Real estate mutual fund managers have unique resources and expertise to determine what are the most advantageous REIT investment opportunities and how to best structure a REIT portfolio. Where these funds have invested and their performance should, therefore, be of keen interest to the retail REIT investor.
The topic is quite relevant. Today's Wall Street Journal had a front page article titled, "Investors Sour on Pro Stock Pickers." It reported that investors pulled $119.3 billion from actively managed U.S. stock funds in 2012 while ETFs have become increasingly popular. The author went on to point out that many mutual funds have underperformed the benchmark stock indexes.
My research focuses on Morningstar's "favorite" U.S. real estate mutual funds. I examined 48 funds that comprise 201 sub-funds. Neither the Pimco funds nor the Barons Fund were considered because of their focus on non-REITs.
|2009 - 2012 Returns|
|1 Month %||3 Month %||1 Year %||3 Year %||5 Year %|
|U.S. Real Estate Mutual Funds||3.14%||1.21%||17.05%||49.57%||24.22|
|Dow Jones Equity All REIT Index||1.95%||0.94%||$14.17||47.93%||5.13|
Mutual funds have consistently beaten the Dow Jones Equity All REIT Index (REI) over the past five years. Two things this chart does not show: (1) There has been disparity in fund performance. For example, the ProFunds Real Estate UltraSector SVC (REPSX) returned 26.24% in 2012, while the Pioneer Real Estate B fund gained (PBREX) 14.22% over the past 12 months. (2) REITs have done particularly well since the abyss of recession and that is why the 3 year returns are so close. When demand for REITs cools, mutual funds should be holding the strongest REITs within the sector.
Interestingly, in 2008, the Dow Jones Equity All REIT Index dropped 42.47% while many of the funds fell even more significantly. I selected the first sub-fund of each fund listed by Morningstar and calculated how it performed in 2008. I found that 29 of the 45 sub-funds (3 funds had yet to be formed in 2008) dropped more than the 42.47% Dow Jones benchmark. The average 2008 return for these 45 sub-funds was -44.57%.
A broader outlook, however, shows that mutual funds have stood their ground. The REIT index has returned an annualized rate of return of 14.3% over the past three years. Only eight of the 202 mutual funds did not beat this mark. Over a five-year span, the REIT index has returned an annualized rate of return of 1.85%, compared to 4.26% for mutual funds. 22 funds did not beat the 1.85% mark, but many of the 22 are non-traditional, including long/short funds and several 50/50 funds that include preferreds and mortgage REITs.
These findings are in step with a study by Kallberg, Liu, and Trzcinka published in 2000 by the Journal of Financial and Quantitative Analysis that concluded average and median alphas for real estate mutual funds are positive, unlike the majority of mutual funds. Additionally, the study found that time-varying positive alphas are much more likely to occur when the real asset market is performing poorly, suggesting that managers add more value in bear markets than in bull markets.
Investors may look at performance during the Great Recession and doubt whether mutual funds do in fact hold the "most advantageous" REITs. But real estate played a unique part because of the housing price crash, and this particular period should not invalidate years of outperformance.
The 52-week range provides investors with an idea of potential downside in an investment, particularly in inhospitable markets. The most common method for reducing volatility is diversification, frequently accomplished by investing in an index or mutual fund. The 52-week range for the SPDR S&P 500 ETF Trust (SPY) in 2012 was 16.78%. The Dow Jones REIT Index 52-week range was a slightly higher 19.13%. Remarkably, real estate funds were able to significantly reduce volatility while holding fewer stocks. The weighted 52 week average range for 2012 was 8.96%. This is line with a 2009 study published in the Journal of Business & Economics Research by Dr. James L. Kuhle and Dr. Rafiqul Rafiq that found REIT mutual funds exhibit "minimal volatility" when measured over 1, 3, 5, and 10 year periods and compared to six other mutual fund categories.
A key feature of REITs is its dividend yield assured by the 90% taxable income rule. REIT dividends have suffered in recent years falling to an average of 3.37% in 2012 for FTSE NAREIT All Equity REITs. Real estate mutual funds in 2012 yielded even less with a weighted dividend average of 2.08% (and 1.49% when unweighted). In comparison, the average dividend yield of the S&P 500 was 2.2% for 2012. Adding more questions to these findings is that several of the 202 funds hold at least several preferreds that should boost the overall yield average.
These deflated yields can partially be attributed to large allocations in "blue chip" REITs, which have been chased by yield-hungry money. Real estate mutual funds tend to avoid significant positions in REITs that are less well known, more risky, and have smaller caps -- three qualities that often boost dividend yield.
