Sauter

By Courtney Darby and Jada A. Graves

Capital flows into real estate mutual funds have been impressive in recent years as investors have sought the solid returns, stellar dividends and positive diversification benefits REITs provide. In the first half of 2005 alone, net inflows into dedicated real estate mutual funds totaled more than $2.6 billion, according to AMG Data Services. However, only a fraction of the total went into real estate exchange-traded funds (ETFs), a segment of the market that differs from actively managed funds but has found a home among some investors.

Even though both index funds and exchange-traded funds follow similar passive management strategies, they represent distinctly different investment options. Such publicly available funds currently include the Vanguard REIT Index Fund and four real estate ETFs (iShares Cohen & Steers Realty Majors Index Fund, iShares Dow Jones U.S. Real Estate Index Fund, streetTRACKS Wilshire REIT Index Fund and Vanguard REIT VIPERS. The iShares funds are part of Barclay's Global Investors' family of ETFs.

Vanguard REIT Index Fund manager George "Gus" Sauter says that an index fund enjoys three advantages over actively managed real estate mutual funds. First, costs are typically lower because there isn't the same infrastructure that's needed to run an active fund (management is handled primarily by computers). Second, index funds provide broad diversification within the REIT sector. For example, because the Vanguard REIT Index Fund mirrors the MSCI U.S. REIT Index, it reduces the risk of just a few large holdings. Third, because index funds use a buy-and-hold strategy, there is lower turnover, resulting in a more tax efficient structure that doesn't realize as many capital gains.

"A REIT index fund should perform better than an actively managed REIT fund, and, on average, it should outperform an actively managed fund," Sauter says, "although it is possible for an individual investor to outperform a REIT index fund, if they can figure out which specific REITs will outperform the REIT market in general. But, there is a lot of risk involved with that."

REIT Exchange Traded Funds Data as of June 30, 2005
Fund Name	Ticker	Inception Date	Share Price	Dividend Yield	Share Volume	Average Daily 1-Year	Total Return 3-Year	Total Return Since Inception
iShares Cohen & Steers Realty	ICF	1/29/2001	71.2	4.08	267,000	35.38	21.82	20.24
iShares Dow Jones U.S. Real Estate Index Fund	IYR	6/12/2000	63.6	4.04	1,334,000	31.49	19.58	19.37
streetTRACKS Wilshire REIT	RWR	4/23/2001	196.8	4.19	27,400	33.05	20.38	20.45
Vanguard REIT VIPERs	VNQ	9/23/2004	58.7	4.39	NA	NA	NA	22.43
Source: ETF Connect

Louis Taylor, senior real estate analyst at Deutsche Bank, whose firm recently published a report on the nuances of real estate index funds, says that even though he doesn't see a significant jump in cost between an ETF and an index fund, there are usually more noticeable differences when comparing either with actively managed funds.

"An ETF's costs versus an index fund's costs are marginal. However, if you compare the costs of an index fund versus an actively managed fund, those costs can vary greatly," Taylor says.

Additionally, the decision to choose an index fund or an ETF over an actively managed fund can also come down to capital gains taxes. Realized capital gains are minimized with both index and ETF funds because the holder can control when to take capital gains. With active portfolio managers, Taylor says the manager has a lot more control.

"With an index fund there aren't any capital gains taxes until an investor sells," Taylor says. "If you're growing value you can continue to grow without paying taxes until you choose to—whereas with an active fund you have to pay them as you go."

There is a small exception to that benefit when any REITs in the index make a capital gain distribution, but Taylor says the amount is minimal. "That would be a refinement whereby the only capital gains that would flow to an index fund holder would be the capital gain component of dividends."

On top of the differences Taylor listed, Sauter also adds that index funds only incur beta risk, which results from tracking a particular market segment, in this case equity REITs. The manager is not concerned with boosting return beyond the market segment. In an actively managed fund, i.e. a traditional mutual fund, the manager tries to boost fund performance above and beyond what the fund's market segment benchmark is returning, called alpha risk. Therefore, in actively managed funds the investors encounter two types of risk—market segment risk and manager risk. The later doesn't apply to computer-managed index funds.

Opinions differ on whether REIT index funds perform better or worse than actively managed REIT funds.

"From what I've seen, there is a high percentage of actively managed real estate funds that beat the respective index they are tracking (or their benchmark) and have outperformed," Taylor says.

Barry Vinocur, editor of Realty Stock Review, says though real estate funds are sometimes considered more efficient than larger indexes, it is still common for actively managed funds not to beat their index.

"The general rule of thumb in the index fund area has been that about two-thirds of actively managed funds do not beat their index," Vinocur says. "In fact, when you look at the REIT space, most of the real estate funds still outperform their underlying benchmarks. However, when looking at broad indexes like the S&P 500 and general equity funds that are meant to provide you with large cap equity exposure, the majority of those managers don't outperform the index."

While they share many similarities, and the terms ETF and index fund are often used interchangeably, the differences come down to how they trade and are distributed. Index funds, as implied by their name, mirror an index—which means the fund typically holds the same proportion of stocks as the respective index it tracks—and are priced at the close of the day. ETFs are set up similarly, but trade throughout the day like stocks.

An obvious benefit to an ETF is the intraday trading option. Also, ETFs are good for short selling and trading on margin. These funds offer index-like benefits, such as low turnover, and have low costs when compared with actively managed mutual funds.

For investors looking to actively trade and hedge their positions, an ETF is the way to go, according to Taylor.

"Institutional investors usually have money to put to work quickly, so they buy an ETF with instant exposure to an index and are done with it. It is the only option to buy a big basket quickly," Taylor says. "However, individual investors, who are probably more interested in the long-term, can have flexibility and not worry with an index fund."

Vinocur says some investors use ETFs as an alternative to nonexistent industry futures. He says if stocks are especially volatile with wide swings, it can be captured in one of the four real estate ETFs as a way of creating futures.

"It's essentially a way of trading for real estate investors who understand the way the market moves and know how to handle a significant amount of money. ETFs give people the ability to make quick bets in and out of the sector, to magnify those bets with custom options," Vinocur says.