Dear friends,

Welcome to June and the unequivocal beginning of summer. I celebrated my 38^th set of Augustana graduates.

Those of you who attend professional sports events think you’ve experienced “the roar of the crowd.” Pfah. Until you’ve been there on the moment when a young person becomes the first member of their family, ever, to earn a college degree, you’ve heard nothing.

I also bade farewell to nine of my faculty colleagues (some of whom I had a hand in hiring, which makes me wonder why they’re going so soon?) and my college’s president, Steve Bahls, who served us for 19 years. Steve is Augustana’s eighth president in 162 years.

It’s all good, and it’s all a touch bittersweet. I’ll miss them. I always do. And I’ll celebrate them. I always do.

My son celebrated, perhaps a bit more vigorously, the successful completion of his B.A. (and the impending beginning of his graduate work in counseling psychology) by charging through a 10’ geyser of water on a 50-degree day.

I nodded.

It’s all a matter of perspective

There is much to celebrate. And there is much to complain about. The question is, which will you choose to do?

The stock market has been the source of some anxiety.

The 14% in broad market indexes so far this year certainly is unpleasant. I should imagine that the declines experienced by yesterday’s Kings (and Queens) of the World are even more so: ARK Innovation is down 53%, the Meme Team stocks – tracked by the BUZZ ETF – are down 36%, a number of cryptocurrencies have been entirely wiped out with fan faves like Doge Coin and Shiba Inu dropping 50-70%, the average company brought public via a SPAC is down 43% YTD … you know bad stuff.

On the other hand, an investor holding the boring ol’ Vanguard Total Stock Market Index Fund (VTSMX) is down a whopping 4% in the past year, and still sitting on annual gains of 13.8% over the past decade. Dan Wiener, mastermind of the Independent Adviser for Vanguard Investors, shared a beautiful bit of perspective in a March 2022 note:

Dan wrote: “Your best defense, as a long-term investor, is to try and tune out the noise …The history of the stock market is littered with reasons to sell including wars, recessions, assassinations, invasions, and yes, even a recent pandemic. Those who sold out almost certainly weren’t able to time their re-entries. Me, I’ve done some buying. What about you?”

The market’s bottom is near … unless it’s not.

The bottom might be imminent. Morningstar (5/17/2022) has become convinced that “the market is undervalued.” Optimists rejoice that we’ve already reached “maximum bearishness” and corporate insiders are buying billions in their companies’ stock. Of course, “maximum bearishness” actually means “compared to recent years, using one measure of a fallible construct.” And insiders buy for many reasons, sometimes to convince the rest of us to follow.

Or the bottom might be cataclysmically far down. One measure of the market’s valuation, the Shiller PE ratio, sits at 32 even after the carnage, not quite twice the historic average. Jeremy Grantham, founder of GMO, estimates it as 40% further down. Not to be outdone, some random hedge fund manager claims it will be 78%. Economist David Rosenberg, the optimist in this group, calls for “a crash” but only by 17% more.

The price of gasoline is worrisome to many

Gas at over $4.00 a gallon? $5.00 a gallon? Who can put up with such madness‽‽

Virtually the rest of the developed world. For the past 25 years.

Price conversions are a bit tricky since petrol is priced in pounds or Euros per litre but the broad pattern is this: petrol topped a $4 / gallon mark in the last 1990s when Bill Clinton was in office and has never dropped below it. Here’s the British price in pence per litre. Any price about 105 pc is above $4 / gallon.

As of May 22, 2022, the per-gallon price in northern Europe was pretty striking.

During Mr. Trump’s last full month in office, the US produced 11M barrels of oil. Currently, we’re producing 11.7M.

Which is to say, it’s not us. It’s not Mr. Biden. It’s not a green cabal. And it’s not unusual … except for us.

And on and on. There are a lot of problems. We’ve created some of them through our own choices, voluntarily made. “We” thought day trading NFTs from our couches was a sure road to riches. “We” thought that driving the six-thousand-pound descendant of a military transport (the progenitor of the SUV) was a good idea. “We” thought that the best way to protect our children was to be sure that as many Americans had as many firearms as possible. (The Economist, 5/28/2022, laments that, in many states, it’s easier to acquire a gun than a puppy.) And many of us thought that shouting, rather than listening, was the way to solve our shared problems.

Perhaps we were wrong.

