Further to my posting from two months ago we now have details on SSgA’s new streetTRACKS DJ Wilshire International Real Estate ETF (RWX). Although there are closed end funds covering international real estate, this is the first ETF to cover this fairly broad [although neglected] asset class. In the case of RWX, it tracks the Dow Jones Wilshire ex-US Real Estate Securities Index. Here’s a chart for this index from the DJ Wilshire Index website which seems to show something close to a 30% return since mid July:

click to enlarge

Clearly, a strong trend up since the summer. Very similar to the Northern Global Real Estate Index Fund [NGREX] which I mentioned in my article from October. Here’s its latest chart:

The recent 2% drop is rather modest compared to the 17% run up since the fund’s inception in early August. Still, we’re talking about time series data that’s far too short for proper analysis. Luckily, Dow Jones provides data for its indices and you can find data specific to its DJ-Wilshire real estate indices on its site.

Some further information on the The DJ-Wilshire ex-US Real Estate Securities Index and the DJ-Wilshire ex-US Real Estate Investment Trust Index can be found in a handy fact sheet [PDF].

More detailed explanations regarding the composition rules in general for the DJ-Wilshire Real Estate Indices can also be found.

After digging through all this, I suppose a good question is how much of a diversifier international real estate really is. Here’s the chart comparing NGREX, SPY and iShare MSCI EAFE Index (EFA):

Again, it’s a short time period and we’ve seen relatively high correlations among most asset classes [both in up and down markets] over the past few years. But this picture really does not provide much comfort of international real estate as a diversifier to broad equity market exposures.

So, now we roll up our sleeves are dig a bit deeper. Using the data from the Dow Jones website for their ex-US Real Estate Securities Index, I show here a simple/crude Excel-built line chart for its price alongside the S&P 500 Index going back about 8 years:

Perhaps not a fair comparison as one index is for the US and the other is for everything outside of the US. So I redid the chart to include EFA which only allows for data going back to August 2001:

We can see that in the international space, real estate has been an outstanding performer, greatly outperforming the broader MSCI EAFE Index, albeit the ETF’s performance is net of some fees but the scope of the difference remains the same. In terms of a diversifier, we can see that real estate securities appear to go down hard [if not harder] than the broader equity markets in times of distress [2002, spring 2004 and summer 2006]. As strong as the S&P 500 and MSCI EAFE have been since this past summer’s correction, the DJ-Wilshire ex-US Real Estate Securities Index has shown even more spectacular growth.

For anyone who is weary of recent highs attained by many broad market indices [US, Canada, various other regions and sectors], you have to wonder how much more gas is in the tank for international real estate.

Of all the so called “alternative” asset classes, real estate has to be the most basic of them. I often define “traditional” asset classes as simply stocks, bonds and cash with alternative covering basically everything else.I have written in the past about real estate, mostly with a negative bent. However, in the interest of finding new instruments (preferably of the indexing type) I refer to this article in the Wall Street Journal (sub. required) that mentions State Street Global Advisors and their SEC filing of an ETF “based on real-estate securities in 23 countries”. With all the attention to real estate in the past few years, it’s interesting that all ETF related products have been so focused on the US market (REITs, homebuilders).

According to the WSJ, this new ETF in the works should solve this problem with one position: “The State Street fund will be based on the Dow Jones Wilshire ex-US Real Estate Securities Index. The “ex-US” means there are no U.S. stocks.” Furthermore, there is some concern regarding just how diversified this one position will be: “Investors should note that, despite the large number of countries in the index, nearly 60% of the holdings are concentrated in just three: Australia with 20%, the United Kingdom with 19%, and Japan with 18%. The top nine countries comprise just more than 90% of the weightings.”

The article mentions a mutual fund, the Northern Global Real Estate Index Fund [NGREX], although as a global fund it includes US securities and thus has a slightly different mandate:

This makes me think about what I wrote about new products being released near market tops. However, with a 9% return since inception, I look to be wrong in this case. On the other hand, seeing this chart simply gives me more reason to put this upcoming ETF on a watch list. Not an immediate buy.Kudos to SSGA for getting back into the ETF game with some decent new offerings, but not with just another US equity mid cap growth ETF (or whatever). I spoke recently about new indices related to environmental services and steel from SSGA (perhaps this could lead to ETFs?), and now international real estate. So how about timber and infrastructure? These have been mainstream asset classes in the institutional space for quite some time now.

