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July 2010 Mutual Fund Red Flags

Now's not the time for a real estate fund.

Andrew Gogerty, 07/27/2010

After taking a breather in 2009, real estate fund investors have jumped back in with two feet in 2010. Through May, the category has received net inflows of nearly $1.6 billion, more than 5 times the net amount invested for all of 2009. This money missed a majority of the rally that began in earnest in March 2009, as investors didn't appear tempted to get back in after the painful crash seen in 2008. That fact isn't surprising; more than 97% of the category's nearly $2.5 billion in net inflows occurred in the second quarter of 2008, just before the sector and the broader market went into a free-fall. But the bad news is they're coming very late to the party.

Two factors likely dominate investors' current attraction to the real estate sector: total returns and current yield. The sector's rally has continued into 2010, and even with the May sell-off, the group's 13.4% gain for the year to date through June 14 is far ahead of its nearest rival, the consumer discretionary category, which has turned in a 9.8% gain thus far. As my colleague stock analyst Todd Lukasik noted in a recent commentary, the large amount of capital that REITs, pension funds, and private investment funds have amassed for commercial real estate investment has thus far overshadowed the available supply of properties available for sale. REIT management teams are reporting plenty of bidding competition on available assets, which has contributed to rising transaction prices in recent quarters.

REITs' rising stock prices have further compressed yields across the board so that they are now near historic lows. Vanguard REIT Index VGSIX, the 800-pound gorilla in the domestic real estate category, has a current yield of just 2.9%, well below the 4% to 5% seen in the past. While that yield is relatively low, it is still nearly double the 1.4% current yield of the S&P 500 Index. That may be a starting point of comparison, but taken a step further, investors could get the same 2.9% yield at Vanguard Intermediate- Term Treasury VFITX without the imbedded leverage or credit risk inherent in the REIT operating structure. Despite the enthusiasm seen in the property transactions, rental and occupancy rates, though stabilizing, are still well below their respective peaks.PAGEBREAK

After the market swoon and recovery seen in recent years, costs and diversification still appear fresh in investors' minds when deciding where to invest. Not surprisingly, Vanguard REIT Index commanded 24% of total net inflows this year but more than its 16% market share at the start of 2010. Fidelity investors appear to have a preference for income, as Fidelity Real Estate Income's FRIFX $160 million of net inflows is significant compared with its $698 million starting asset base, while sibling Fidelity Real Estate Investment FRESX has seen outflows this year. So, too, has Analyst Pick T. Rowe Price Real Estate TRREX, one of the largest funds after Vanguard, seeing $126 million head out the door so far this year.

The biggest move, however, has been in First American Real Estate Securities FARCX, which, despite only having a 3% market share to start the year, accounted for 21% of net inflows so far this year. Investors likely are attracted to comanager Jay Rosenberg and John Wenker's consistent recent and long-term performance. That fund does have long-term appeal, as do many others, but investors should still note that the underlying REITs are not out of the woods just yet.

Andrew Gogerty is a mutual fund analyst with Morningstar.

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