Trial by Fire Most real estate fund managers have for sometime handily outperformed their relevant benchmarks. For the first time in recent memory, that's no longer the case. by Barry Vinocur

As of early June, only one—Alpine International Real Estate Equity—of the 38 funds tracked by Realty Stock Review (Property's sister publication) was in the black for the year. The other 37 funds had all posted negative year-to-date (through June 4) total returns, ranging from Templeton Global Real Estate Securities' negative 0.46% total return to CGM Realty's negative 9.14% total return.

More notable than year-to-date returns, however, were two other pieces of data. First, again for the year-to-date period through June 4, the average real estate fund tracked by Realty Stock Review (using performance data supplied by Lipper Analytical) not only trailed the Standard & Poor's 500-Stock Index on a total return basis for the year-to-date period, but also, and more importantly, for the trailing 12-month, three- and five-year periods.

Second, for some time, real estate fund managers have noted that, unlike other "active" managers, they had no trouble outperforming their benchmark. However, for the year-to-date period, again through June 4, roughly 40% of the funds tracked by Realty Stock Review (including the industry's two largest funds—Cohen & Steers Realty Shares and Fidelity Real Estate) were trailing Vanguard's REIT Index Fund, which tracks the Morgan Stanley REIT Index (see table at the top of page 52).

Should investor's expect real estate funds to outperform the broader market? It depends on who you ask, as well as how REITs are performing when you ask the question. In late-1996 and early-1997, for instance, REITs were on fire, and industry analysts and fund managers weren't shy about trumpeting how the stocks were faring vs. the broader market. These days, those same folks aren't doing much crowing. To be fair, no one really expected that REITs would trounce the S&P 500 year in and year out the way they did in 1996.

More important than how REITs and real estate funds perform vs. the broader market is how the various funds stack up vs. the relevant benchmarks (see pages 75-77).

Why are so many REIT funds trailing the Morgan Stanley REIT Index this year? One reason may be the shift that has taken place in that index. Like most other benchmarks, the Morgan Stanley REIT Index is market-cap weighted. Until recently, real estate fund managers handily outperformed the index if they overweighted, for example, hotels and office/industrial, which, on a market-cap basis, were a small portion of the index. Since office/industrial and hotel REITs were the place to be in 1996 and again last year, most fund managers easily beat the Morgan Stanley index.

But as we note elsewhere in this issue (see pages 75-77), office/industrial and hotel REITs now account for roughly half the Morgan Stanley index on a market-cap basis. At the same time, not only has it become a stock picker's market—making a simple sector bet strategy far more risky—but most of the high-octane office/industrial and hotel companies, which now represent a large portion of the index, have been among the REIT market's worst performers thus far in 1998.

Growing by Leaps and Bounds
Since 1993, both the number of real estate funds and the assets in those funds have soared, along with the market for publicly traded real estate stocks. Specifically, at year-end 1993, Realty Stock Review was tracking seven real estate funds with assets of $990.1 million. As of June 5, Realty Stock Review was following just under 40 funds, with total assets of approximately $11.4 billion (down from roughly $12.5 billion earlier this year). As we noted in our last issue (Spring 1998), since late last year, a number of large mutual fund complexes, including T. Rowe Price and Dreyfus, began offering real estate funds.

As we have noted in previous issues of Property, our sister publication, Realty Stock Review, counts the number of real estate funds differently than either Lipper Analytical or Morningstar. If a fund complex offers a fund with three share classes, Realty Stock Review totals the assets invested in each class and treats it as one fund. For that reason, Realty Stock Review appears to be tracking far fewer real estate funds than either Lipper or Morningstar.

Making Sense of the Numbers
There are a number of considerations that should be taken into account when choosing a real estate fund. For the most part, those considerations are no different from those that should be considered when making any mutual fund investment, such as loads, the presence of a 12b-1 fee, expense and turnover ratios, and how long the portfolio manager has been at the fund's helm.

When looking at the performance of real estate funds, it's important to keep in mind that, though there have been some ups and downs, REITs have yet to experience a "bear market" since the sector sprang back to life in the early-1990s. That's important because knowing how a fund performs in down markets is at least as important as how it fares with the wind at its back.

Investor concerns about a prolonged stock market correction, or worse, a bear market, led some real estate fund managers to suggest their funds represent a port in a storm. This assertion received a lot of attention roughly two years ago, when the S&P 500 dropped by 4.4% during the summer's mini-market correction and the Wilshire REIT Index rose by 0.1%.

Some real estate fund managers emphasize their funds' low betas. In fact, Morningstar's data shows extraordinarily low betas vs. the S&P 500 for all real estate funds. But those funds also have R2s that are (or approach) zero. (See page 78 for definitions of terms.) Morningstar also calculates real estate fund betas vs. the Wilshire index, which is far more relevant.

In his book, Wealth Management: The Financial Advisor's Guide to Investing and Managing Client Assets (Irwin Professional Publishing, 1997), certified financial planner Harold Evensky discusses the use of beta and its interrelationship with R², or the coefficient of determination. "It's of no value to measure the risk of a portfolio by its beta, if the beta is based on an inappropriate market," he states. He adds that his firm looks for another "best fit index" if R² falls below 75.

What do low betas and R²s of real estate funds vs. the S&P 500 tell you? In effect, that at least over the past several years, there's been a very low, if any, correlation between the performance of the S&P 500 and the performance of these funds. Put another way, the risk associated with real estate funds cannot be explained by the risk in the S&P 500. But that isn't to say that property-linked stocks, or the funds that invest in them, are not "risky."

To get a better handle on risk when analyzing real estate funds, you should look at standard deviation, as well as Sharpe ratios. The table on above shows the Sharpe Ratio, as calculated by Morningstar, of those real estate funds that have been around for at least 36 months. Morningstar's Sharpe Ratio is a trailing-three-year measure.

"The most popular quantitative measure of risk-adjusted return is probably the Sharpe Ratio, which is calculated by subtracting the risk free (T-bill) rate from a portfolio's total return and then dividing this by its standard deviation. The resulting fraction can be thought of as return per unit of risk. The higher a portfolio's Sharpe ratio, the better the risk-adjusted performance," wrote Morgan Stanley Dean Witter's Leah Modigliani last year.

To help with your comparison of real estate funds, in addition to their Sharpe ratios, the table above lists the respective funds' year-to-date total return (data is as of the end of May unless otherwise noted), as well as a number of other performance periods. The table also shows each fund's expense ratio.