The Top ETFs Over Three Years: Real Estate Dominates
Charles Rotblut recently spoke at the 2015 AAII Investor Conference. For information on how to subscribe to recordings of the presentations, go to www.aaii.com/conferenceaudio for more details.
Exchange-traded fundinvestors would have done well over the past three years by having a high allocation to real estate.
Five funds that focus on real estate investment trustsbeat all ETFs in terms of performance for the three-year period ending June 30, 2012. A sixth real estate ETF came in seventh place.
Preventing a clean sweep of the top 10 spots were two health care funds, a retail sector fund and one fund that invests in Thailand. This is not the mixture most investors held in their portfolios.
For the second consecutive year, I asked my colleagues to compile a list of the best-performing exchange-traded funds over the past three years. This list is designed to complement both “The Individual Investor’s Guide to Exchange-Traded Funds 2012” (published in the August 2012 AAII Journal) and my annual article on mutual funds with the best five-year performance (see “The Top Funds Over Five Years: Bond Funds Take the Lead” in the March 2012 AAII Journal). Given the growth of ETFs, I thought there would be continuing interest in an article that looks at the best-performing exchange-traded funds.
Caveats & Notes
Before I delve into the details, there are a few caveats and notes worth pointing out.
A three-year period has been used for ETFs because many exchange-traded funds still lack five-year histories. This shorter time period prevents a direct, apples-to-apples comparison to the annual listing of the best-performing mutual funds, however. The time periods covered are also six months off; though seemingly short, it can make a difference in terms of which fund categories are represented in the top-10 lists. Keep in mind that a six-month shift not only picks up six new months of performance, but it also drops six months of activity. (We use this split to keep the top fund data comparable between the ETF guide, which is published in July, and the mutual fund guide, which is published in February.)
The overwhelming majority of exchange-traded funds are passively managed. Though there are some actively managed ETFs, most are designed to track an index (passive management). With a few exceptions, actively managed ETFs have yet to attract significant amounts of investor dollars. As I stated in last month’s AAII Journal, there are only three actively managed ETFs with assets of more than $1 billion. In contrast, most mutual funds are actively managed, meaning their managers handpick the securities to invest in.
Nonetheless, there are similarities between the two types of investments. Both mutual fund and exchange-traded fund performance is significantly influenced by broad market, asset preference and category-specific trends. In some cases, passive strategies are the best way to take advantage of these trends, favoring ETFs. In other cases, active management is better, favoring mutual funds. Looking at the longer-term performance of both types of investments makes the decision process easier by dampening the short-term market noise that can distort the numbers.
Always keep in mind that fund analysis involves more than just looking at total return. Performance relative to a fund’s peers, the fund’s volatility, the composition of the fund, the strategy used, expenses and size are all important factors. Proper diversification is also very important; you need to seek out the fund or security that best fulfills your diversification needs. Furthermore, look at the fund’s portfolio, the index it is designed to follow and the weighting strategy used. An ETF’s risk cannot be judged by the fund’s name alone.
Which Funds Were Included
I largely restricted the list of ETFs to those with three years of annual return data and a minimum of $200 million in assets. (Exceptions were made when the performance of a smaller fund warranted it.) Funds that use leverage to provide double or triple the return of their underlying index or that follow inverse strategies (they rise in price when the underlying index falls) were excluded from consideration. These funds are designed to be held for short periods of time, not several years.
Table 1 on pages 28 through 31 shows the top ETFs by category. Three-year performance was calculated through June 30, 2012, to match the statistics displayed in “The Individual Investor’s Guide to Exchange-Traded Funds 2012,” which was published in the August 2011 AAII Journal.
In addition to three-year performance, returns for the year to date, the last 12 months and each of the past five years (where available) are displayed, along with returns for the most recent bull market (March 1, 2009, through March 31, 2012) and bear market (November 1, 2007, through February 28, 2009). Returns that are in the top 25% of all ETFs within their investment category are shown in boldface. Other pertinent information is presented, including yield, tax-cost ratio, risk, portfolio composition and expenses. Risk numbers that are in the lowest 25% of all ETFs within the investment category are also shown in boldface. Twelve-month and three-year annual total returns based on market value have been added this year to show how closely each fund’s price performance matches its net asset valueperformance. The bigger the difference, the larger the premium or discount shares of the fund have traded at over the period.
Some of the categories used here combine two or more separate categories from last issue’s ETF Guide. This was done in cases where there were not a significant number of qualifying funds and combining individual categories made sense. When categories were combined, category averages are not displayed.
The Top Real Estate ETFs
As stated at the beginning of this article, real estate ETFs dominated the list of top-performing funds, accounting for six of the top seven spots.
IShares FTSE NAREIT Residential Plus Capped Index Fund (REZ) claimed the top spot with a three-year annualized return of 34.3%. The fund holds REITs that invest in residential properties (apartments), health care properties (hospitals, nursing homes, etc.) and self-storage real estate. Though the fund delivered a 15.8% return to investors in 2011 and gained 10.6% during the first half of 2012, the impact of the calendar cannot be ignored. This fund lost 59.3% of its value during the last bear market period, setting the stage for the current impressive three-year performance. The bull market return period is very close to the trailing three-year return period ending in June. We are using performance from March 1, 2009, through March 31, 2012, to measure bull market performance.