There’s got to be something to be said about the timing of fund offerings. We all saw the incredible push of Nasdaq linked products around the peak of 1999-2000. I remember Guaranteed Investment Certificate [GIC] linked notes offered at my local bank, and many of the other Canadian banks, that were linked to the Nasdaq 100 Index being launched near the end of our Canadian RRSP season - this is synonymous to the IRA in the US. The deadline for yearly contributions is the end of February (for the previous tax year). No need to remind you of how the Nasdaq moved after February 2000 but just in case, here’s a chart:

So I wonder now about real estate. It’s a topic that has been discussed at great length by many market observers. Like high-tech, investors can’t say later that they didn’t see it coming. I know many people in the Far East who have everything in real estate. After what happened in Japan, I wonder if they expect it to happen in their home country at some point in time … but just not now. Maybe, but there continue to be new fund offerings allowing global investors to add more fuel to the fire (Note that after each fund’s name below, I include both their ticker symbol as well as its inception date.) They include:1. US domiciled real estate ETFs: Many of these are a fund of REITs such as:

a. iShares Cohen & Steers Realty Majors Index Fund (ICF) 1/29/2001

b. iShares Dow Jones U.S. Real Estate Index Fund (IYR) 6/12/2000

c. streetTracks Wilshire REIT (RWR) 4/23/2001

d. Vanguard REIT (VNQ) 9/23/2004

For group #1, the ETFs with REIT exposure, the growth has obviously been great. Here’s the 2 year chart:

Like the equity markets, you basically have a nice rate of growth since early 2003. Since these ETFs have been around for well over five years (except for Vanguard which was late into ETFs anyway), investors have had a good chance to participate in the rise.2. US domiciled real estate ETFs not focused on REITs but on home builders:

a. SPDR Homebuilders (XHB) 1/31/2006

b. PowerShares Dynamic Building (PKB) 10/26/2005

c. iShares Dow Jones US Home Construction Index Fund (ITB) 5/1/2006

Group 2 is a different story. Homebuilding was the second wave of real estate investing via ETFs with fund launches in late 2005 and early 2006. How have they done this year?

3. European domiciled real estate ETFs: I’ve seen recent news that a European ETF provider called Indexchange Investments has just launched three new real estate equities based ETFs on the Frankfurt and Stuttgart exchanges. They cover three geographic regions with these specific indices:

a. The Dow Jones Stoxx 600 Real Estate index – this index tracks 22 European real estate equities

b. The DJ Stoxx Americas 600 Real Estate index – this index holds Canadian and American real estate equities

c. The DJ Stoxx Asia/Pacific 600 Real Estate index. This index is composed of real estate stocks in Japan, Hong Kong, Singapore, Australia and New Zealand

Group #3 represents recent fund offerings in the real estate space geared for European investors. I’m sure similar funds either exist or are in the works for Asian and other international investors. I think about the timing of these and wonder.

There are other means for investors to get into real estate investing via capital markets (on top of your primary home, winter cottage, investment property for rental income, timeshare in the warmer regions, etc.) and these include:

Housing futures and options traded on the Chicago Mercantile Exchange. Based on S&P/Case-Shiller Home Price Indices, these cash-settled derivative contracts cover 10 major US cities individually as well as in aggregate through a weighted composite index. These actually look like a great hedging vehicle for residents in any of these large metropolitan areas with significant and highly appreciated home values. Of course, someone has to be on the other side to speculate. Goldman Sachs has recently entered into a licensing agreement with S&P for the development of financial products based on the S&P/ Case-Shiller Home Price Indices. Perhaps investors will soon be able to participate in this specialty market without direct involvement in derivative instruments.

Property derivatives have been in existence for about a decade in the UK albeit in limited use. The market for this type of instrument has grown in the past few years however these are instruments, often custom made, for real estate developers and perhaps institutional investors (pension funds) who are building hedging programs to overlay on top of their real estate portfolio. Again, speculators (hedge funds and others) would likely be on the other side.

I wouldn’t be surprised to see increased derivative and ETF development for real estate, just like we have seen recently for commodities (GLD, SLV, USO, DBC) the other asset class with plenty of press regarding its recent climb in prices. These are two of the most common alternative investment asset classes but I wonder if investors today have weightings in these two asset classes that are as large, or larger, than their holdings in traditional stock and bond positions.

Bottom line: Be aware of new investment products in the real estate space. Perhaps some areas (emerging markets, east Asia) may be worthwhile for further analysis, but I’d be careful. No one can know if it will be as bad as the Japanese real estate market in the 1990’s or the Nasdaq crash but it’s the timing of new product development that’s the issue.

There has been so much discussion about US real estate as an overvalued asset class. I’ll keep this simple. There is an interesting article on Contrary Investor that shows how out of hand things have become. (The site requires you to sign up as a subscriber but at no cost.)The argument given is that real estate is a good leading indicator of the national economy in general. Nothing new there but it’s the charts that give a good indication of the extreme situation investors need to be aware of. Here are some charts from the article:

The conclusion you can draw from the above is of a hard landing. Same with this chart: According to the writer, “we’re looking at the number of US homes for sale multiplied by the median US home price as of now. Without sounding melodramatic, price and volume is telling us one large and very important story here. We’ve never seen anything like this.” What I have put above hardly comes close to analysis so I strongly suggest reading this report and do some further digging. But when you look at the ETF space, you have further evidence of the same. Take a look at the barcharts.com’s ETF site. Here’s the list of top ten ETFs sorted by YTD returns:

Numbers 6, 7 and 9 (ICF, RWR, VNQ) show about 18% to 19% returns YTD. If you’ve been holding them, you’re looking good. The 3-year charts look nice with a few downward bumps along the way.

The only question now is if there is risk of a more substantial drawdown (high Fed uncertainty is making this a very interesting time) and if so, whether shorting should be considered.

