Does indexed investing have a place in your portfolio?

By Steve Bergsman

"I always tell people their first investment should be an index fund."

This recommendation doesn't come from an investment banker on Wall Street, but a professor of finance at Stetson University in Florida. Dr. Stuart Michelson has been researching the performance of index funds, first publishing his data four years ago in the Journal of Financial Planning.

His primary findings show that index funds consistently outperformed actively managed funds except in a few categories: aggressive growth, small cap and international. There probably should be a fourth exception—real estate—but when Michelson was conducting his research just five years ago there weren't enough real estate index funds to study. Today there are.

While real estate index fund investing remains a niche play, the number of individual funds continues to expand, which means conservative investors or those investors seeking to reduce volatility associated with actively managed funds have more options from which to choose.

Donald Cassidy, a senior research analyst at Lipper, tracks seven real estate index funds with 13 classes (same funds marketed through different channels). The value of those seven funds totaled $12.9 billion at the end of 2005, up handsomely from $11 billion at the close of 2004.

Leading Domestic Real Estate Indexes FTSE NAREIT U.S. Real Estate Index Series MSCI U.S. REIT Index Dow Jones Wilshire REIT Index Dow Jones Wilshire Real Estate Securities Index S&P REIT Composite Index Cohen & Steers Realty Majors Index

According to Cassidy's data, for the four-year period 2002 through 2005, actively managed real estate funds outperformed index funds (even after accounting for fees). However, in 2001, index funds outperformed their actively managed counterparts. Interestingly, through the first five weeks of 2006, the index funds were doing slightly better, up 6.0 percent as compared to 5.2 percent for actively managed funds.

"There are arguments either way as to which is a better investment," Cassidy says. "If your fund uses an index of 75 components then that is what you are in, period. On the other hand, if a couple of bright new managers emerge and start doing smart things, there's a lift to actively managed funds. Presumably the smart guys are being paid to identify such things as knowing it's a better time to be in office as opposed to apartments, or to move out of a California weighting and be in Texas."

Lower Costs Benefit Index Investors

An index fund, in simple terms, can be defined as an investment fund that tracks the result of a specific market index. The most precise tracking would be to hold all the investments in the index, in the same proportion. However, there are usually slight variations between funds tracking the same index, mostly because managers statistically model an index, getting close to that perfect match but not exactly—and models differ.

"Two index funds would look alike characteristically, meaning the types of companies they hold, but performance differs due to pricing and how the fund is managed," says Fran Kinniry, a principal with Vanguard Investment Counseling and Research, which operates the Vanguard REIT Index Fund. "There are indexes that do it well and indexes that do it less well."

Index funds come in two formats: a mutual fund; and much more frequently as an exchange-traded fund (actively traded on a stock exchange).

		CSFB and NCREIF Offer Derivatives Market To add another option for investors, listed real estate securities are not alone when it comes to real estate index funds.

The idea behind the index fund is that it will achieve market returns. Unlike an actively managed fund there are no real opportunities or expectations for it to outperform the market—while the assumption of risk is perceived to be less. When investors opt for an actively managed mutual fund, they are, in fact, betting the fund manager is savvy enough to create an investment that will be superior to whatever benchmark (index) it is measured against. So, it would seem odd that Michelson's research would indicate the better investment is an index fund.

"When you talk about the large caps, managers are not able to consistently find the under-valued securities," Michelson says. "With the anomaly, the small caps, those managers do have a better universe to pick from in terms of finding undervalued securities."

Unfortunately, that doesn't explain the situation with real estate securities. And the answer is, even when the actively managed funds performed better than index funds (including ETFs), there really wasn't a lot of difference in performance. In 2003, the most striking year in terms of a performance differential, actively managed funds were about 200 basis points ahead of index funds.

The important thing to remember about index funds is that they are cheaper to run. Index funds do not require a day-to-day portfolio manager, therefore investors pay lower fees. Generally, the expense ratio of an index fund is below 0.2 percent, while the expense ratio of the average mutual fund runs 1.36 percent.

"Clearly, you start out ahead with an index fund," Cassidy says. "You have less of a drag. It's like two jockeys in a horse race. The lighter jockey is at a slight advantage because his horse doesn't have to carry the extra weight."

Leading Index Fund Providers

While Cassidy charts an expanding number of index funds (again, including ETFs), this corner of the industry is really dominated by one company, Vanguard. "The Vanguard REIT Index Fund, with four classes, holds a touch more than $7 billion of the almost $13 billion in the whole asset class," Cassidy says.