A second reason for the lower yield is that many funds are holding a significant amount of cash. For example, the passively managed Vanguard REIT Index Fund (VNQ) has a 3.68% yield and only 0.59% of its portfolio is cash. In contrast, the T. Rowe Price Real Estate Fund (TRREX) holds many of the same REITs as the Vanguard but yields only 2.19%, according to Morningstar. The clearest difference is that the T. Rowe has over 7% of its portfolio in cash.
All else equal, a 7% cash holding difference would not deflate the yield between the Vanguard and T. Rowe portfolios by over 100 basis points. Further, my calculations show that strictly based on the Fund's Q3 reported holdings, the dividend yield for the T. Rowe Price Real Estate should be 2.83%. I welcome explanations for the gap between actual yield according to Morningstar and yield based on Q3 portfolio holdings. Possible explanations include: (1) Portfolio compositions are constantly changing, and therefore guesstimating what the yield ought to be based on a Q3 portfolio snapshot can easily produce flawed assumptions; (2) A portion of the dividend yield pays for fund fees; (3) The fund has engaged in covered call strategies and other programs that do not produce yield; and (4) A portion of the yield is put into cash or reinvested.
A 2007 study published in the Financial Services Review by Crystal Lin and Kenneth Yung examined the fund manager's role in the performance of real estate mutual funds. One of their conclusions was that real estate mutual funds tend to be more representative of growth mutual funds over value oriented mutual funds. It is therefore likely that managers are reinvesting a portion of the yield as part of a growth strategy. The topic exceeds the scope of this article. The point I hoped to establish was that real estate mutual funds are yielding significantly less than the REIT average.
I sorted through the top five holdings of the 202 sub-funds because I was seeking REITs that fund managers consider core holdings in a REIT portfolio. The top five holdings represent a 29.85% weighted average of the funds' portfolios. The following are the most common holdings:
|Funds||%||Sub-Funds||%||% of Portfolio|
|Simon Property Group||47||98%||198||98%||10.78%|
|Boston Property Group||26||54%||131||65%||5.04%|
|American Tower Corp||9||19%||25||12%||5.26%|
|Health Care REIT||8||17%||33||16%||4.72%|
These holdings also happen to be the 12 largest REITs on the S&P 500. The four other S&P 500 REITs are HST, KIM, PCL, and AIV, of which only HST was a top five stock by 4 funds and 23 sub-funds.
Real Estate mutual funds, as to be expected, hold many REITs, ranging from several dozen to over 100 when passively managed. SPG was the only REIT to average more than 5% of a fund's portfolio. Virtually every single sub-fund held Simon Property Group, and the average portfolio percentage of SPG was more than double the second most common top five portfolio holding. SPG is the largest shopping mall operator in the U.S., and has nearly doubled its cash dividend over the past several years. The stock was up 23.34% in 2012, but underperformed against the regional mall sector.
I was unable to identify any pattern in core properties other than that the U.S. real estate mutual funds tend to have the highest percentage of their portfolios in the largest cap-REITs.
The weighted average turnover rate for the 202 funds is 40.34%. Turnover is the measure of how often a manager sells all the stocks in the fund in a given year. In practice, the rate is misleading. For example, if a fund has a 100% turnover rate, the manager might have held 50% of all positions for the past three years and turned over the other 50% twice throughout the year. So the 40.34 turnover rate simply confirms that these funds are actively being managed and adjusted according to economic conditions and new opportunities.
Mutual funds on average have done a consistently good job of minimizing volatility while outperforming the REIT index. In a recent Forbes article, REIT expert Brad Thomas interviewed portfolio manager Andrew Duffy of the James Alpha Global Real Estate Investment Fund, who had this to say about mutual funds vs. ETFs:
ETFs typically own 100% of the constituents of a market index, i.e., "the good, the bad and the ugly." Conversely, mutual funds seek, through careful analysis and diligent research, to own only the good companies. Why would you want to own the bad and the ugly companies when you can invest via a mutual fund that seeks to own only the good ones?
While the argument for owning a fund over an ETF is convincing, and especially in the real estate sector as I have demonstrated, there are also reasons to own individual REITs over a fund.
Much of the recent REIT demand, it is often argued, has been a result of REITs being considered a good bond alternative. However, investing in mutual funds would not be the best place to directly capture that precious yield. Investors would be better off considering individual REITs, a PIMCO fund for example, or preferreds when the overriding objective is to invest in a bond alternative.
For the retail investor investing in REITs, mutual fund compositions are not the ideal place to discover advantageous investment opportunities. Of course, if an investor finds a specific REIT attractive and a mutual fund owns it -- that is great validation. But for the most part, mutual funds are constrained by their size and risk profiles to make their significant investments in the largest REITs. The retail REIT investor should, however, take note as to how these mutual funds are structured. Investors typically are attracted to REITs for their high levels of continuing current income and the opportunity for long-term gradual growth. The real estate mutual fund "core" structure of owning large positions in large-cap REITs has proven to be highly effective in achieving this objective.