The iShares US Real Estate (NYSEARCA: IYR) exchange-traded fund, or ETF, was started in 2000 to track the investment results of the Dow Jones U.S. Real Estate Index, which measures the performance of the real estate sector of the U.S. equity market. The fund invests in a variety of large-, mid- and small-cap real estate companies, and the majority of IYR's holdings represent real estate investment trusts, or REITs.

A unique feature of IYR is it holds REITs of all types, including equity REITs that invest in actual real estate such as hotels and residential and commercial properties, as well as nonequity REITs that buy and hold various mortgage securities.

How It Tracks It

IYR's holdings include a wide variety of REITs. About 24% of the fund's portfolio is invested in specialized REITs. Retail and residential REITs account for 19% and 14% of IYR total holdings, respectively. The fund also invested in office REITs with 11% allocation and health care REITs with 10% allocation. Since IYR includes various nonequity REITs, IYR holds more diverse holdings when compared to other REIT funds.

The fund's top five holdings account for 22.5% with no single REIT having more than 8% allocation. IYR's top 10 holdings have 35.6% allocation and include well-known REITs, such as Simon Property Group REIT Inc., American Tower REIT Corp., Public Storage REIT, Crown Castle International REIT Co. and Equity Residential REIT.

Historically, the fund demonstrates a tracking error of less than 1% when compared to the Dow Jones U.S. Real Estate Index. The primary source of the error comes from transaction costs, pricing differences and differences between securities held by the fund and those included in the underlying index. Also, a tracking error may arise since IYR incurs fees and expenses, while the Dow Jones U.S. Real Estate Index does not.

Management

The fund is managed and advised by BlackRock Fund Advisors and is part of a broader iShares ETF family that passively tracks the performance of various U.S. equity indexes. BlackRock Fund Advisors is a subsidiary of BlackRock, Inc. and it is a well-established provider of investment advisory services for assets in excess of $4.5 trillion.

Characteristics

IYR was started on June 12, 2000, to take advantage of high dividend yields and capital appreciation demonstrated by the real estate sector in the United States. The fund utilizes a passive investment strategy and a representative sampling approach to select securities for its portfolio so the fund's aggregate return mirrors that of the underlying index. While rebalancing is typical for the fund, IYR does not trade REITs' shares when they seem to be undervalued or overvalued. The fund's annual expense ratio is 0.45%, which is somewhat higher when compared to similar REIT funds.

IYR is traded on the New York Stock Exchange Arca and investors can purchase the fund's shares through numerous investment brokers.

Suitability and Recommendations

Historically, equity REITs are more correlated with the real estate market in the U.S. than the nonequity REITs that are part of IYR's portfolio. Nonequity REITs are very different from equity REITs, as they borrow funds to buy and hold various mortgage securities instead of investing directly into real estate properties. Thus, the main source of the profit for nonequity REITs comes from the difference between interest paid on purchased mortgage securities and the cost of debt used for these investments. Nonequity REITs are directly exposed to a risk of default on mortgage securities, which can escalate very quickly. Investors interested in buying IYR should consider nonequity REITs and decide whether they belong in their portfolio.

REITs typically earn profits from receiving rental payments from the properties they buy and lease. Because many financial professionals consider a REIT a nonfinancial asset, investors are attracted to this class of asset as a valuable way to obtain additional diversification for their portfolios. Also, inflation may benefit REITs, as rents tend to rise with increases in general price level.

REITs are highly sensitive to changes in interest rates and the general price level for mortgages. As the interest rate in the U.S. is expected to increase in the future, this may cause the earnings of many REITs to fall as a result of a higher cost of capital. Also, as many REITs exhibit high levels of leverage, this makes them highly risky investments.

For investors who follow modern portfolio theory, or MPT,, IYR is most appropriate for income investing and to some extent, growth, as REITs pay high dividend income and real estate tends to appreciate over time. Also, because IYR contains mortgage REITs, the fund is to some degree appropriate for fixed-income investing.

Since 2010, IYR has demonstrated a somewhat higher level of volatility and an average rate of return when compared to the S&P 500 Index. The fund's five-year standard deviation was 14.5%, which is higher than the standard deviation of 11.7% for the S&P 500 Index. With the five-year average rate of return of 11.8% for the fund being lower than 16.1% for the S&P 500 Index, IYR's five-year Sharpe ratio was 0.84, which is significantly lower than 1.34 for the S&P 500 Index.

IYR is most appropriate for investors who are looking to gain exposure to the U.S. real estate sector and want to obtain hedge against inflation. Due to its high dividend yield of 3.3%, as of August 2015, the fund is appropriate for investors interested in income investing.

How Financial Adviser Clients Could Use This ETF

For financial advisers looking to add diversification to their clients' portfolios, IYR presents a compelling option to obtain exposure to the real estate sector and be able to hold REITs of all classifications. Because rents tend to go up with inflation, holding IYR may provide a partial hedge against inflation and yield a higher rate of real return. Financial advisers also find IYR attractive for clients who are interested in income investing and want to receive a high dividend yield as REITs have to pay out at least 90% of their earnings in the form of dividends to maintain their incorporation status. For this reason, REITs held by the fund have above-average dividend yields when compared to non-REIT companies.

Because the correlation between real estate and financial assets has gone up since 1995 as a result of mortgage securitization and wide availability of equity REITs, financial advisers should caution their clients against using IYR as a pure diversification tool.

Main Competitors and Alternatives

When it comes to investing in REIT funds, there are several options available for investors. The Vanguard REIT fund offers an appealing option with an expense ratio of 0.10%, which is much lower than that of IYR, and provides similar exposure to the U.S. real estate sector.

Another option is the iShares Mortgage Real Estate Capped fund, which invests principally in nonequity REITs that hold mortgage-backed securities. This fund charges a slightly higher expense ratio of 0.48%.

The Schwab U.S. REIT fund offers another excellent alternative to IYR. This fund holds primarily large- and medium-cap REITs and charges one of the lowest expense fees of 0.07% among all REIT funds.

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