Behold the little industry group that roared-at least for a while.

    In case you have not yet heard, Real Estate Investment Trusts (REITs) were promoted from being just a small industry group to a full-fledged asset class. They even skipped right over being a sector, as I don't recall the Global Industry Classification Standard (GICS) adding an eleventh category. This must be the case, because everywhere I look, mutual fund wrap programs and asset allocation shops are including a separate and distinct allocation just for REITs.
    This phenomenon can most likely be attributed to the recent real estate boom, now slowing, causing retail dollars to chase the "hot dot." Not only has real estate been the "hot dot" but it's also been the hot topic, getting press almost daily. That may be a reason why it has been propelled to its current status as a new asset class.
    Performance can't be the only reason. After all, why isn't the fertilizers and agricultural chemicals industry a separate asset class? That industry has outperformed REITs for more than three years now, returning roughly 38%, 83% and 31% in '03, '04 and '05, respectively. Plus fertilizers and agricultural chemicals are up nearly 8% through the first four months of this year. That seems like a "hotter dot" than REITs.   
    Whatever the reason, the intentional inclusion of REITs seems contradictory to most platforms' philosophies. Consider the typical mutual fund wrap program. Managers of these programs incorporate a blend of various mutual funds to create several asset allocation models that typically are fully diversified and cover the standard asset classes from fixed income to equity, small cap to large cap, domestic to international and value to growth. These "fund of fund" managers (myself included) tend to utilize professional money management via mutual funds because, admittedly, they do not have the expertise or means by which to buy and sell a portfolio of individual stocks and bonds for their clients. Consequently, they "outsource" that responsibility to a third party. That being said, via extensive due diligence and analytics, they pride themselves on being able to select the "best" funds to use in each portfolio, which is, modestly speaking, a very valuable service. Put simply, they select certain funds basically because they believe that the manager(s) of each of those funds is good at what they do.
    This begs the question, is there something special about REITs that sets them apart that would lend itself to this trend? Let us first be clear on REITs themselves. REITs are stocks just like Coca-Cola or Microsoft or GE. All stocks get classified in subsectors or industries, and those industries are classified as part of a sector. Standard and Poor's, for example, places Coca-Cola in the beverages industry, which is part of the consumer staples sector. Mutual fund portfolio managers perform their research on Coca-Cola and other names in the consumer staples sector and make decisions whether or not to include any of them in their fund.
    REITs are no different, as they are merely an industry that is part of the financial sector, alongside banks and insurance companies, to name two. They are primarily value oriented and tend to be small- and mid-cap names. They make up approximately 10% of the overall financials sector, which is roughly 20% to 25% of the overall domestic equity market. Just shy of 200 REITs are registered with the SEC and trade on one of the major stock exchanges (the majority on the NYSE). As of the end of the first quarter of this year there were 11 REITs in the S&P 500 index, 12 REITs in the S&P 400 index and 14 REITs in the S&P 600 index.
    Now to be fair, REITs differ from the typical stock in that they are required to pay at least 90% of their taxable income to shareholders in the form of dividends. Hence, REITs tend to offer better-than-market yields. The yield for the past few years has been relatively attractive, but the argument no longer can be made that bonds are not offering competitive yields now that the Fed has raised rates 16 times. Additionally, there are many other stocks that offer dividend yields that exceed the average REIT. And what many people forget is that because REITs don't pay corporate taxes, most dividends paid by REITs are taxed as ordinary income and not at the new 15% rate. On top of all that, REITs are not immune to difficult times either. You need only look at 1999, 1998 and 1990 to notice that. The Nareit, a broad based REIT index, was down roughly 6%, 19% and 17%, respectively, in those years.
    Logically speaking, an equity portfolio manager's available universe of stocks contains REITs along with all other industries and sectors. If you select a particular mutual fund for a portion of a portfolio, I think most people would suspect that you feel that that particular fund's management team is one that is skilled at managing money. You must believe that they are good at identifying what names to own and what names to avoid. Whether they are bottom-up or top-down investors, sector neutral or otherwise, they have the ability to purchase REITs if they deem it appropriate. And since the financials sector is the largest of the ten GICS sectors, you would be hard pressed to find a broad equity manager without some allocation there. Fund managers are choosing to buy or not buy REITs for their particular fund for a specific reason.
    Understanding this to be the case, many mutual fund wrap platforms have decided that their own, handpicked funds must not know what they are doing, because they are incorporating pure REIT allocations outside of the REIT exposure found within their selected funds. In short, they are overriding the hired experts.
    I can hear the arguments already. But what about those programs that overweight growth versus value or emerging versus developed markets? Isn't that the same thing? Several programs incorporate some tactical biases or bets within their allocation model, yet there is a distinct difference between tilting an allocation in the direction of one asset class versus betting on an entire small subsector. Whether one can successfully do the former is an argument for another article. The point remains that the advisory community didn't seem to bat an eye when the REIT industry all of a sudden became an asset class unto itself. Everyone just accepted it.
    Mutual fund programs that carve out REITs as a separate asset class typically allocate anywhere between 5% and 20% of their equity allocation to the industry. If REITs are only about 2% to 3% of the overall equity market, then those separate allocations constitute an 80% to 1,000% overweight versus the broad market! And that doesn't even include any allocation to REITs inherent in the other funds in the portfolio. That's a pretty big bet by almost anyone's standards.
    REITs as an asset class eventually will fade away, most likely when the returns become less attractive and the real estate market slows further. It's a fad, plain and simple. Years from now, REITs will be able to look back on the good old days and remember when the small industry walked among the big asset classes. Who knows, maybe fertilizers will get their chance someday.

Joshua M. Kaplan is chief investment strategist for Smart Financial Advisors in Devon, Pa. He can be reached at or (610) 254-0700.