debt increases and the REITs have less money for business investment. However, rising rates usually imply increased economic activity, and as the economy expands, there is a higher demand for real estate, which is positive for REITs. The effect of higher rates depends on the type of real estate owned by the REIT. For example, if the real estate has tenants with short leases, interest rates would have less impact because the rents could be raised quickly. Among the real estate sectors, hotels generally have the shortest leases followed by (from short to long) apartments, industrial property, retail properties, and healthcare. There are currently 16 ETFs focused on equity REITs. To reduce the analysis space, I selected only the ETFs that met the following requirements: A history that goes back to 2007 (to see how the fund reacted during the 2008 bear market). Generally, REITs were devastated in 2008, but, like other equities, they have recovered strongly since 2009. A market cap of at least $100 million. An average daily trading volume of at least 50,000 shares. The 6 ETFs that passed the screen are summarized below. Vanguard REIT Index (NYSEARCA: VNQ ). This ETF was launched in 2004 and is the largest REIT ETF. It tracks the MSCI US REIT Index, which is a pure equity index. The fund has 145 holdings diversified across real estate sectors with retail being the largest constituent at 25% followed by residential (17%), specialized (14%), Office 14%, and health care (13%). Specialized REITs are companies or trusts that do not generate a majority of revenue from rental and lease operations, such as storage properties. VNQ holds a large percentage (40%) of medium cap firms and also has 19% in small cap holdings. The fund charges a low 0.12%, which is substantially less than most of its competitors. The fund yields 3.9%. iShares U.S. Real Estate (NYSEARCA: IYR ). This is the only ETF that holds REITs of all kinds including mortgage REITs and timber REITs. The fund has 119 holdings spread over commercial (44%), specialized (37%), and the residential (14%) sectors. The fund has an expense ratio of 0.43% and yield 3.7%. iShares Cohen & Steers REIT (NYSEARCA: ICF ). This ETF is highly concentrated, holding only 30 of the largest REITs. The strategy assumes that large REITs will be better able to weather downturns. The holdings are spread across the commercial (51%), specialized (28%), and the residential (21%) sectors. The expense ratio is 0.35% and the yield is 3.2%. SPDR DJ Wilshire REIT (NYSEARCA: RWR ) . This ETF tracks the Dow Jones US Select REIT index. The fund holds 95 REITs spread over the commercial (53%), specialized (27%), and residential (20%) sectors. The fund has an expense ratio of 0.25% and yields 3.2%. i Shares Residential Real Estate Capped (NYSEARCA: REZ ). This ETF is touted as a residential REIT fund but only about 47% of the holdings are residential REITs. The other 53% are primarily specialized REITs. The fund has 38 holding, has an expense ratio of 0.48% and yields 3.3%. S&P REIT Index (NYSEARCA: FRI ). This ETF covers a large portion of the US REIT market with 156 holdings spread over commercial (55%), specialized (28%) and residential (17%) sectors. The fund has one of the highest expense ratios at 0.50% and yield 2.6%. For comparison, I used the following CEF: Cohen and Steers REIT and Preferred Income Fund. This CEF sells for a discount of 17.6%, which is larger than its 5-year average discount of 9.9%. The portfolio consists of 203 holdings with 49% in REITs and 49% in preferred shares. The fund uses 26% leverage and has an expense ratio of 1.7%. The distribution is 8.4%, consisting primarily of income with about 40% return of capital over the past 9 months. I also included the following ETF to provide a comparison to the overall stock market. SPDR S&P 500 Trust ETF (NYSEARCA: SPY ). This ETF tracks the S&P 500 index and has an ultra-low expense ratio of 0.09%. It yields 2%. For the funds that met my criteria, I plotted the annualized rate of return in excess of the risk-free rate (called Excess Mu on the charts) versus the volatility for each fund. This data is shown in Figure 1. The risk-free rate was assumed to be zero to make comparisons easier. (click to enlarge) Figure 1. Risk versus reward over bear-bull cycle Figure 1 illustrates that REIT funds have had a large range of returns and volatilities. To better assess the relative performance of these funds, I calculated the Sharpe Ratio. The Sharpe Ratio is a metric, developed by Nobel laureate William Sharpe that measures risk-adjusted