More Detail On REITs

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A public official responded to this recent post on real estate investment trusts (REITs) with two pertinent questions: 1) Is it better to buy a specific, open-ended, actively managed REIT or a broad-based REIT index? 2) Is it true that actively managed REIT funds do not track all that closely to the stock market and are less volatile than broad-based REIT indexes?

On the first question, the answer depends entirely on the track record of the actively managed REIT and its performance prospects going forward.  If it has a good track record, if it has consistently outperformed its benchmark index and shows evidence it will continue to do so––for instance, the stability of its staff––then it is generally a better bet than a broad-based REIT index.  But there are two other important considerations:

1. Actively managed REITs generally charge higher management fees than broad-based index products. Make sure that the better performance more than compensates for the additional fees.
2. Many actively managed REITs concentrate on particular regions of the country and/or on particular sorts of real estate investments –– shopping malls, for example, or office buildings. If those concentrations are not part of your strategy, then the investment is not for you, however strong it may appear.  If the focus fits, but you also want a broad diversification within real estate, then you might need to buy into several other actively managed funds. Or you could combine a particularly good actively managed REIT with holdings of a broad index product, the one for its outperformance, the other to broaden your exposure.

This second consideration brings us to the public official’s second question.  Yes, actively managed REITs tend correlate less with the stock market than do broad-based REIT index products.  This is because both the stock market and broad-based REIT investments have national exposures, and thus both reflect the health of the U.S. economy.  The same comparison applies to broad-based and narrowly based stock funds.  With a more narrowly based investment, you are implicitly betting on that narrow area over the broader economy.  There is nothing wrong with that strategy, of course, but know what you are doing when you seek to avoid correlation to the broader market in this way.

Investing with an emphasis on stability can offer less volatility even when narrowly focused.  Selecting such an approach or choosing a broad-based portfolio (similar to an index) to dampen volatility will depend on your particular objectives and preferences.  If you’re tempted to go with the narrower, actively managed alternative, be sure to compare its historic volatility record to the stock market or any other relevant comparison point.  And be sure that the calculations show lower amounts of volatility year-by-year over a long period of time, and not just over an unusually favorable period.