Real Estate ETF Serves as Financial Proxy

NEW YORK ( TheStreet) -- Real estate investment trusts, or REITs, offer diversification and high yields with a low correlation to equities. REITs are a separate asset class worthy of a hefty allocation in a diversified portfolio, many money managers argue.

But real estate was a big catalyst for the financial crisis, undercutting the diversification argument. REITs, as measured by the iShares DJ US Real Estate Index Fund ( IYR), fared worse than the S&P 500 Index during the bear market but not quite as bad as the financial sector, viewed by the Financial Select Sector SPDR ( XLF).

REITs have less utility for diversifying a portfolio, though they're not bad investments, and many still have generous yields. In addition to broad-based REIT funds like the iShares DJ US Real Estate Index Fund, there are also several narrower REIT exchange traded funds covering things like office space, retail space and mortgage real estate investment trusts. Based on concerns about the next shoe dropping in commercial real estate, ongoing issues about mortgage resets and questions about when the consumer will come back as savings rates go up and debt levels go down, one area of the REIT world to consider is the residential segment.

Residential includes apartments, health-care facilities and storage units. The iShares FTSE NAREIT Residential Plus Capped Index Fund ( REZ) captures that segment. The big idea here is that if people are forcibly downsized, they will put things into storage as they move from large houses to smaller apartments. This effect stands to benefit holdings such as Public Storage ( PSA), Equity Residential ( EQR) and Avalon Bay Communities ( AVB).

Like most REITs and REIT funds, the Residential Plus Capped Index Fund pays a decent dividend. However, like most ETFs, the payout has been a moving target. The last two dividends have been $0.30 per share, which, if that persists, works out to a 4.2% yield. As rough as it has been, however, this group has held up better than most REIT segments. If the road to economic recovery is as long and slow as many believe, it's possible that the Residential Plus Capped Index Fund would continue to outperform on a relative basis.

The risk to the fund is the apartment REITs, which comprise 45% of the fund. It's easy to envision that over the next couple of years, as job security remains shaky, management companies may have to lower rents.

While I have little faith in REITs as portfolio diversifiers, they can be good investments. Because of the correlation between REITs and financials during the crisis, I would consider any REIT exposure as part of the financial portion of a diversified portfolio. Many index providers do this already.

The idea of using REITs for part of the financial exposure, combined with a foreign sector ETF like the WisdomTree International Financial Sector Fund ( DRF), could be a good way to ride out the next couple of years in case there is another shoe to drop with U.S. banks.

At the time of publication, the WisdomTree International Financial Sector Fund was a client holding.

Roger Nusbaum is a portfolio manager with Your Source Financial of Phoenix, and the author of Random Roger's Big Picture Blog. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Nusbaum appreciates your feedback; click here to send him an email.

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