KBWY: High-Yield REIT Index ETF, Strong 8.6% Yield, Excessively Risky Holdings (KBWY)

I last covered the Invesco KBW Premium Yield Equity REIT ETF (NASDAQ:KBWY), an index ETF investing in high-yield small-cap U.S. REITs, in late 2021. In that article, I argued that KBWY’s undiversified small-cap holdings were excessively risky, making the fund a sell. Since then, KBWY has underperformed in the S&P 500, due to unfavorable conditions in the real estate industry and several underperforming investments.

Although conditions in the real estate industry will likely improve as the Federal Reserve slashes rates, KBWY remains an excessively risky, underperforming investment. As such, I would not invest in the fund.

KBWY – Fund Basics

• Sponsor: Invesco.
• Underlying Index: KBW Nasdaq Premium Yield Equity REIT Index.
• Dividend Yield: 8.55%.
• Expense Ratio: 0.35%.
• Total Returns CAGR 10Y: 3.41%.

KBWY – Overview and Analysis

Index and Portfolio

KBWY is a small-cap U.S. REIT index ETF, tracking the KBW Nasdaq Premium Yield Equity REIT Index. Said index includes all relevant REITs meeting a basic set of criteria, and explicitly excludes large-cap and international securities. KBWY focuses on small-cap REITs, with an average market cap of just $2.0B billion, less than 10% of the REIT average, and 1% of the equity average.

For the fund, securities are weighted according to their dividend yield: the higher the yield the greater the weight. Said weighting scheme serves to increase the fund’s yield, but also its risks, volatility, and potential losses during downturns. Diversification is significantly reduced as well, with KBWY investing in just 31 different securities, compared to hundreds for most broad-based REIT and equity ETFs.

The fund’s portfolio is only moderately concentrated, with the fund’s top ten holdings accounting for 45% of its value.

Overall, I’ve found KBWY’s portfolio to be much less diversified and riskier than average. Expect significant losses and underperformance during downturns and bear markets, as was the case in early 2020.

Drawdowns and volatility are both much higher too.

I’ve also found that KBWY’s lack of diversification sometimes leads to idiosyncratic risks and losses. As an example, the fund’s sizable position in the Office Properties Income Trust (OPI) led to underperformance during the first half of 2022. OPI is currently the fund’s fourth-largest holding, but weights were higher in the past.

Another position in The GEO Group, Inc. (GEO) led to losses a few years back. No fund can avoid underperforming investments forever, but more diversified funds suffer significantly lower losses from losses in any individual position. The opposite is true for less diversified, more concentrated funds like KBWY.

In my opinion and experience, concentration is sometimes a positive for more aggressive actively managed funds, assuming a competent management team. As an example, the Saba Closed-End Funds ETF’s (CEFS) strategy of amassing significant positions in discounted CEFs, and then pressuring management to narrow the discount through share buybacks or other initiatives, has led to significant gains in the past.

On the other hand, concentration is generally a negative for index funds, as these rarely engage in similar strategies, nor do in-depth analysis of their holdings. There is very little thought given to KBWY’s significant investments in OPI, prior to that in GEO, so position sizes should be kept small, to minimize losses from these.

Overall, I’ve found that KBWY’s low diversification and lack of concentration have led to losses in the past, making me wary of investing in the fund.

Dividend Analysis

KBWY weights its portfolio on dividend yields, which results in a strong overall 8.6% yield for the fund. It is a strong yield on an absolute basis, and much higher than that of the average REIT, equity, and bond ETF.

On a more negative note, the fund’s dividend growth track record is quite mediocre, with dividends declining long-term amidst high volatility. Dividends have seen some growth these past twelve months, but some of that seems to have been due to normal ETF dividend volatility.

In my opinion, KBWY’s strong dividends are an important benefit for shareholders, notwithstanding an overall mediocre dividend growth track record. On the other hand, there are several other ETFs targeting other niche income sub-asset classes with both higher yields and stronger growth. These include the VanEck BDC Income ETF (NYSEARCA: BIZD), with a 10.8% dividend yield and strong growth.

And the Invesco KBW High Dividend Yield Financial ETF (KBWD), with a stable 11.5% yield:

Mind you these are all very different funds, targeting different asset classes, but they do offer higher, more sustainable yields. It seems to me that if investors are going to invest in some of the smaller, more niche income sub-asset classes out there, they should choose the best.

Performance Track-Record

KBWY’s performance track record is below-average, at best. Long-term returns are significantly lower than those of the S&P 500 and moderately lower than those of broader U.S. REIT indexes. Returns have somewhat improved since after the pandemic, mostly due to significant losses during the pandemic. Volatility and risk are high.

Overall, the fund’s track record is below-average, and is a negative for the fund and its shareholders.

Quick Market Analysis

KBWY is a real estate fund, and the real estate industry as a whole has a reasonably compelling investment thesis: lower rates. Prior rate hikes led to a significant contraction in real estate demand, prices and activity, due to costly financing and higher opportunity costs. Real estate simply looks less appealing when t-bills yield +5.0%, and unaffordable when mortgage rates climb to 8.0%.

Federal Reserve hikes have led to real estate underperformance since early 2022, and that includes KBWY.

The flip side of the above is that real estate and REITs should outperform as rates decline next year. The market seems to think so too, with REIT indexes and funds outperforming since the rates peaked in November, and after dovish Fed guidance in December.

Due to the above, I think the real estate industry has a very compelling investment thesis right now. At the same time, I think there are much better ways to play that than an investment in KBWY, due to its excessive risk and mediocre performance track record. Specifically, Cohen & Steers has a suite of fantastic, high-yield REIT CEFs. Of these, the Cohen & Steers Quality Income Realty Fund (RQI) trades with the widest 6.7% discount. Discounts are generally higher, so waiting for better timing might be best.

Conclusion

KBWY is an excessively risky, underperforming investment. As such, I would not invest in the fund.