REIT ETFs: Active Management or Passive Indexing?

Does active REIT investing work?

Several organizations have performed extensive research when it comes to active versus passive REIT investing, although not in the context of REIT ETFs. 

The first one to consider is the annual SPIVA Scorecard compiled by S&P Dow Jones Indices. The SPIVA Scorecard measures the performance of actively managed funds across the world against their index benchmarks. As expected, most tend to underperform. 

The real estate fund section is benchmarked against the S&P United States REIT Index, and it details what percentage of actively managed REIT funds underperform the index over 1, 3, 5, 10, and 15 years. The results? 68.49%, 45.57%, 51.81%, 72.73%, and 87.37% underperformed respectively. 

The 3-year and 5-year performance figures stand out to me. Compared to other equity categories, the percentage of managed REIT ETFs that underperformed their index benchmarks over 3-year and 5-year periods was much lower. However, there's no telling if this is statistically significant or just an outlier. 

Morningstar also conducted analysis in 2014 and found that the percentage of actively managed funds that managed to beat the index began sharply declining after 2002. Over the last decade from 2014, they found that the majority of active REIT funds underperformed their index counterparts.

One of Morningstar's theories was that the inclusion of REITs in indexes like the S&P 500 in 2001 and subsequent investor inflows turned them into a "mainstream" asset class. Prior to this, Morningstar noted that REITs were "under-owned, under-researched, and less liquid", which could have created opportunities a fund manager could capitalize on. 

Morningstar's theory lines up with a study from 2000 titled "The Value Added from Investment Managers: An Examination of Funds of REITs". Here, the authors found that the average and median alphas (net of expenses) of REIT funds were positive and were much more likely to be generated when the REIT sector performed poorly. 

Active REIT ETFs today

In my opinion, the debate on active versus passive investing for REIT ETFs can be summed up by the following observations:

1. A minority of actively managed REIT ETFs will always outperform their passive index counterparts net of fees, but the majority will underperform. 
2. As more and more time goes on, both the number of outperforming actively managed REIT ETFs and the degree to which these actively managed REIT ETFs outperform will shrink. 
3. Actively managed REIT ETFs face many headwinds that passively managed ETFs do not, such as higher expense ratios, greater portfolio turnover, and the risk of management style drift. 
4. Identifying which actively managed REIT ETFs will outperform ex-ante is highly difficult, if not possible for the average retail investor to do. 
5. Actively managed REITs may have a higher chance of outperforming passively managed REIT index ETFs when market conditions are poor or volatile. 

Investors interested in taking their chances with actively managed REIT ETFs can consider the following:

• ALPS Active REIT ETF (REIT)
• Invesco Active U.S. Real Estate Fund ETF (PSR)

Of the two ETFs, PSR has the longest performance history, dating back to 2009. Here's how it historically performed net of fees versus two popular passive REIT index ETFs, the Vanguard Real Estate ETF (VNQ) and the iShares Core U.S. REIT ETF (USRT) respectively.

On a trailing basis, PSR outperformed both VNQ and USRT, although just very slightly for the former. It did so with less risk though, with lower volatility and drawdowns for a better risk-adjusted return. On a rolling basis, PSR performed fairly similarly to VNQ, but keep in mind that this is net of fees. If PSR reduced its expense ratio from 0.35% to 0.12% to compete with VNQ, I could see this narrowing. 

Please note this article is for information purposes only and does not in any way constitute investment advice. It is essential that you seek advice from a registered financial professional prior to making any investment decision.