If you need to breathe, consider gardening (the psychological health effects of which can be pretty dramatic), supporting the slowly reopening business in Ukraine or perhaps picking up a copy of The Bright Ages: A New History of Medieval Europe (2021) at your local independent bookseller. It does a nice job of helping us rethink our tendency to see, and perhaps, celebrate the darkness (in this case, of “the dark ages”) while ignoring a wealth of evidence that the average person, on the average day, had a pretty good life.

Most importantly, consider stepping away from your newsfeed. To be clear: nothing you do today erases the losses your portfolio has already incurred. Staring and making yourself sick won’t help, and will likely lead to more imprudence. If you’ve got a long-term plan, stick with it and get on with your day. If you now reflect on your long-term plan, stick with it until you’ve had the opportunity to think clearly (about asset allocation, tax loss harvesting, and options for the next phase of the market).

Riddle me this, Batman. When is “the most active stock” not a stock?

Answer: Daily.

The Wall Street Journal publishes, daily among its market tables, a list of the ten most active stocks. Two oddnesses on this list:

1. The most active stock is not a stock. On this fine day in May, it was the TQQQ ETF.

That’s a 2x leveraged bet on the NASDAQ; the fund rises 2% for every 1% the NASDAQ rises that day.

That’s not usual. Virtually every day in May, at least one ETF finished in the top three spots.

2. There are signs of a mania, or perhaps madness or panic, here.

The “most active stock” is actually a leveraged bet in favor of the NASDAQ. The third most active stock is an equally leveraged bet against the NASDAQ, the fifth and 10^th are straight bets on the S&P 500 and NASDAQ, respectively.

On several days in May, the #1 and #2 spots were occupied by the leveraged and reversed leverage NASDAQ with nearly 160 million leveraged bets being placed simultaneously in each direction.

The only way to win that game is not to play it. Either own a stock market yourself (the house always gets its cut) or invest with an eye of how a stock or asset class acts over the course of years or decades, not hours or days.

How much stock exposure should a long-term investor have?

It’s an interesting and vexing question, whose answer is always the same: “it depends.”

Several unconstrained, long-term funds at least give you a starting point for the discussion. FPA Crescent (FPACX), a ferociously independent fund that’s Gold rated at Morningstar (and my single largest personal holding) is 27% cash and 70% equity. Leuthold Core (LCORX), a rigorously quantitative allocation fund that’s also Gold rated, is 34% cash and 49% equities.  GMO Implementation (GIMFX), which used to be called GMO Benchmark-Free Allocation and will sport a $5 million minimum, is 28% cash and 58% equities.

My own portfolio remains about where I intend it to be: around half growth and half stability, half in the US and half international. In May, I made three purchases above and beyond my automatic monthly investments. In two cases, I gave $1,000 (a lot for me) to managers who have the freedom to buy stocks or to hold cash: Eric Cinnamond at Palm Valley Capital Fund (PVCFX) and Steve Romick at FPA Crescent (FPACX). I trust them to obsess so I don’t have to. The third purchase was moving money from “pure” cash to my cash surrogate, David Sherman’s RiverPark Short-Term High Yield Fund (RPHIX).

Stand, if you can, with the people of Ukraine

No one knows how the end of the Russian invasion of Europe will play out. It appears that Mr. Putin has been backed into a corner and, like any cornered creature, is lashing blindly out. The military strategy now appears centered on simple, brutal acts of annihilation: a “destroy everything, kill everyone” spasm. The US has shown remarkable leadership and most European countries have shown remarkable fortitude in opposing the invasion, supporting the Ukrainian military without escalating the war and welcoming refugees – some two million of them – into their countries.

Their need is great. Help if you can. Dan Wiener reports that a young friend has launched a line of shirts and caps to raise money for the Ukrainian people. She’s been getting some nice press in the Bay Area for her efforts. Chip launched herself at the website early; I think I might know what Father’s Day will bring.

One of the highlights of my short visit to the Morningstar Investment Conference was a quiet talk with Victoria Odinotska, a native of Ukraine and president of a really good media relations firm, Kanter Public Relations. Blessedly, Victoria’s family is now all of the country though many of her friends remain resolutely behind.

In Victoria’s judgment, two of the most compelling options for those looking to offer support is Razom for Ukraine (where “razom” translates as “together”) and United Help Ukraine, which has both humanitarian aid for civilians and a wounded warriors outreach.

Our June issue celebrates learning

In addition to my reflections above, there’s a theme of learning and growth this month.

Devesh Shah reflects on his recent journeys, both physical and mental, and on what they might offer the average investor in uncertain times

Mark Freeland writes about real estate investing and real estate funds, areas that he was not previously experienced with but which is essayed to master.

