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ETF Specialist

Much Ado About REITs

The interest-rate concerns that have left REITs in the dust this year may be overblown.

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The lackluster performance of REIT funds this year has been a sharp contrast from their previous market-beating returns since 2009. REIT exchange-traded funds like   Vanguard REIT Index ETF (VNQ) outperformed the S&P 500 in each of the past four years, often by a significant margin. However, year to date through the end of November 2013, REITs have only returned 2.2% compared with  SPDR S&P 500's (SPY) 29% return. It's been a bumpy ride, too, as VNQ's one-year standard deviation was 80% greater than SPY's, which is well above the three-year average difference in volatility. Earlier this year, after the Fed first mentioned that it may scale back its bond-buying program, REITs slid more than 15% between May 20 and June 20.

Fears that interest rates will increase are largely to blame for the category's heightened volatility and diminished performance. Because REITs must pay out most of their income as dividends in exchange for their advantaged tax treatment, they rely heavily on short-term borrowing for growth. For REITs, higher rates mean more-expensive debt servicing and less business reinvestment, as well as less cash to pay out to investors. REITs also could fall out of favor if their yield doesn't keep pace with Treasuries, putting downward pressure on the sector's valuation.

Abby Woodham does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.

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