This is due in part to the Vanguard REIT Index Fund being one of the oldest and best-known real estate index funds around, having launched in 1996.

The Vanguard REIT Index Fund has been an attractive investment option because the cost is so low, Kinniry says. "It is one-tenth the average cost of a real estate (actively managed) fund."

Vanguard's index fund tracks the MSCI U.S. REIT Index. Since inception, its average return has been 14.3 percent. Last year, the fund was up 11.9 percent, and boasts a three-year total return of 25 percent, with a five-year return of 18 percent.

One of the more prevalent names in real estate index funds is Barclays Global Investors, which offers five U.S. REIT funds, two that are specific to defined benefit plans, one for defined contribution plans and two exchange-traded funds. Its well-known iShares Dow Jones U.S. Real Estate Index Fund (IYR), representing the Dow Jones Real Estate Index, was launched in 2001. Barclay's other ETF is based on the Cohen & Steers Realty Majors Index.

		FTSE EPRA/NAREIT Global Index Gives International Investing A Boost The proliferation of a truly international real estate market facilitated the need for a worldwide benchmark.

The variety in Barclays' offerings happened as the result of demand, says Amy Schioldager, managing director and head of U.S. Equity Portfolio Management at Barclays. Defined benefit plans have a relatively solid history investing in real estate, but defined contribution plans have come later to the party.

"Three years ago, one in 12 defined contribution plans had a real estate option, now one in six do, so you can see real estate has become an option in their line-up and an index fund is a low-risk exposure to that segment of the market," Schioldager says.

Any time one asset class outperforms others, investors want in, adds Robert Wade, a vice president and principal with Wilshire Associates, Inc., "and real estate has been one of the top performing asset classes over the past several years." Wade should know, as his company has created a series of real estate securities indexes, now known by the appellation Dow Jones Wilshire.

From Feb. 1, 2004 to Feb. 1, 2005, the Dow Jones Wilshire REIT Index was up 26.4 percent. That has been good news for index funds such as streetTRACKS Wilshire REIT Index Fund (managed by State Street) that track the Wilshire.

Value of Active Management

Indexing in general is a good option because of the portfolio balance it delivers, says Wade, as real estate diversifies away from stocks and bonds, and an index fund, itself, holds a diversified portfolio. If you buy a single REIT, it can go up or down dramatically, but when buying into an index fund, the risk is split among the stocks in the fund.

		The Index Company Puts Its Footprint on REIT Market Already responsible for calculation and distribution of the FTSE EPRA/NAREIT Global REIT Index Series, the FTSE Group expanded its role in the real estate investment market in March by adding responsibility for calculating and distributing NAREIT's domestic REIT indexes.

A managed mutual fund does the same thing, so which is a better investment for 2006? Some real estate investment professionals think an actively managed fund is an investor's best bet.

"At this point in the cycle, if you could find the right manager, it actually makes sense to go with an active manager," says Jordan Heller, head of the wealth management practice for the Schonbraun McCann Group. "The active manager will outperform the indexes as long as he or she is a good one. Although we are pretty far along in both the real estate and interest rate cycles, there are still opportunities in certain sectors, regions and property types."

Michelson notes that actively managed funds do better than index funds when the real estate market changes cycles, such as into a recession or out of one. Heller sees changes ahead in the market, which is why, he says, "an active manager it going to be able to differentiate and add value in this market, much more so than in previous years."

Then there are those investment managers such as Ken Campbell, a managing director with ING Clarion, who staunchly believe in the value of active management regardless of market timing. "We have consistently maintained over a very long period of time that an investor can do better in an actively managed fund as opposed to an index fund," Campbell says.

		Staying Active The increasing number of real estate index funds at this point in time doesn't seem to have had much effect on the way active real estate mutual fund managers operate.

Of course, Campbell has a particular slant on the issue, as ING Clarion Real Estate Securities LP is a member of ING Real Estate and a wholly owned subsidiary of ING Groep, N.V. It holds $8.4 billion in assets under management including a real estate securities fund and two closed-end funds, one of which is globally oriented.

"Over a three to five-year period, active management beats the index in a relatively emerging or maturing group such as REITs," Campbell says. "It is tough to beat the indexes in a mature group."

For investors seeking to maximize potential return and willing to pay associated fees and assume additional risk, actively managed mutual funds might be the way to go. Conversely, for those investors willing to moderate returns while reducing risk, then index funds could be the better option.

Regardless of the direction an investor chooses, "you are adding an element to your overall portfolio that reduces the overall volatility," notes Lipper's Cassidy. "This is a good thing for investors."