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  A Very Tough Year 1998 is a year real estate fund managers would no doubt just as soon forget. For the first time since the REIT bull market began in 1991, roughly half of the funds are trailing their benchmarks. Moreover, all but one of approximately 50 such funds was in the red for the year at the end of August. by Barry Vinocur |
As of the end of August, only one—Dreyfus Real Estate—of the roughly 50 funds tracked by Realty Stock Review (Property’s sister publication) was in the black for the year (see table at the top of page 56). The other funds were all down more than 10% for the year—ranging from Alpine Interna-tional Real Estate Equity’s negative 12.0% total re-turn and Cohen & Steers Equity Income’s negative 14.7% total return to Alpine U.S. Real Estate’s negative 26.7% total return and Cohen & Steers Special Equity’s negative 33.5% total return.
Though not a subject most fund managers care to discuss at length—if at all—the available data suggest that many, if not all, real estate funds have been experiencing net redemptions for some time. (CGM Realty recently informed Realty Stock Review that it would no longer participate in the newsletter’s weekly survey of the net assets invested in real estate funds.) Cohen & Steers Capital Management, which provides some of the sector’s best disclosure—in addition to holding quarterly conference calls, the firm publishes a complete list of the holdings in each of its three open-end funds at the end of each quarter—told financial advisors who participated during its second quarter conference call in early August that from January through the end of July, its flagship fund, Cohen & Steers Realty Shares, had experienced net redemptions of just over $500 million. That compares to just over $900 million in net inflows into the fund last year.
In a recent research report, Prudential Securities, using data compiled by AMG Data Services, noted that $166 million had flowed out of real estate funds during July, continuing the “negative money flows” of the prior four months. “This, along with a decrease of $252 million due to share price performance, caused real estate fund net assets to shrink by $418 million in June,” the Prudential analysts wrote. “After particularly strong months in January and February, money inflows have taken a turn for the worse, thus applying pressure to already anemic real estate share prices.”
As the table on page 56 shows, the average real estate fund at the end of August not only was trailing the performance of the Standard & Poor’s 500-Stock Index by a wide margin during the first eight months of 1998 and for the trailing 12-month period, but also for the trailing three- and five-year periods (through the end of August)—a fact that doesn’t help the flow of funds, into the sector, generally, or into real estate funds, specifically.
Should investors 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.
| Real Estate Mutual Funds (Funds Ranked by Year-to-Date Total Return Through August 31, 1998)
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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. Most fund managers compare their performance to one or more of the following benchmarks: the NAREIT Equity REIT Index, the Morgan Stanley REIT Index, or the Wilshire Real Estate Securities Index. As we noted in our last issue, for the first time in several years, many fund managers are no longer beating one of the most widely followed benchmarks—the Morgan Stanley REIT Index. As of the end of August, roughly half of the funds tracked by Realty Stock Review were trailing Vanguard’s real estate fund, an index fund that mimics the Morgan Stanley index.
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 the end of August, the newsletter was following roughly 50 funds, with total assets of $9.6 billion (down from just over $11 billion in early June). As we have noted previously, over roughly the past 12 months, a number of large fund complexes (including T. Rowe Price and Dreyfus) and wirehouses (notably, Merrill Lynch and Prudential Securities) launched real estate funds.
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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, which count each share class as a separate fund.
Making Sense of the Numbers
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, until this year REITs hadn’t experienced a “bear market” since the sector sprang back to life in 1991. That’s important because knowing how a fund performs in down markets is at least as valuable as how it fares with the wind at its back.
Investor concerns about a prolonged stock market correction—or worse, a bear market—have 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 pages 78-79 for a definition of terms). (Morn-ingstar 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,” Evensky wrote. He adds that his firm looks for another “best fit index” if R2 falls below 75.
What do the low betas and R2s of real estate funds vs. the S&P 500 tell you? That 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. (As you might expect, the R2 of the Vanguard 500 Index Trust is 100, which tells you that all of that fund’s risk can be explained by the risk of the S&P 500 index.) 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 page 58 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,” states Morgan Stanley Dean Witter’s Leah Modigliani.
To help with your comparison of real estate funds, in addition to their Sharpe ratios, the table on page 58 lists the respective funds’ year-to-date total return (data is as of the end of August), as well as a number of other performance periods. The table also shows each fund’s expense ratio.