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Summary Over the past 8 years, REZ has outperformed the other REIT ETFs. REITs are generally more volatile than the S&P 500. REIT ETFs help diversify a S&P 500 focused portfolio but are highly correlated among themselves. As a retiree looking for income, I am a fan of Real Estate Investment Trusts (REITs). I own some individual REITs, but for diversification, I tend to gravitate to REIT funds, especially Closed-End Funds (CEFs) or Exchange Traded Funds (ETFs). In July, I wrote an article on how to choose the “best” REIT CEF and selected the Cohen and Steers REIT and Preferred Income Fund (NYSE: RNP ) as my favorite. This article focuses on selecting the “best” ETF and also compares the performance of these ETFs with RNP. There are many ways to define “best.” Some investors may use total return as a metric, but as a retiree, risk is as important to me as return. Therefore, I define “best” as the fund that provides the most reward for a given level of risk and I measure risk by the volatility. Please note that I am not advocating that this is the way everyone should define “best”; I am just saying that this is the definition that works for me. For those that have not read my previous articles, I will quickly summarize some of the characteristics of REITs. In 1960, Congress created a new type of security called REITs that allowed real estate investments to be traded as a stock. The objective of this landmark legislation was to provide a way for small investors to participate in the income from large scale real estate projects. A REIT is a company that specializes in real estate, either through properties or mortgages. There are two major types of REITs: Equity REITs purchase and operate real estate properties. Income usually comes through the collection of rents. About 90% of REITs are equity REITs. Mortgage REITs invest in mortgages or mortgage-backed securities. Income is generated primarily from the interest that is earned on mortgage loans. The risks and rewards associated with mortgage REITs are very different than those associated with equity REITs. This article will only consider equity REITs. One of the reasons REITs are so popular is that they receive special tax treatment, and as a result, are required to distribute at least 90% of their taxable income each year. This usually translates into relatively large yields. But because REITs must pay out 90% of their income, they rely on debt for growth. This means that REITs are sensitive to interest rates. If the interest rates rise, the cost of debt increases and the REITs have less money for business investment. However, rising rates usually imply increased economic activity, and as the economy expands, there is a higher demand for real estate, which is positive for REITs. The effect of higher rates depends on the type of real estate owned by the REIT. For example, if the real estate has tenants with short leases, interest rates would have less impact because the rents could be raised quickly. Among the real estate sectors, hotels generally have the shortest leases followed by (from short to long) apartments, industrial property, retail properties, and healthcare. There are currently 16 ETFs focused on equity REITs. To reduce the analysis space, I selected only the ETFs that met the following requirements: A history that goes back to 2007 (to see how the fund reacted during the 2008 bear market). Generally, REITs were devastated in 2008, but, like other equities, they have recovered strongly since 2009. A market cap of at least $100 million. An average daily trading volume of at least 50,000 shares. The 6 ETFs that passed the screen are summarized below. Vanguard REIT Index (NYSEARCA: VNQ ). This ETF was launched in 2004 and is the largest REIT ETF. It tracks the MSCI US REIT Index, which is a pure equity index. The fund has 145 holdings diversified across real estate sectors with retail being the largest constituent at 25% followed by residential (17%), specialized (14%), Office 14%, and health care (13%). Specialized REITs are companies or trusts that do not generate a majority of revenue from rental and lease operations, such as storage properties. VNQ holds a large percentage (40%) of medium cap firms and also has 19% in small cap holdings. The fund charges a low 0.12%, which is substantially less than most of its competitors. The fund yields 3.9%. iShares U.S. Real Estate (NYSEARCA: IYR ). This is the only ETF that holds REITs of all kinds including mortgage REITs and timber REITs. The fund has 119 holdings spread over commercial (44%), specialized (37%), and the residential (14%) sectors. The fund has an expense ratio of 0.43% and yield 3.7%. iShares Cohen & Steers REIT (NYSEARCA: ICF ). This ETF is highly concentrated, holding only 30 of the largest REITs. The strategy assumes that large REITs will be better able to weather downturns. The holdings are spread across the commercial (51%), specialized (28%), and the residential (21%) sectors. The expense ratio is 0.35% and the yield is 3.2%. SPDR DJ Wilshire REIT (NYSEARCA: RWR ) . This ETF tracks the Dow Jones US Select REIT index. The fund holds 95 REITs spread over the commercial (53%), specialized (27%), and residential (20%) sectors. The fund has an expense ratio of 0.25% and yields 3.2%. i Shares Residential Real Estate Capped (NYSEARCA: REZ ). This ETF is touted as a residential REIT fund but only about 47% of the holdings are residential REITs. The other 53% are primarily specialized REITs. The fund has 38 holding, has an expense ratio of 0.48% and yields 3.3%. S&P REIT Index (NYSEARCA: FRI ). This ETF covers a large portion of the US REIT market with 156 holdings spread over commercial (55%), specialized (28%) and residential (17%) sectors. The fund has one of the highest expense ratios at 0.50% and yield 2.6%. For