Vanguard Financials ETF: Know What You're Buying -- and What You Aren't

The Vanguard Financials ETF (NYSEMKT: VFH) is one of many sector-focused exchange-traded funds that investors can buy. On the surface that seems like an easy thing to understand. Want financials exposure? Buy the Vanguard Financials ETF. But there are a few details that you need to know before you buy this exchange-traded fund (ETF).

What does the Vanguard Financials ETF do?

This ETF's name says a great deal about what it does. In fact, if that's all you looked at when considering this exchange-traded fund you wouldn't be far off the mark. According to the ETF's website, it "seeks to track the performance of a benchmark index that measures the investment return of stocks in the financials sector."

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Scroll down to the portfolio breakdown and there's a long list of finance-related business lines, from diversified banks at the top (roughly 21% of assets) to commercial and residential mortgage finance at the bottom (around 0.5% of assets). Very clearly, the Vanguard Financials ETF invests in what its name implies.

However, it is an index ETF, so the index is going to determine what the portfolio actually looks like. In this case, the index is the MSCI US Investable Market Index (IMI)/Financials 25/50. Vanguard doesn't actually explain what the index does, so you have to go to MSCI to get the methodology. The big question investors should have is: What does 25/50 mean?

It isn't as complicated as it sounds. Basically, in order to be considered a diversified investment product an ETF has to follow certain allocation rules. One is that no more than 25% of the portfolio can be in a single stock. Another is that the sum of all of the investments that make up 5% or more of a portfolio can't exceed 50% of total assets. This is a net benefit for investors, especially when considering a sector fund. It ensures that you aren't really buying a fund where performance is driven by just one or two stocks, which is actually pretty common in the ETF world.

Data by YCharts

There's one thing "wrong" with the Vanguard Financials ETF's portfolio

If you want broad exposure to the financials sector, the Vanguard Financials ETF would be a good enough choice. But if you actually dig into its list of subsector exposure, there's something you might find lacking.

The Vanguard Financials ETF has mortgage real estate investment trusts (REITs) on the list of sectors to which it is exposed. They make up a slim 0.7% of the portfolio. What's not on the list are plain old property-owning REITs, which many consider financial stocks. And, given that mortgage REITs make the list, it may seem odd that property-owning REITs don't.

Data by YCharts.

This isn't actually an omission. In 2016, property-owning REITs and real estate management and brokerage companies were moved into their own classification by Dow Jones and MSCI. So the real estate industry is its own thing, with REITs making up nearly all of the new sector. That's well and good, but if you have a more historical view of financials you might want to include REITs in your portfolio. If you buy the Vanguard Financials ETF thinking you have done that, you are mistaken.

A simple Vanguard solution

If the lack of property-owning REITs in the Vanguard Financials ETF bothers you, which is completely reasonable, you can solve that problem by pairing it with a small investment in Vanguard Real Estate Index ETF (NYSEMKT: VNQ). It is worth noting that Vanguard Financials ETF's dividend yield is a tiny 1.8% while the yield of Vanguard's REIT offering is a much more attractive 4%. You are definitely giving something up by forgoing REITs.

But adding the Vanguard Real Estate Index ETF is a pretty easy fix even though it complicates your portfolio by adding another holding to the list. The real key to the story here, however, is that you can't just go by an ETF's name and think you know what you'll be getting. You need to dig into the details.

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Reuben Gregg Brewer has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Vanguard Real Estate ETF. The Motley Fool has a disclosure policy.