New Kid on the Real Estate Block

It looks like BMO has finally made a splash in the ETF market. Most of the bank’s family of exchange-traded funds, launched about a year ago, either duplicated existing products from iShares or focused on exotic asset classes. But they’ve changed that with the launch of BMO Equal Weight REITs Index ETF (ZRE) last month. This new fund tracks an important asset class — real estate — and does so with a strategy that may be superior to its competition.

Until the launch of BMO’s fund last month, the iShares S&P/TSX Capped REIT Index Fund (XRE) was the only exchange-traded fund tracking the Canadian real estate sector. With almost a billion dollars in assets, it’s a category killer. But perhaps not for long.

Let’s compare the two funds to get a better understanding of how they differ. First we’ll take a closer look at the index that XRE tracks. The S&P/TSX Capped REIT Index is a subset of the S&P/TSX Composite. That means that if a REIT is not part of the S&P/TSX Composite, it can’t be included in XRE. That explains why there are only 11 REITs in the iShares ETF, even though there are more than 11 publicly traded real estate investment trusts in Canada.

The S&P/TSX Capped REIT Index is capitalization-weighted, meaning that  companies occupy a share of the index proportional to their size (as measured by the current price of a share multiplied by the number or shares outstanding). As a result, RioCan, the largest REIT in the country, makes up a whopping 25% of XRE, which is the maximum allowable. (The word “Capped” in the index’s name refers to the rule that no single security can represent more than 25%.) Indeed, the index is extremely top-heavy: the largest three holdings comprise half the ETF’s holdings.

Now let’s look at BMO’s new fund. This ETF tracks the Dow Jones Canada Select Equal Weight REIT Index. The companies in this index do not need to be part of the S&P/TSX Composite Index. As result, BMO’s fund includes 17 securities, six more than XRE. More importantly, however, the Dow Jones index is not capitalization-weighted. It’s equal weighted, meaning that every REIT is given the same weight in the index (100% / 17 = 5.9%) regardless of market cap.

Many commentators on this blog and others have argued that the equal weighting strategy is inherently superior, because it doesn’t concentrate the fund’s holdings on a small number of securities. That assessment may be valid, but as with any investment decision, it needs to be considered carefully. Capitalization-weighted indexes are not perfect, but they have endured for decades because they are based on fundamentally sound principles. In tomorrow’s post I’ll look at the pros and cons of equal weighted indexes and consider whether they truly are a better way to invest.

Disclosure: I currently own XRE in my own portfolio.

Filed under: Asset classes, ETFs, Indexes, New products