Property ETFs can be a flexible and inexpensive way to benefit from the positive characteristics of property as an asset. Jennifer Grancio reports

For institutional investors, using exchange traded funds (ETFs) for property investment is a new concept. For those unfamiliar with them, ETFs are an investment tool that combines the ease of trading a single share with the security of exposure to a broad market index.

ETFs are based on market indices and ordinary investors benefit from the huge economies of scale at major institutions trading the component elements of an ETF in large volumes. As a result, ETFs can have total expense ratios as low as 20 basis points, making them extremely competitive compared with virtually all mutual fund products. ETFs are available from brokers, like normal shares, and trade throughout market hours on most major stock exchanges.  Their structure also means that the price closely reflects the net asset value, without any lasting discounts or premiums.
The first ETF was launched in the US in 1993 and their use took off with the late 1990s' equity boom. Since then, growth has been spectacular, with total ETF assets of €388bn by June 2006, including €55bn held in ETFs in Europe.

Originally, ETFs were mainly used for tracking major equity indices, such as the S&P 500 index. Now ETFs cover a wide range of equity indices, covering different regions and market capitalisations, and other asset classes, such as fixed income, commodities, such as gold and silver, and property.

There are a number of reasons for believing that ETFs are well suited to property investment. Primarily, ETFs offer a simple way to obtain wide diversification in property, both internationally and across different sectors of the property market. In addition, the flexibility of ETFs means that they can be used for a range of investment approaches. ETFs can also maximise the benefits of real estate investment trusts (REITs), as a tax-efficient property investment vehicle. And ETFs can also help institutional investors as part of the general trend away from direct property holding and towards pooled investment.

The latter trend has been noticeable among pension funds over the past few years. While there is increasing recognition that property offers an attractive mix of capital growth, income and diversification away from equity markets, it can be expensive and time-consuming to invest directly. Direct investment requires a large minimum sum of £50-100m (€75-150m) and many pension funds lack the in-house expertise to run a property portfolio. Property is also illiquid, so changing the asset allocation to it can be slow and cumbersome. 

As a result, all but the largest investors now invest in property indirectly through pooled funds or limited partnerships. But these vehicles can be subject to a degree of illiquidity, particularly in closed-end funds, and charging structures can be complex, with several types of expense levied. Another problem is that the recent success of pooled property funds in attracting funds has forced them to buy properties at high prices or hold cash. This is starting to affect their performance. Pooled property vehicles may also invest solely or predominantly in a single country.

This latter point is likely to be a consideration for investors in the UK, where commercial property has done well for several years. Some property experts believe that the UK market is at its peak and are advising investors that they should diversify into Europe and the rest of the world.

Against this background, ETFs look to provide a useful way of gaining many of the benefits of property exposure, without the drawbacks of conventional pooled vehicles. Here it is important to note that ETFs invest in property company shares as a proxy for holding property either directly or indirectly.

One of the key advantages to using ETFs for property investment is the ease with which asset allocation decisions can be made. Remember, according to investment studies, around 95% of investment performance can be explained by asset allocation, rather than individual stock selection.

The flexibility of ETFs also means that investors can use them for various trading strategies. Property ETFs can be part of a core-satellite investment approach, at a lower cost than most conventional specialist manager funds.

Tactical asset allocation moves can be easily made using ETFs, if investors decide to vary their holding in property relative to bonds or equities, for example. And large institutions that invest directly in property can use ETFs to maintain their property exposure if they are out of the market while a property transaction is in the process of being completed. REITs are now another reason to consider ETFs as a property investment vehicle. This year, the UK and Germany have launched REITs, joining such countries as the US, Japan, Australia, France, Belgium and the Netherlands. Regulations vary between individual countries, but generally REITs allow existing property companies to convert into a more tax-efficient structure and new property funds, often specialising in particular sectors, can be set up as REITs.

In the UK there are now 14 REIT funds, with more planned. In the US there are now REITs for each property sector: office, retail, industrial and warehousing. REITs have even been set up for niche sectors, such as healthcare, golf courses or timber land.
Amy Schioldager, a managing director at Barclays Global Investors in the US, said REITs there have been shown to have a lower correlation to the broader stock market than ordinary equities, making them a valuable diversifier for investors. And as yield is an important part of property investment, a transparent ETF wrapper for tax-efficient REITs makes a lot of sense.

ETFs and REITs are relatively new concepts for many institutional investors and their advisers. But it is clear that they could work well in partnership and it makes sense for investors to educate themselves on the potential benefits of using ETFs for investment in property in general, and REITs in particular.

Jennifer Grancio is head of distribution for iShares Europe