performance. It is calculated as the ratio of the excess return over the volatility. This reward-to-risk ratio (assuming that risk is measured by volatility) is a good way to compare peers to assess if higher returns are due to superior investment performance or from taking additional risk. In Figure 1, I plotted a red line that represents the Sharpe Ratio associated with RNP. If an asset is above the line, it has a higher Sharpe Ratio than RNP. Conversely, if an asset is below the line, the reward-to-risk is worse than RNP. Some interesting observations are evident from the figure. REIT performance is tightly bunched in the risk versus reward space with similar volatilities and performances. All the REITs were significantly more volatile than the S&P 500 but also delivered more total return. RNP was among the top performers illustrating that this CEF did as well or better than most ETFs. Cohen and Steers manages both RNP and ICF. RNP performed better than ICF, likely due to the use of leverage. REZ was the best performer on a risk-adjusted basis followed closely by VNQ and RWR. FRI was the least volatile ETF and ICF was the most volatile. FRI and IYR lagged in terms of risk-adjusted performance. One of the reasons often touted for owning REITs is the diversification they provide. To be “diversified,” you want to choose assets such that when some assets are down, others are up. In mathematical terms, you want to select assets that are uncorrelated (or at least not highly correlated) with each other. To assess the degree of diversification, I calculated the pair-wise correlations associated with the REIT funds. The results are provided as a correlation matrix in Figure 2. (click to enlarge) Figure 2. Correlation matrix over bear-bull cycle As is apparent from the matrix, REITs did provide a fair amount of portfolio diversification for an equity based portfolio and a CEF based portfolio . However, the REIT ETFs were generally highly correlated with one another. This is not surprising since the number of REITs is relatively small and the ETF portfolios have substantial overlap. Thus, you do not receive much diversification by purchasing more than one of the ETF funds. Next, I looked at the past 5-year period to see if the REIT performance had significantly changed. The results are shown in Figure 3. The performances were tightly bunched, but RNP and REZ were still the best performers. IYR continued to lag. You should also note that with the 2008 bear market removed from the analysis, volatilities were substantially reduced. In fact, over the past 5 years, REIT ETFs were only slightly more volatile than the S&P 500. (click to enlarge) Figure 3. Risk versus reward over past 5 years Continuing the analysis, I re-ran the analysis over the past 3 years and the results are shown in Figure 4. During this period I was able to add the following ETF to the mix. Schwab US REIT (NYSEARCA: SCHH ). This ETF has the lowest expense ratio (0.07%) of any REIT fund. The fund tracks the same index as RWR but has a much smaller expense ratio. The fund holds 95 REITs spread over the commercial (53%), specialized (27%), and residential (20%) sectors. The fund yields 3.2%. Over this period, all the REIT funds were again tightly bunched, without a large variation in either return or volatility. For the past 3 years, the ETFs slightly outperformed RNP on a risk-adjusted basis. All the REITs performed significantly poorer than SPY over the period. (click to enlarge) Figure 4. Risk versus reward over past 3 years Finally, I looked at the past 12 months (Figure 5). What a difference a couple of years made. REZ continued to be the best performer, followed by ICF, and then SCHH and RWR. RNP had similar performance to SCHH. It is interesting to note that ICH outperformed RNP, illustrating that leverage does not always increase total return. Most of the REIT funds outperformed SPY over the past year. The popular IYR fund lagged during the period. (click to enlarge) Figure 5. Risk versus reward over past 12 months Bottom Line The performance of REIT ETFs depends on the time period analyzed. During some periods, REITs outperformed SPY but lagged in other periods. RNP (the reference CEF) held it own against ETFs, usually being among the top performers on a risk-adjusted basis. In terms of ETFs, REZ was clearly the best performer in all time frames analyzed. Since REIT ETFs are highly correlated with one another, you do not receive significant diversification by purchasing more than one. If you decide to invest in this asset class, I would recommend REZ.