There’s been alot of recent news about new offerings being introduced by WisdomTree and Powershares and some not so recently by the bigger shops. I have two comments:

1. Market cap weighted indices. Rob Arnott is often credited with the introduction of an alternative to market cap weighted indices – specifically, the idea of an equal weighted cap index. The data looked conclusive and made a lot of common sense. In many ways, the basic idea overlapped well with the Fama-French 3-factor model which considers size (small versus large stocks) and value (high book-to-market ratios versus low BTM ratios) in addition to just market risk [CAPM]. So when the Rydex S&P Equal Weighted ETF (RSP) came out in 2003, which in highsight was a perfect long-term entry point after the bear market of 2000-2002, it looked like a good core holding for US equity exposure.Thereafter, Arnott’s writing moved into the area of fundamental weighted indexing and with it, a combination of various fundamental measures which could determine the composition of an index in a slightly more complex manner. More recently, Arnott’s firm Research Affiliates has worked with various manufacturers to introduce the next stage of non-market cap weighted ETFs, specifically PowerShares FTSE™ RAFI US 1000 Portfolio (PRF) as well as ClaymorETFs FTSE™ RAFI Canadian Index Fund (CRQ on the TSX), both based on his concepts of fundamental indexing. However, just like any other method of building an “index”, fundamental indexing will perform better than other manners of indexing in certain, but not all, markets.

WisdomTree’s new ETFs tread fairly closely to these also using the term “fundamental weighted indexing” in their marketing material (.pdf). I give true credit for a practical alternative to market cap weighted indices to Dimensional Fund Advisors. I find it interesting that DFA, the real pioneers of “thinking outside the box” in the world of index investing and whose funds revolve around the Fama-French 3-factor model, have not entered the ETF space. Their US-domiciled funds have a much longer-term track record compared to most ETFs, and have a loyal, almost “cult-like” following which is now growing internationally into the UK, Australia, Canada and other jurisdictions.

However, the way in which they market their funds through selective advisors does not lend well to a transition into ETFs. Furthermore, with the recent entry of WisdomTree, there may not be enough space in such a specific ETF market, but there still are some differences between the philosophies and methodologies at the two firms.

To me, the simplicity of RSP (equal weighted indexing) is magnified compared to the newer offerings of recent weeks or even the 3-factor model+. Costs seem comparable, but what we are seeing here is the move towards something that looks less like a traditional index instrument and more like a quasi-active fund. Powershares seems to be pushing the envelope the most as WisdomTree’s offerings lean more towards a simple dividend oriented bias.

Will someone try to build a fund that tracks an index whose underlying constituents are actively managed, such as a hedge fund index? Whether the logistics works out or not, I’d rather not see that happen. I can only imagine the spread between the market price versus the underlying fund’s NAV in addition to the numerous other potential complexities. Overall, it certainly is interesting what’s happening and I’m always eager to see what new innovation in coming down the pipe.

2. Although I am happy to see innovation in the ETF space as explained above with alternatives to market cap weighted indices, I am not so happy with what is broadly coined as “alternative investments”. Obviously, we’ve seen new products brought forth in conjunction with the commodities boom of the past few years, and especially very recently (GLD), (SLV), (USO), (DBC).

My concern with these is similar to the countless Nasdaq linked index products which came out just prior to the top in 2000. The idea of investing in materials and energy makes sense as components in a broadly diversified global portfolio. I just can’t see them being major (> 10% in each) holdings in this kind of portfolio.

Speaking of this type of portfolio, what would be a good model to follow? I like to see what certain large institutions are doing. Up here in Canada, we have a few pension behemoths that are quite innovative. In the US, there are far more interesting ones to choose from, but I’ll focus on endowments such as those at Yale and Harvard.

Without going to deep into details, I propose a read of Yale’s latest annual report (.pdf). A key excerpt that shows how different they think in terms of asset allocation:

Today, target allocations call for less than 20 percent in domestic marketable securities, while the diversifying assets of foreign equity, private equity, absolute return strategies, and real estate dominate the Endowment, representing more than 80 percent of the target portfolio.

Furthermore, they state that:

The Endowment’s long time horizon is well suited to exploiting illiquid, less efficient markets such as venture capital, leveraged buyouts, oil and gas, timber, and real estate.

Clearly, there are challenges to building an ETF, or other highly liquid instrument, for certain of these asset classes. So far, for investors interested in building a portfolio more aligned to institutions such as Yale, the energy complex and real estate are areas where they have been able to participate.

For real estate, REIT ETFs (RWR), (IYR), (ICF) are a start and Robert Shiller has been making the rounds promoting housing futures that began trading on the CME in late April. So, for the next stage of the growing ETF universe, what about an offering related to timber? Investment returns related (among other things) to the physiology of trees sounds like something that should be uncorrelated to the broad markets and may also provide decent yield. Another interesting area is infrastructure. So far, closed end funds (MIC), (MFD), (MGU) are the only viable choice for non-institutional investors.

Despite the interest from institutions in both these areas, I doubt there’s any significant interest from the ordinary investor that could lead to an ETF. But how many large cap value funds (whether domestic, international, or whatever) can you have out there?