Real Estate Investment Trust (REIT) Funds Explained
REITs are a popular investment target for funds of many kinds, as real estate investments are a very identifiable asset class and fund managers can easily assemble a large group of similarly structured REITs. On the other hand, individual REIT investing that focuses on picking and choosing among huge REIT selections, even for fund managers, may prove to be more difficult. A dedicated portfolio of REIT-only holdings is often constructed through an index tracking fund, because various REIT indexes of different market segments and areas make it fairly easy to buy a group of REITs which resembles the components of a REIT index. In general, there are two types of REIT Index funds, passively managed REIT mutual funds and the exchange traded REIT funds (ETF).
Passive Mutual Fund
REIT holdings in an index-like mutual fund are therefore not actively selected by managers. Instead, they are computer-based, consisting of virtually all the components that make up a particular REIT index. It still functions like a mutual fund, so that shares can be bought and sold only through the fund company at the end of a trading day based on the end-of-day net asset value (NAV) of the fund’s holdings. But a passively managed mutual fund has a lower expense ratio and a higher tax efficiency than a traditional mutual fund, besides the most noticeable difference of having higher levels of diversification. The cost of “managing” an index fund of any kind is always much lower than funds that are actively managed. And the same passive nature also helps reduce investment turnover, a highlight of many actively managed funds resulting from constant buying and selling, and thus potentially reduces some capital gain taxes.
Indexed ETF
All ETFs are natural index funds and there are many REIT-focused ETFs. The usual cost advantage of buying an ETF over buying a mutual fund becomes marginal for REIT investors, when the mutual fund is indexed and passively managed. But the difference in tax efficiencies between an ETF and a passive mutual fund remains significant, despite the new buy-and-hold investment strategy used by a passive mutual fund. While individual ETF investors can potentially incur a capital gains tax when they sell their own ETF shares themselves, all mutual fund investors share the capital gains tax burden whenever there are redemption requests by some of the investors, because the fund has to sell a portion of its portfolio to meet the withdrawals.
Passively managed mutual funds and exchange traded funds present two different choices for REIT investors interested in investing in an index fund that provides better diversification, lower cost, and higher tax efficiency. However, when making such an investment choice, the contrasting tradability between the two types of index funds is likely to be the deciding factor, all other things being equal. For certain REIT investors who trade actively and like to make bets among different types of properties in different areas, an ETF would be ideal, as shares of the funds are traded like stocks any time during the day. For other REIT investors who have a buy-and-hold, long-term strategy, a passive mutual fund would be the best fit, since the inconvenience of share redemptions through the fund company becomes a non-issue for infrequent selling. In addition, holding relatively volatile ETF shares exposes value investors to unnecessary risks, as ETF prices can deviate from the underlying REIT value from time to time, whereas a mutual fund’s NAV is always certain.
