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 [email protected] or (610) 254-0700.