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A Bronze-Rated Fund for Exposure to Foreign Real Estate Stocks

Investors may be missing out on half the global real estate market.

The prospective benefits of global diversification apply to virtually all corners of your portfolio, including real estate securities. At the end of November 2019, publicly traded U.S. real estate securities made up just shy of 50% of the total market capitalization of the global opportunity set in this market segment--as proxied by the FTSE EPRA Nareit Global Index. Investors without any ex-U.S. real estate exposure are missing out on half the market.

Vanguard Global ex-U.S. Real Estate VNQI is a sound choice for broadly diversified, low-cost exposure to foreign real estate securities. This fund tracks a market-cap-weighted index that is representative of the opportunity set available to investors in this market segment. It also has a durable edge over peers in the form of its lowest-in-class expense ratio. That said, the fact that its benchmark omits U.S. securities and includes emerging-markets ones makes it a misfit in a Morningstar Category dominated by more globally oriented peers. Also, its emerging-markets exposure has translated to significantly higher risk than most funds in the category. It earns a Morningstar Analyst Rating of Bronze.

REITs make up about 47% of the fund's portfolio. REITs must distribute most of their taxable income to shareholders. Its remaining holdings are engaged in a diverse array of real-estate-related activities and include real estate operating companies, real estate developers, and non-REIT property managers. Developers construct buildings on new or underutilized land. Unlike REITs, which are restricted from building in some nations, developers can take on more-speculative projects. Developers are more volatile than REITs because their cash flows are less predictable, and payout ratios are generally much lower.

The fund also holds a meaningful stake (about 20%) in emerging-markets firms. Over the long term, emerging-markets real estate firms should benefit from rising incomes and consumer spending, which will drive demand for high-quality spaces, slowly boost rents, and increase occupancy rates. Growth in shopping centers and office space should provide a lift for commercial real estate firms and REITs.

The fund invests about 50% of its assets in companies operating in the Pacific region, including 24% in Japanese real estate firms. As it has major exposure to this geography, investors should be cognizant of the outlook for interest rates and growth in the region.

Process The fund tracks the S&P Global ex-U.S. Property Index, a broad, market-cap-weighted benchmark containing international property companies. This benchmark effectively diversifies risk and accurately reflects the composition of its target market. That said, it omits U.S. real estate securities, which represent a major portion of the opportunity set and most peer funds' portfolios. This omission supports the fund's Below Average Process Pillar rating. Constituents must meet size and liquidity requirements and are weighted by their float-adjusted market cap. To qualify, firms must be classified under the GICS real estate industry group, meaning they specialize in real estate development or management. The index includes real estate firms that are not structured as REITs, but homebuilders and real estate agents are excluded. The fund has over 692 holdings, substantially more than any other international real estate index fund. The fund uses full replication to track its benchmark, owning virtually every security in the index in approximate proportion to its index weight. Vanguard equitizes any cash balances with futures contracts, and it has a zero target on the portion of the cash balance that isn't equitized.

How real estate is owned in public markets varies by geography. The REIT structure is common in mature real estate markets where there is generally less property development, such as the United States, Japan, and Australia. However, in much of Asia and in other emerging markets, real estate firms more commonly use different corporate structures.

REITs make up about 47% of the fund's assets. That's a lower percentage than what's found in other foreign or global real estate funds, in part because this fund has a larger allocation to emerging-markets real estate firms than peers. Regardless of corporate structure, however, foreign real estate firms have some aspects that are similar to U.S. REITs. In both cases, they buy, manage, and sell properties. And foreign real estate firms' volatility profile, in aggregate, is similar to that of U.S. REITs.

Unlike U.S. real estate funds, which are almost entirely composed of REITs, about 53% of this fund's portfolio is invested in real estate developers and non-REIT property managers. Developers focus on constructing spaces on new or underutilized land. REITs are restricted from breaking new ground in some countries, but property developers can take on more-speculative projects. Developers are more volatile than REITs because their cash flows are less predictable and their payout ratios generally are lower.

Performance Since its inception, the fund has lagged both the category average (by 55 basis points annually) and the category index, the S&P Global REIT Index (by 327 basis points annually). It has outperformed its nearest peer--SPDR Dow Jones International Real Estate ETF RWX--by 68 basis points annually over that same span. This speaks to the fund's narrow mandate relative to the broader category. Much of its category-relative performance can be explained by the fact that U.S. real estate securities outperformed their international peers during this period. Vanguard Real Estate ETF VNQ outstripped VNQI by 429 basis points annually during this stretch. Given that it includes a meaningful increment of emerging-markets securities, VNQI will be inherently more volatile than the broader category as well as the narrower subset of its immediate, internationally focused peers.

The fund has hewed closely to its benchmark since its November 2010 inception. In fact, it has outperformed its bogy by about 30 basis points annually during that span.

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