The timing of the period reviewed also favored the five other real estate ETFs that appear on the top-10 list. For example, iShares Cohen & Steers Realty Majors (ICF), SPDR Dow Jones REIT (RWR) and Vanguard REIT Index (VNQ) had bear market losses of 68.5%, 66.4% and 64.5%, respectively. In the three-year period starting in July 2009, the three rebounded with annualized gains of 33.9%, 33.2% and 33.0%, respectively.
It wasn’t just the easing of the credit crunch and the corresponding bottoming of real estate that helped these funds; falling interest rates also played a role. REITs pay higher yields, making these funds attractive to income-seeking investors. The downside of the impressive price performance is that yields on these funds now only range between 2.9% to 3.3%—higher than the S&P 500 index, but potentially lower than some REIT investors would prefer. (By means of comparison, at the end of 2008, yields for these funds ranged between 7.1% and 8.9%.)
The Other Top 10 ETFs
Two healthcare funds are in this year’s top-10 list. PowerShares Dynamic Pharmaceuticals Portfolio (PJP) prevented real estate funds from also claiming the sixth spot, elbowing its way in with a 30.3% annualized return over three years. First Trust NYSE Arca Biotechnology Index (FBT) claimed the 10th spot with a 27.4% annualized return. Though in the same sector, these two funds are very different.
PowerShares Dynamic Pharmaceuticals Portfolio fund invests in pharmaceutical companies, with Bristol-Myers Squibb Co. (BMY), Amgen (AMGN), Merck & Company (MRK), Johnson & Johnson (JNJ), Eli Lilly and Co. (LLY) and Abbott Laboratories (ABT) making up 30% of the portfolio. In other words, this fund holds established pharmaceutical companies and gives a larger weighting to some companies than others.
In contrast, First Trust NYSE Arca Biotech Index fund is an equal-weighted fund. Rather than following the traditional indexing methodology of giving more weight to larger companies, the portfolio is evenly allocated to all stocks held by the fund. The advantage of such weighting strategies is that they prevent a single or a small group of stocks from significantly influencing the performance of the index or the fund following that index. The downside is that such strategies can lead to more volatility and higher expenses. Furthermore, this ETF targets smaller biotech companies, such as Regeneron Pharmaceuticals (REGN), Life Technologies (LIFE) and United Therapeutics (UTHR). Biotech stocks have historically been more risky than their larger drug company brethren because the companies often depend on just a few existing or experimental drugs.
SPDR S&P Retail (XRT) and iShares MSCI Thailand Investable Market Index (THD) took the eighth and ninth spots with annualized returns of 30.2% and 29.8%. SPDR S&P Retail, which is also an equal-weighted fund, benefited from the rebound in consumer spending over the past three years. IShares MSCI Thailand, as its name implies, invests in Thailand-based companies. Country-specific funds, especially those of smaller, emerging economies, carry several risks, including limited information about the foreign economy, political instability and currency fluctuations. In addition, during the past 12 months, this ETF has traded at a premium to its underlying assets, with an annualized market return of 11.9%, compared to a net asset value return of 9.9%. This means investors have paid more than a dollar for a dollar’s worth of assets. (As I was writing this in mid-August, THD was trading at a 0.83% premium.)
Dividend Funds Lead Several Categories
The quest for income led investors not only to real estate funds, but also to dividend funds. ETFs that tracked dividend-oriented stock indexes were the top performers in the large-cap, small-cap, global and foreign stock categories.
Leading the domestic large-cap dividend funds over three years was WisdomTree Equity Income (DHS). This fund follows a dividend-weighted index that seeks out stocks with high yields and then weights them by their aggregate cash dividends. This is one of several types of alternative strategies that some funds follow. Such strategies seek to weight stocks by a component other than market capitalization with the intention of generating better performance. They are a hybrid between passive and active strategies because, although the ETF does track an index, the index itself is based on a manager’s idea to achieve better performance through an alternative method.
Look Beyond Performance
There is always a temptation to look more favorably at the best-performing funds. Though performance does matter, it is just one factor to consider.
You should also consider your portfolio needs. A basic allocation of ETFs holding domestic stocks with varying market capitalizations, international stocks, government bonds, corporate bonds and international bonds will serve most investors well. Once this basic portfolio allocation is established, other asset classes—such as real estate and commodities—and more specialized funds can be added.
Sector and country funds can boost a portfolio’s returns, but prudence is required when using them. Make sure you understand the factors that have driven a sector’s performance over the past few years and how likely it is that those trends will continue in the future. You cannot safely navigate a windy road by only using a rear-view mirror. Country-specific ETFs can allow you to target specific markets, but can be more volatile and expose you to exchange-rate risks.
Be sure you fully understand the index that the ETF is designed to follow. Similar sounding indexes can have different return characteristics. They can also either hold different stocks or weight the same stocks differently. A quick visit to an ETF family’s website can give you the list of current holdings.
Finally, use this rule of thumb when looking at ETFs: “Just because you can invest in something doesn’t mean you should.” Buy only those ETFs that you fully understand; avoid those tracking indexes or investing in sectors or countries with risks that you cannot identify.
Table 1. Top ETFs Over Three Years