Active vs. Passive: The REIT Edition

Passive investing is rooted in the efficient-market hypothesis, which questions if active managers are able to consistently generate excess returns over a stated benchmark. Many investors have begun to employ passive strategies in more “efficient” areas of the market, such as U.S. large caps. However, in smaller niches of the market, such as real estate, there is less of a consensus on the active versus passive debate.

The relative merit of active or passive strategies for U.S. real estate is an interesting question that deserves further exploration, especially as passive real estate strategies gain traction. Does the average actively managed real estate fund generate enough excess return to beat low-cost passive options? Have there been any interesting trends in the performance of actively managed real estate funds over the past decade?  In a stable to rising-interest-rate environment, is it better to go active or passive?

To answer these questions, we created a data set of mutual funds to include all funds in Morningstar’s domestic real estate category from 1996 through the end of 2013. To minimize survivorship bias, funds that liquidated or merged were included in the sample. However, because of the five-year evaluation periods used in the tests, funds that did not survive for 60 months were excluded.

The resulting sample group included 112 mutual funds. In the event that a fund had multiple share classes, only the share class with the lowest expense ratio was included. Although the average investor in each fund might not have access to lower-cost institutional share classes (and therefore would experience a higher cost of ownership than the I-share expense ratio would suggest), a mutual fund’s lowest-cost share class is the best representation of the fund’s cost of active management without the noise of varying distribution costs.

The Vanguard REIT Index Fund was used as a benchmark instead of a REIT index. By comparing active funds with a passively managed competitor, we are able to compare the performance of the two strategies on an apples-to-apples basis. The investor share class (ticker (VGSIX)) was used from 1996 to 2003, and the fund’s even cheaper institutional share class was used (ticker (VGSNX)) following its inception in late 2003.

With this methodology, the deck was slightly stacked in favor of actively managed mutual funds. Calculating returns using the institutional share class may have given funds an unfair cost advantage compared with the real-life experience of investors in pricier A shares, and studying fund returns over rolling five-year periods meant that funds that flamed out in fewer than 60 months weren’t present.

However, despite these distinct advantages, the actively managed funds still disappointed.

Beat Rates

To begin, we looked at the “beat rate” of actively managed REIT funds, which is the percentage of actively managed mutual funds that outperformed the passive option over a certain time period. Beat rates change over time, so we used rolling five-year annualized returns starting in 1996. The Y-axis states the ending month and year of the rolling five-year period.

Beat rates fluctuated between 50% and 70% from 1996 until 2002, at which point they begin to sharply decline. No more than 40% of active funds were able to beat the Vanguard fund since the five-year period beginning in October 2005, and more recently, the beat rate has fallen as low as 20%. For a sector often considered a strong candidate for active management, the actively managed funds, as a group, have not performed well compared with passive options over the past decade.

A Precipitous Decline in Alpha

With the decline in beat rates in mind, we calculated the average rolling five-year alpha of actively managed real estate funds withrespect to the Vanguard fund.

 

Before the five-year period beginning in September 2003, the average real estate fund consistently generated positive alpha. However, in the following years, the percentage of funds able to provide alpha declined to below 40%, and the average fund’s alpha fell below zero for several years. Only recently have actively managed funds, on average, been able to generate positive alpha.

 

Not surprisingly, the percentage of funds that exhibited positive alpha over five-year periods declined concurrently with beat rates. Over the past decade, active fund managers on average found it increasingly difficult to beat the market.

Contributing Factors to Active Fund Underperformance

There are several factors that may have combined over the past 10 years to contribute to the declining relative performance of actively managed real estate funds.

As my colleague Sam Lee pointed out in his recent article, “something about REITs changed in the early 2000s.” One likely culprit is the inclusion of REITs in major indexes, such as the S&P 500 in 2001. Before the rise of indexing and passively managed investments, most REITs were small-cap value investments. During the 80s and 90s, an active manager would have had a better chance at beating the market, as REITs were relatively underowned, under-researched, and less liquid. Index inclusion has resulted in strong inflows to the asset class, turning REITs into a more mainstream asset class.

Another contributing factor is style purity, or the tendency of active funds to not be 100% invested in assets related to their fund category. When an asset experiences a bull market, index funds can outperform active funds that do not have the same style purity. Actively managed funds, by holding a small cash reserve or real estate-related (but not REIT) securities, can result in a lag relative to a passive fund in years like 2009 when the Vanguard REIT Index fund returned more than 30%. REITs have, in fact, experienced a sustained bull market over the past several years.

Are We at an Inflection Point?

Morningstar Risk is a measure of a fund’s annualized downside volatility, and Morningstar Return is a fund’s load-adjusted excess return over the risk-free rate. Combining the two into Morningstar Risk-Adjusted Return allows investors to compare the returns of funds after controlling for risk. Below is a graph that shows the percentage of actively managed funds that provided 1) higher Morningstar Return, 2) lower Morningstar Risk, and 3) higher Morningstar Risk-Adjusted Return, on a rolling five-year period, than the Vanguard fund.

Although the percentage of actively managed funds with higher Morningstar Return has steadily declined, an increasing percentage has been able to provide lower Morningstar Risk than the Vanguard fund. The group’s lower risk helped damp the effect of decreasing return in the risk-adjusted return equation. Over the past 10 years of rolling five-year risk-adjusted return, about half of actively managed funds were able to beat the Vanguard fund--higher than their beat rate in simple net return terms, with a more gradual decrease than the beat rates based on net returns.

The recent decline in actively managed funds’ Morningstar Risk, combined with the potentially rising-interest-rate environment for REITs, could trigger an improvement in the relative performance of actively managed real estate funds. 2013 marked the first year of subpar returns for the REIT sector after the Fed announced that it would consider tapering. Real estate could be entering a bear market, during which an active fund’s style impurity could serve as a boost to returns. Furthermore, as rates tick upward, active managers may be able to generate alpha by managing the “duration” risk of REITs, which rely on debt for growth. For REITs, higher rates mean more-expensive debt servicing and less business reinvestment. The five-year beat rate has already begun to tick upwards again and may continue to do so if REITs lag the broad market.

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