Just Energy Group Q2 Earnings Review – No Slowdown In Sight

Summary Shares have appreciated substantially since July. Total revenue grew 18%, with the more profitable consumer segment growing 20%. The U.K. operation and the solar program will pave the way for future growth. After a poor performance in 2014 and trading flat in H1 2015, Just Energy (NYSE: JE ) is finally back on track. Since my last analysis on the company in July, shares have appreciated by 30% from $5.23 to $6.82 today. Let’s see how the company performed in Q2 (year end is in March). The company continued to deliver top-line growth. Increasing sales by a whopping 18% quarter on quarter from C$918 million to C$1.1 billion. This doesn’t surprise me one bit. With the exception of FY 2012, the company has always delivered consistent growth from year to year. (see below). Many consumers are aware of Just Energy’s incessant marketing, and the financials reflect that. Sales can be broken down into consumer sales and commercial sales. Quarter on quarter, consumer sales have grown by 20% and commercial sales by 16%. The growth from consumer sales are much more valuable because traditionally commercial customers simply paid less. In Q2, gross margin for the consumer division was 22%. In contrast, the commercial division only yielded 9%. After deducting various operating expenses, the consumer division is more than twice as profitable as the commercial division (C$27 million of operating profit vs. C$10 million of operating profit). We can also examine growth from by looking at how much money the company charges its customers, which would reflect more of an “organic growth” as opposed to revenue generated by acquiring new customers. For the consumer segment, margin per customer rose 24% from C$176/RCE in Q2 2015 to C$219/RCE in Q2 2016. Evidently, the company should be able to achieve sales growth even if customer acquisition slows. Despite these great results, the company still reported a loss. The main culprit is derivative losses. During the quarter, the company made a fair value adjustment of C$117 million due to declining commodity prices (i.e. the company would have to purchase commodities at higher prices than the market if contracts are settled now). These losses will eventually go away as the contracts expire (i.e. not recurring). Outlook I believe that the future is bright for Just Energy. The company is still rather small in the U.K. and has plenty of run way to expand. Just two quarters ago, U.K. contributed 202,000 RCEs. In Q3, this number has grown 36% to 275,000 RCEs. In addition, the company is also exploring non-traditional initiatives such as the partnership with Clean Power Finance to enter the residential solar market, which is all the rage right now. While the exact impact on the bottom line is not clear yet as results are still preliminary, I believe that this program will be a smash hit. Because the company is marketing to existing customers, I believe that the adoption rate should be fairly high. This means that the solar program should be able to generate incremental profit without the company spending too much money (as opposed to a new customer acquisition).

Dollar/Yen As A Hedge To Oil Investments

Summary Oil and oil companies seem like attractive bets, however there are many near term risks. In an environment of persistent low oil prices, the BOJ has assured continued QE or increases in QE. The dollar has an inverse correlation to oil, therefore a dollar hedge allows for a pure supply/demand bet on oil. The case for being long oil (NYSEARCA: OIL ) has been made numerous times on this website and others, but I will recap a few of the salient points here for completeness. Oil may be attractive from a supply point of view. Most of the new supply that led to the recent glut came from shale oil wells in the United States. In fact, oil production from other sources of world oil actually declined during the period from 2012 to 2014. Source: Resilience.org Shale oil wells have rapid decline curves compared to conventional wells. Source: oilprice.com As shown above, the production rate is a small fraction of the initial production by years 2-3. Therefore, we ought to expect that roughly two years after oil rig counts began to decline, the supplies of crude oil ought to begin to fall rapidly. However, the timetable for this recovery in oil price has been delayed due to the fact that several E&P companies were slow to stop drilling. In a last ditch effort to produce cash flows from their land, many companies continued to drill even at unfavorable prices. Source: marketrealist.com Though crude began to fall in July of 2014, companies didn’t start reducing rig count until many months later, and rig counts didn’t reach the current lower range until the spring of this year. This led to a situation where US supply didn’t start to roll over until the beginning of this year. Despite the drop in rig