Index concentration is becoming a bigger challenge for investors, particularly those relying on broad-based Exchange Traded Funds (ETFs) for exposure.
Consider the S&P500 Index in the United States. The so-called ‘magnificent seven’ account for about a third of that index by market capitalisation.
US equities, as measured by the S&P 500, provided a cracking 25% return over one year to end-December 2024, thanks largely to the magnificent seven: Apple, Alphabet, Meta, Microsoft, Nvidia, Netflix and Amazon.
Heaven help investors if any of those stocks – each priced for perfection, and then some – stumbles. That’s the downside of index concentration and relying on a handful of richly priced stocks.
That’s one reason I suggested, in this column last week, that investors trim exposure to US equities, take profits and reallocate to other developed markets that have lagged, such as Europe and Japan.
Index concentration is also a local problem. In Australia, banks and resource stocks (materials and energy) accounted for just over half the S&P/ASX 200 Index at end-December 2024 – a trend that has persisted for years.
The top 10 stocks comprised almost half the ASX 200 by market capitalisation, meaning this market – at least in index terms – is a bet on four big banks and three miners. Sadly, our top seven stocks have been collectively far less magnificent.
It gets worse at sector level. Start with Australian Real Estate Investment Trusts (A-REITs). Goodman Group was worth just over 40% of the S&P/ASX 200 A-REIT Index at end-December 2024. Shares in Goodman, an industrial property and data-centre owner, have soared in the past two years, before stumbling a little this week.
Goodman’s growth has underpinned strong gains in the ASX 200 A-REIT Index. On a total-return basis, the A-REIT index has returned a whopping 28% over one year – better than US equities.
My point is, taking some indices at face value distorts the true story. Many A-REITs have struggled in the past two years, amid high interest rates. Strip Goodman Group from the A-REIT index and it’s a different story.
With indices, it always pays to look ‘beneath the hood’ to understand sector and stock composition. Am I getting diversified exposure through an index or is it a concentrated bet in terms of sector and stock holdings?
Mark my words: the next great market meltdown, whenever it occurs, will come from booming growth in index investing chasing an ever-narrowing group of overvalued stocks. It rarely ends well when everybody owns the same thing, driving valuations – and risk – to stratospheric levels.
The good news from index concentration is the opportunities it creates for nimble active investors. As more passive funds flow to index behemoths, such as the magnificent seven in the US, better opportunities are emerging elsewhere.
That is true of Australia’s A-REIT sector. It’s been battered to varying degrees by rising interest rates; the boom in work-from-home and its impact on office demand; retail weakness amid the cost-of-living crisis and growth in e-commerce; and other problems.
The sector looks more interesting amid expectations that the Reserve Bank will finally cut interest rates this year. As readers know, I’ve argued for some time that rate cuts in Australia will be delayed due to persistent strong employment growth and stubborn inflation.
Rate cuts might come sooner based on this week’s favourable inflation data. What really matters is the number and scale of cuts this rate cycle. On that score, I think markets will be disappointed.
Nevertheless, some rate cuts will come as more consumers buckle under the weight of high interest rates and cost-of-living pressures, and as savings buffers for homeowners (mortgage offset accounts) dwindle.
Lower rates are good for A-REITs as they reduce interest costs. The flipside is a lot of A-REIT debt was incurred when rates were lower will need to be refinanced at higher rates. Rising interest costs could hurt A-REIT distributions.
I note some influential A-REIT analysts have recently upgraded their outlook for the sector, principally on the rate-cut story. To my thinking, retail A-REITs such as Vicinity Centres and Scentre Group are the best opportunities. I’m still concerned about office property; the work-from-home trend will be hard to extinguish.
Chart 1: Vicinity Centres (ASX: VCX)
Source: Google Finance
Chart 2: Scentre Group
Source: Google Finance
Although A-REIT valuations collectively appeal – excluding Goodman Group, which is fully valued – I prefer offshore REITs to local ones.
As mentioned, US equities, from an asset-allocation perspective in portfolios, look expensive. But there are also opportunities beneath headline indices and global REIT funds with high US exposure could provide them in 2025.
Trump’s unequivocal pro-business stance and prioritisation of US interests and values could boost REITs there. Combined with US rate cuts in 2025, albeit fewer than initially expected, and the US REIT sector has some growing tailwinds.
Trump’s love of all things AI – he announced this month a US$500 billion private sector investment to develop AI infrastructure – is another positive for US REITs. The much-heralded Stargate project will boost demand for data centres given the enormous computing power and energy AI requires.
Australians have limited choice in data-centre exposure, particularly if one considers Goodman Group is fully valued. Investors who want exposure to the AI boom through data centres need to invest overseas where there is more choice.
A small group of ETFs on ASX provide exposure to international REITs. Investors can also consider unlisted managed funds that offer global property exposure.
For those who prefer the convenience and simplicity of property ETFs – and are content with index rather than active management in this space – global REIT ETFs are a portfolio consideration at this stage of the rate cycle.
The VanEck FTSE International Property (AUD) hedged ETF (ASX: REIT) provides exposure to 300 international REITS worldwide.
By country, almost 80% of REIT is invested in the US, which I prefer for listed property exposure this year due to the strength of the US economy and the growing momentum in US business sentiment and consumer confidence.
By sector, REIT has 11% exposure to data centres, 13% exposure to healthcare property and 11% exposure to multi-family residential REITs. Investors can’t get this type of exposure to niche REITs through the Australian REIT market.
REIT had a measly total return of 2.4% over one year to end-December 2024. Over three years, the ETF has an annualised return of minus 6.74%.
That performance has hurt investors in the fund but is an opportunity for prospective investors to buy after a sustained period of low returns. The ETF is hedged for currency exposure.
Chart 3: VanEck FTSE International Property (AUD) hedged ETF
Source: Google Finance
The SPDR Dow Jones Global Real Estate ESG ETF (ASX: DJRE) is another option for investors seeking global property exposure via ASX.
DJRE holds 226 global REITs, of which about three-quarters of exposure is in the US. The ETF does not appear to have significant exposure to data centres, although it’s hard to tell from its broad sub-sector labels.
DJRE returned almost 12% over one year to end-December 2024. The ETF is not hedged for currency movements – a position that has aided its returns compared to the VanEck REIT, which is currency hedged.
DJRE and REIT both charge 0.2% in fees annually. Both are worth consideration by investors seeking global REIT portfolio exposure, in a sector that typically does better in the early stages of an easing monetary policy cycle.
Chart 4: SPDR Dow Jones Global Real Estate ESG ETF
Source: Google Finance
Tony Featherstone is a former managing editor of BRW, Shares and Personal Investor magazines. The information in this article should not be considered personal advice. It has been prepared without considering your objectives, financial situation or needs. Before acting on information in this article consider its appropriateness and accuracy, regarding your objectives, financial situation and needs. Do further research of your own and/or seek personal financial advice from a licensed adviser before making any financial or investment decisions based on this article. All prices and analysis at 29 January 2025.
