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XLRE: Quality, Not Quantity In Real Estate

Lara Crigger

The $2.27 billion Real Estate Select Sector SPDR Fund (XLRE) is not unique.

Several other bigger, better-known ETFs cover the U.S. real estate space, such as the $34 billion Vanguard REIT ETF (VNQ) or the $4.5 billion iShares U.S. Real Estate ETF (IYR). These funds have more assets than XLRE. Higher daily volumes. Longer track records. At a glance, it's hard to see how XLRE can compete.

But XLRE has one big point in its favor: an uber-concentrated portfolio. Whereas most real estate ETF portfolios cast a wide net over the sector, including 100 stocks in their portfolios (or more), XLRE holds just 31 names.

That smaller basket is XLRE's biggest selling point, says Jason Ware, chief investment officer of the $1 billion Albion Financial Group, adding that, for him, XLRE hits "the sweet spot" between diversification and high-conviction picks.

"We don't need a fund that has 100 or 150 holdings in it," he says. "We'd rather have a fund of only 30 REITs, as long as they're all REITs we actually want to own."

A Sector Is Born

XLRE is one of 10 Select Sector SPDR ETFs that slice and dice the S&P 500 Index into chunks along certain investment themes, such as energy or financials. In XLRE's case, that's real estate: The Real Estate Select Sector Index tracks a market-cap-weighted basket of real estate investment trusts (REITs).

The Select Sector Indexes follow the Global Industry Classification Standard (GICS), a system jointly developed by S&P and MSCI in 1999 to standardize which companies fall into which thematic buckets.

For 15 years, the GICS lumped real estate with banks and brokerage firms into the financials sector. Back when the GICS first launched, that choice made sense: In 2001, for example, REITs represented just 0.6% of the financials sector, and 0.1% of the S&P 500 as a whole.

But throughout the 2000s, as investment into real estate grew, it began to evolve into its own unique asset class, distinct from financials. Real estate also came to increasingly drive sector performance: By 2014, REITs had swelled to 19% of financials.

"The operating structure of real estate firms is much different than that of the big financial firms," said Matt Bartolini, VP at State Street Global Advisors and head of SPDR Americas Research. That impacts their risk/return profile, he added: "For example, real estate did really well during the interest rate decline, asynchronous to financials."

 

A Newcomer Struggles
In late 2014, S&P and MSCI decided to spin off real estate into its own separate category. Mortgage REITs—which finance real estate rather than acquire or maintain property—remained with the financials. But equity REITS—the shopping malls and self-storage companies; the apartment complexes and assisted-living facilities—all moved to a brand-new real estate sector, effective September 2016.

XLRE, which tracked this new sector category, launched in October 2015. Yet the fund failed to gain much traction until the following year, when State Street shifted the real estate exposure in its existing financials fund, the Financial Select Sector SPDR Fund (XLF), into XLRE. This transition, timed to coincide with when the GICS change became official, transformed XLRE overnight into a $3 billion fund.

From there, however, XLRE has mostly stagnated. Today the fund has $2.27 billion in assets and $56 million in daily volume. That's not bad, of course. But it's nowhere near the level of, say, XLF, which has more than 20 times XLRE's AUM ($21 billion) and more than 25 times its daily volume ($1.7 billion).

That said, XLRE is also more than a decade younger than the other Select Sector SPDR ETFs, with barely two years' trading under its belt. The fund may just need time to catch up.

Quality, Not Quantity

XLRE's 31-stock portfolio is much smaller than those of its competitors: The Schwab U.S. REIT ETF (SCHH) and the SPDR Dow Jones REIT ETF (RWR) both hold 105 companies; IYR holds 126, VNQ holds 156. (For context, only about 200 REITs currently trade on major stock exchanges.)

XLRE's portfolio still hides a few surprises, however.

True, in XLRE, you'll find many of the same residential and commercial REITs you'd find in VNQ or RWR: Its top 10 include Public Storage, a self-storage REIT; AvalonBay Communities, a high-end apartment developer; and Simon Property Group, the U.S.' largest shopping mall operator.

Interestingly, though, two of XLRE's top three names—American Tower Corporation and Crown Castle International—are cell tower companies. Cell tower companies own and lease the physical infrastructure carriers that Verizon, AT&T and Sprint use to provide mobile network coverage; together, American Tower and Crown Castle comprise over 15% of XLRE's portfolio.

"American Tower and Crown Castle are fantastic. We like that they're overweight in XLRE," says Ware.

Also, XLRE invests 4.2% in Weyerhaeuser, one of the largest private owners of timberlands in the world. The company owns some 13 million acres of U.S. timberland and leases another 14 million acres in Canada.

 

Neither cell tower companies nor Weyerhaeuser appear in the portfolio of real estate behemoth VNQ. Nor are they included in smaller-but-still-popular ETFs SCHH and RWR, which share the same index.

American Tower, Crown Castle and Weyerhaeuser do appear in IYR's lineup, however, but in much smaller proportions: Together, the cell tower companies comprise just 8.7% of IYR, while Weyerhaeuser makes up barely over 2.5%.

To some, this breakdown may sound like splitting hairs. But percentages matter, especially since IYR's portfolio holds more than quadruple the stocks XLRE does. Investors get watered-down coverage, and also pay more for it: At 44 basis points, IYR is significantly more expensive than the 14 bps XLRE charges.

"You can over-diversify," says Ware.

Long-Term Play

As part of the Select Sector SPDR ETF suite, XLRE's intended use is as part of a sector rotation strategy, notes Bartolini. As such, he sees "a good amount of cross-pollination" between investors in other Select Sector SPDR funds, such as XLF and XLK.

"Being able to ensure there aren't any gaps in your coverage is a big positive," he says. "XLRE provides granularity, without fear of style drift."

Active sector rotation, however, is not how Ware's firm uses the ETF.

"For us, XLRE is a long-term play," he explained. "We're bullish on U.S. real estate, and XLRE gives our clients diversification while augmenting income."

He points to XLRE's yield, which, at 3.7%, is substantially higher than other investments now offer in today's environment of ultra-low interest rates.

XLRE, like all REIT funds, does carry significant sensitivity to interest rates. That risk dictates whether Albion remains invested, says Ware.

"If rates rise without economic growth, REITs will be impacted negatively, and we'll exit the fund," he noted. "If the economy's doing well, though, I think REITs can absorb rate rises, and so can XLRE."

 

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