counts, the supply coming out of US shale is still higher than it was at the start of the crash in oil prices: Source: QuintoCapital.com This makes for an interesting situation of time arbitrage. The sharp decline in shale wells, combined with a lack of new drilling in the U.S., means that by 2017 (2 years from the peak shale oil supply seen in the above chart) the U.S. supply should be low enough to begin to positively affect oil prices. Investors who are convinced of the above argument may take a long position either in the commodity (via futures) or in specific, cash-rich E&P names that are unlikely to go bankrupt, and wait out the supply-demand imbalance. However, there is a danger in catching a falling knife – commodity speculators are currently riding the trend for lower prices, and stock traders are following suit with oil stocks. In addition, there is a risk that the oil supply/demand mismatch may worsen when Iran brings new production online. A long position in oil or oil stocks could pay off eventually, but lead to disastrous portfolio results in the meantime. Therefore, it is desirable to hedge such a position. The Case for Shorting the Yen ( YCS ) Japan’s central bank, unlike the Federal Reserve, uses a measure of inflation that includes the cost of energy. Thus, the fall in oil prices has set back its goal of ending deflation. Though Haruhiko Kuroda has been insisting that this is a temporary setback, one must consider what would have to happen for an investment in a cash-rich E&P firm to go poorly – namely, we would have to see much lower oil prices before the supply glut ends. Take a look at comments Kuroda made earlier this year (emphasis added): “…however, based on the assumption that crude oil prices are expected to rise moderately from the recent level , the CPI is likely to reach 2 percent in or around fiscal 2015. Needless to say, the Bank maintains its policy stance that it will make adjustments as necessary without hesitation, when there are changes in trend inflation, in order to achieve the price stability target at the earliest possible time. The Bank will not respond to developments in crude oil prices themselves, but in conducting monetary policy, it will closely monitor how they affect inflation expectations — or, in other words, whether conversion of the deflationary mindset will nevertheless proceed.” And, more recently, “The timing of reaching the inflation target depends on oil, he told reporters in Tokyo. Kuroda, 71, reiterated that the BOJ won’t hesitate to adjust policy if necessary.” And “Kuroda said he didn’t see limits to further policy steps, amid concern among private analysts that the BOJ’s campaign — mainly purchases of Japanese government bonds, or JGBs — is running up against constraints. He didn’t think a limit on buying JGBs would come soon.” The latest inflation numbers for September showed inflation at -.1% , a far cry from the 2% goal. While Kuroda stated that the BOJ will not specifically respond to oil prices, lower oil prices are bound to continue to bring down inflation expectations. I take the above comments as basically an assurance that as long as oil prices stay low, the BOJ will continue its QE program, and if oil prices fall further, there is a high likelihood that the BOJ will ramp up its QE program yet again. The Case for Being Long The U.S. Dollar There has been a strong inverse relationship between the dollar (NYSEARCA: UUP ) and oil: Source: quintocapital.com This correlation makes sense: because oil is priced in dollars, the strong dollar has contributed to the fall in oil prices. While Japan has been concentrated on stepping up its QE program, the US Federal Reserve has basically told market participants that it plans to raise rates in December. This divergence in policies is driving the USD/JPY higher, and the oil price lower. So going long the dollar in addition to being long oil provides investors a way to play oil purely for its supply-demand characteristics, rather than its aspect as an alternative currency. A word about China There has been a perception that the crash in Chinese stock prices will lead, or already has led, to weakening oil demand. However, the opposite is actually true – Chinese oil demand is actually up 9.2% year-over-year , as lower prices have stimulated demand. As Stanley Druckenmiller said earlier this year , the cure for high prices is high prices, and the cure for low prices is low prices. Putting it together I think there’s a strong case out there for being long oil right now. However, there is always a risk that the fall in oil could become overdone, and we could see oil prices that are in the $20-$30 range before we see prices in the $60-70 range. In order to hedge this volatility, I think there’s a good case for being long the US dollar, specifically against the yen, which will devalue further if oil either stays low or drops further. Any thoughts are always appreciated.