Fund Focus: Real estate funds

Many investors have gravitated toward higher-yielding investments, and it’s easy to understand why. When a portfolio of 60 percent stock and 40 percent bonds currently produces income of only 2 percent annually, and when most retirement drawdown strategies call for tapping 3 percent or more of assets every year, investors can no longer simply rely on the yield—unless they find higher-yielding investments.

Real estate—largely via Real Estate Investment Trusts—is one of the high-yielding vehicles to attract income-seeking investors. The firms are special corporations that by law must return at least 90 percent of their earnings to shareholders annually. As a consequence, many REITs usually report yields that exceed those of stocks by a significant margin. REITs currently yield more than 4 percent, as measured by the FTSE NAREIT Composite Index, and the yield of the Standard & Poor’s 500 index consistently sits around 2 percent.

Most REIT funds invest in publicly traded REITs, such as shopping malls, apartment complexes, health care property including hospitals and assisted living facilities, and commercial office space. But mortgage REITs differ from other REITs: They invest not in real estate but in mortgage bonds. Their dividend yields are currently close to 10 percent. But if interest rates rise, the prices of the mortgage bonds they hold are likely to fall significantly.

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Like stocks, real estate fund returns have rebounded nicely in the last five years (see chart below) while yielding, in many cases, more than 4 percent. Many investors are enamored with the income that REITs have always provided. But that doesn’t mean REITs should serve as a substitute for bonds in a portfolio; they still have a stronger correlation with stocks than with bonds. Even more so in some cases: REITs did worse than U.S. stocks during that dark period from October 2007 to March 2009. Stocks lost more than half of their value, but over the same period REITs fell more than 70 percent. Bond prices fluctuate far less. So although the incomes may be similar, the volatility of REITs and bonds are decidedly not—therefore, don’t consider devoting more than 10 percent of a portfolio to REITs.

We screened actively managed non-mortgage REIT funds for those that consistently outperformed their peers, as measured by Morningstar’s real estate fund benchmark. The six most consistent performers currently open to investors are listed below.

But one note deserves emphasis. Although it’s not an actively managed fund, the Vanguard REIT index fund (ticker VGSIX) actually had a better consistency percentage (the percentage of the time its one-year returns beat the Real Estate Funds index over the last five years) than any of the actively managed funds listed in the chart. And with an expense ratio of only 0.24 percent, its costs are similar to those of the index-tracking ETFs and are far less than those of the actively managed funds.

This article originally appeared in the June 2014 issue of Consumer Reports Money Adviser.