If you are looking for an exchange-traded fund (ETF) that will provide you with dividend income, you can go down one of two broad paths: You can buy an ETF focused on dividends, or you can buy an ETF that focuses on a sector that is focused on dividends. That may sound like doublespeak, but it isn't.
This is why investors with $1,000 or less will want to take a look at Vanguard Real Estate Index ETF (VNQ -1.00%) today.
A quick look at Vanguard Real Estate Index ETF
Vanguard Real Estate Index ETF isn't a particularly exciting exchange-traded fund. As its name implies, it is meant to track the real estate investment trust (REIT) sector in a fairly broad manner. It is pretty cheap to own, with an expense ratio of just 0.12%. And it has a generous dividend yield of 4.3%, which compares very favorably to the yield of the S&P 500 index, which is a scant 1.3% right now.
Real estate investment trusts are specifically designed to pass income on to investors in a tax-efficient manner. So long as a REIT pays out 90% of its taxable income, it doesn't pay corporate-level taxes. The purpose of a REIT is to provide individual investors access to institutional-level rental properties, like office buildings, apartment buildings, and hospitals.
The drawback is that individual investors have to treat the dividends like regular income, which is subject to higher taxes than regular dividend payments. So Vanguard Real Estate Index ETF is, by design, focused on stocks that are focused on providing investors income -- thus, the relatively high yield.
There's a little wrinkle here, though: Many sector-specific ETFs end up with a couple of stocks that make up a disproportionate share of the fund's assets. Vanguard Real Estate Index ETF, however, tracks the MSCI US Investable Market Real Estate 25/50 Index, which is specifically designed to enhance portfolio diversification. No more than 25% of the ETF can be invested in any single REIT, and the sum of all REITs with 5% or higher weighting can't make up more than 50% of the ETF's portfolio.
That's a complex way of saying that the ETF is designed so that the biggest holdings won't be shockingly overweighted. For example, Prologis (NYSE: PLD) is the largest holding, at around 7.6% of assets, while that same stock makes up 10.3% of the SPDR Dow Jones REIT ETF (RWR -1.01%). If you appreciate diversification, Vanguard REIT Index ETF is designed for you.
Why buy a REIT index today?
Although the dividend yield is the clear attraction for investors here, the bigger picture is that Vanguard Real Estate Index ETF has lagged the market. As the chart highlights, this ETF fell along with the broader market during the early days of the coronavirus pandemic. But it didn't recover along with the market. That's largely because interest rates rose, which is a general headwind for REITs because it increases operating costs.
REITs use debt to fund the acquisition of properties. As such, higher rates mean higher costs. But there's an offset here that investors need to consider.
Property markets eventually adjust to rate changes because buyers will stop acquiring new properties if it doesn't make financial sense to buy them. So sellers eventually lower asking prices, which improves the profitability of acquisitions for buyers. This can take some time to happen, but history suggests that property markets will eventually adjust.
VNQ Dividend Yield data by YCharts
And that's the buying opportunity here: You are, effectively, buying a diversified and broad-based portfolio of REITs while the sector is in a state of flux. That has investors worried, and the index has lagged.
Buying Vanguard Real Estate Index ETF today is a bit of a contrarian play. Note in the chart that the yield spread between the S&P 500 index and this ETF is near the widest levels of the past decade, which highlights how unloved the REIT sector is right now.
If you can stomach going against the crowd...
Here's the rub: In order to buy Vanguard Real Estate Index ETF, you need to first be able to take a contrarian position, and second, believe that REITs will eventually come back into favor among investors. That's not going to be something every investor will want to sign up for. However, you will be getting paid very well to wait with an investment that is purpose-built to pay you dividends. It's an attractive proposition if you can stomach some near-term uncertainty.
