The $34.7 billion Vanguard REIT ETF is going to get a radical renovation next year when it changes the index it tracks.

But will the move create value for investors? Nobody knows for sure.

Vanguard, the $4.4 trillion asset manager, wants to adopt a new benchmark for the ETF (VNQ) that would add specialty REITs and real estate management and development firms to the mix. Currently, the fund — the largest U.S. sector product and the 20th largest ETF overall — tracks a smaller selection of real estate investment trusts — companies that own, manage or invest in properties.

Vanguard is cutting commissions for 15 mutual fund shares.
"Vanguard is missing out on the best-performing stocks this year," said Todd Rosenbluth, director of ETFs and mutual funds at CFRA.

The decision is being put to shareholders, who have until Nov. 15 to vote on the change.

A new index may bode well for holders who have watched their ETF underperform competing products like State Street’s Real Estate Select Sector SPDR fund, since it would add high-flying stocks like American Tower and Crown Castle International to its portfolio. But it could also decrease the fund’s dividend, potentially hurting those who value the ETF for its 4.3% yield.

"Vanguard is missing out on the best-performing stocks this year," said Todd Rosenbluth, director of ETFs and mutual funds at CFRA. But "it looks like the new index will have a slightly lower yield based on June data," he said.

The Malvern, Pennsylvania-based asset manager is proposing the shake-up in order to align VNQ’s holdings with the real estate sector classification adopted a year ago by S&P Dow Jones Indices and MSCI, said Arianna Stefanoni Sherlock, a spokeswoman at Vanguard. The change moved REITs out of financials and into their own category, creating an 11th index sector.

State Street’s real estate ETF (XLRE) changed up its holdings a year ago in response and has been rewarded for it. The State Street fund has gained 8.7% this year, compared with 3.9% for VNQ, according to data compiled by Bloomberg.

The new index could also supercharge the Vanguard fund’s performance if year-to-date track records are anything to go by. The MSCI U.S. Investable Market Real Estate 25/50 Index — the proposed benchmark — has handily outperformed the existing gauge this year, returning 7.1% with gross dividends reinvested through Aug. 31, compared with 3.7% for the current index.

That’s thanks to stocks like American Tower, which has gained 38.3% this year through Sept. 11, and which would become the fund’s most heavily-weighted company at 5.5%. Another specialty REIT, Crown Castle, would also join the fund at a weighting of 3.5%. It’s climbed 23.2% this year, as the expanding use of mobile devices and e-commerce have stoked demand for the kinds of data centers and cell towers the two companies own and operate.

Funds best positioned for volatility
These funds have the smallest beta scores, either positive or negative, indicating the least variability from market returns.

Also, the new gauge would have 181 constituents, compared with 155 in the existing index, which would help boost its diversification, according to Rosenbluth.

But it may not be so rosy for those who value VNQ for its dividend. As of June 30, the proposed benchmark had a dividend yield of 3.74%, lower than the existing index.

That could be a sticking point for investors who view REIT funds as "the performance-enhancing drugs of dividend ETFs," said Eric Balchunas, a Bloomberg Intelligence analyst.

Whether that’s enough to get shareholders to vote against the change or dump the ETF is an open question. Rosenbluth said the drop in yield will have "minimal impact." Still, there are going to be some Vanguard investors who are reluctant to see any change in their fund, good or bad.

"It alters the risk characteristics of the fund," said Robert Michaud, chief investment officer of New Frontier Advisors, who owns the ETF. "When a fund going forward is not going to behave in the way it did in the past, then we have to rethink how we’re investing with it."

Bloomberg News