comparison, I used the following CEF: Cohen and Steers REIT and Preferred Income Fund. This CEF sells for a discount of 17.6%, which is larger than its 5-year average discount of 9.9%. The portfolio consists of 203 holdings with 49% in REITs and 49% in preferred shares. The fund uses 26% leverage and has an expense ratio of 1.7%. The distribution is 8.4%, consisting primarily of income with about 40% return of capital over the past 9 months. I also included the following ETF to provide a comparison to the overall stock market. SPDR S&P 500 Trust ETF (NYSEARCA: SPY ). This ETF tracks the S&P 500 index and has an ultra-low expense ratio of 0.09%. It yields 2%. For the funds that met my criteria, I plotted the annualized rate of return in excess of the risk-free rate (called Excess Mu on the charts) versus the volatility for each fund. This data is shown in Figure 1. The risk-free rate was assumed to be zero to make comparisons easier. (click to enlarge) Figure 1. Risk versus reward over bear-bull cycle Figure 1 illustrates that REIT funds have had a large range of returns and volatilities. To better assess the relative performance of these funds, I calculated the Sharpe Ratio. The Sharpe Ratio is a metric, developed by Nobel laureate William Sharpe that measures risk-adjusted performance. It is calculated as the ratio of the excess return over the volatility. This reward-to-risk ratio (assuming that risk is measured by volatility) is a good way to compare peers to assess if higher returns are due to superior investment performance or from taking additional risk. In Figure 1, I plotted a red line that represents the Sharpe Ratio associated with RNP. If an asset is above the line, it has a higher Sharpe Ratio than RNP. Conversely, if an asset is below the line, the reward-to-risk is worse than RNP. Some interesting observations are evident from the figure. REIT performance is tightly bunched in the risk versus reward space with similar volatilities and performances. All the REITs were significantly more volatile than the S&P 500 but also delivered more total return. RNP was among the top performers illustrating that this CEF did as well or better than most ETFs. Cohen and Steers manages both RNP and ICF. RNP performed better than ICF, likely due to the use of leverage. REZ was the best performer on a risk-adjusted basis followed closely by VNQ and RWR. FRI was the least volatile ETF and ICF was the most volatile. FRI and IYR lagged in terms of risk-adjusted performance. One of the reasons often touted for owning REITs is the diversification they provide. To be “diversified,” you want to choose assets such that when some assets are down, others are up. In mathematical terms, you want to select assets that are uncorrelated (or at least not highly correlated) with each other. To assess the degree of diversification, I calculated the pair-wise correlations associated with the REIT funds. The results are provided as a correlation matrix in Figure 2. (click to enlarge) Figure 2. Correlation matrix over bear-bull cycle As is apparent from the matrix, REITs did provide a fair amount of portfolio diversification for an equity based portfolio and a CEF based portfolio . However, the REIT ETFs were generally highly correlated with one another. This is not surprising since the number of REITs is relatively small and the ETF portfolios have substantial overlap. Thus, you do not receive much diversification by purchasing more than one of the ETF funds. Next, I looked at the past 5-year period to see if the REIT performance had significantly changed. The results are shown in Figure 3. The performances were tightly bunched, but RNP and REZ were still the best performers. IYR continued to lag. You should also note that with the 2008 bear market removed from the analysis, volatilities were substantially reduced. In fact, over the past 5 years, REIT ETFs were only slightly more volatile than the S&P 500. (click to enlarge) Figure 3. Risk versus reward over past 5 years Continuing the analysis, I re-ran the analysis over the past 3 years and the results are shown in Figure 4. During this period I was able to add the following ETF to the mix. Schwab US REIT (NYSEARCA: SCHH ). This ETF has the lowest expense ratio (0.07%) of any REIT fund. The fund tracks the same index as RWR but has a much smaller expense ratio. The fund holds 95 REITs spread over the commercial (53%), specialized (27%), and residential (20%) sectors. The fund yields 3.2%. Over this period, all the REIT funds were again tightly bunched, without a large variation in either return or volatility. For the past 3 years, the ETFs slightly outperformed RNP on a risk-adjusted basis. All the REITs performed significantly poorer than SPY over the period. (click to enlarge) Figure 4. Risk versus reward over past 3 years Finally, I looked at the past 12 months (Figure 5). What a difference a couple of years made. REZ continued to be the best performer, followed by ICF, and then SCHH and RWR. RNP had similar performance to SCHH. It is interesting to note that ICH outperformed RNP, illustrating that leverage does not always increase total return. Most of the REIT funds outperformed SPY over the past year. The popular IYR fund lagged during the period. (click to enlarge) Figure 5. Risk versus reward over past 12 months Bottom Line The performance of REIT ETFs depends on the time period analyzed. During some periods, REITs outperformed SPY but lagged in other periods. RNP (the reference CEF) held it own against ETFs, usually being among the top performers on a risk-adjusted basis. In terms of ETFs, REZ was clearly the best performer in all time frames analyzed. Since REIT ETFs are highly correlated with one another, you do not receive significant diversification by purchasing more than one. If you decide to invest in this asset class, I would recommend REZ.