Charles Boccadoro shares his reflections on average personalization, multi-asset oysters and the pain, even now, of reliving Bill Gross’s unraveling.

And The Shadow does what The Shadow does: tracking down some of the industry’s many twists, twirls and disappearances.

I think you’ll enjoy, and hope you’ll learn.

Our July issue was seeded at Morningstar

I have a number of healthy conversations with really bright people. Those are the jumping off point for some mid-year content: an updated profile of Moerus Worldwide Value following a conversation with Michael Campagna, an updated profile of Harbor International Small Cap in light of some data Waldemar Mozes shared, and a long-overdue refresh for Matthews Asia Growth & Income which continues to do exactly what it’s supposed to do: provide really strong absolute returns in up markets (think 16-17% per year when its relative performance looks terrible) and top tier relative returns (think top 25% of the peer group) in falling ones. Met a new manager there, Siddharth Bhargava, and we’ll talk about what I might have learned!

Help out the folks at Conestoga Funds

This month we profile an interesting new fund, Conestoga Micro Cap Fund. It uses the same discipline as their very successful Small Cap Fund but applies it to smaller names in a less efficient corner of the market. The new fund is a converted hedge fund with a solid record.

If you’re an advisor, read the profile and think “huh … that’s interesting,” you would do them a favor? Call your brokerage – Fido, TD, Schwab, whoever – and ask them to add the fund to their platform? I had a nice chat with one of the Conestoga guys who I’ve known for a long while and he says the platforms tell him that they won’t act until they hear from advisors who say they want it.

And thanks!

Hope your road is a long one.
May there be many summer mornings when,
with what pleasure, what joy,
you enter harbors you’re seeing for the first time;
may you stop at Phoenician trading stations
to buy fine things,
mother of pearl and coral, amber and ebony,
sensual perfume of every kind—
as many sensual perfumes as you can;
and may you visit many Egyptian cities
to learn and go on learning from their scholars.

Keep Ithaka always in your mind.
Arriving there is what you’re destined for.
But don’t hurry the journey at all.
Better if it lasts for years,
so you’re old by the time you reach the island,
wealthy with all you’ve gained on the way,
not expecting Ithaka to make you rich.

(C.P. Cavafy, “Ithaka,” 1894, 1910 … maybe a little 1911)

I’ve been traveling a lot recently. My mind often travels, through books and arguments and streams of data; more recently, my body has gone on the road as well. I’d like to share a little of what those travels have meant, to me as a person as an investor.

Journeys of the body

I finally went to Mumbai to meet my parents after two years of pandemic-related travel disruption. The weather was still mild in late March, early April and we were lucky to travel for a few days to the holy city of Rishikesh, in northern India. The journey allowed me to fulfill a life-long desire to take a dip in the holy Ganga river. In mid-April, we went to Provence for the kids’ spring break. Finally, in mid-May, I went to Chicago to attend the Morningstar Investor Conference where I finally met in person Charles Boccadoro, David Snowball, and some very thoughtful fund managers.

Traveling is very important to me because I crave to hear first person stories of what’s going on in our world. Our planet represents billions of experiences and while it’s convenient to look for an easy narrative in the news, travel offers purely divine lessons for the curious minded. When I travel, I try and listen carefully. Whether it is the gentle flow of the Ganga or the wildly different perspectives of strangers, there is so much to learn and so many old delusions that need to get destroyed.

Journeys of the body

Hearing the flow of the waters of the Ganga near Rishikesh

At Devprayag, where two rivers, the Bhagarathi and Alaknanda merge with the underground Saraswati River, to form the Holy Ganga.

At the Pont Du Gard where a two millennium-old aqueduct crosses the river Gardon.

And in Chicago, with Charles

Journeys of the mind

I am also listening to lots of professional investors and fund managers. By watching their videos, podcasts, and reading their letters to shareholders, we get to view the market through their lenses. There is a saying on Wall Street: Nobody ever made money talking. Listen carefully. What better time than the financial turmoil of 2022 to listen carefully. Genuine internal progress is made through reading, listening, observing, and then analyzing and thinking. Finally, we must adapt the knowledge to what works for each one of us individually.

Unexpected market environments bring portfolio losses for almost everyone. We know that to be the price for being in liquid capital market assets. But for that price, we also get a silver lining. Among some benefits of a market selloff are forced humility, healthier valuations, tax loss harvesting, and a good starting point for the lightly invested folks. One more benefit is to learn from a variety of professional fund managers to see how they played this game so far and what they think is next on the horizon. It is also an opportunity to calibrate what we thought would happen to our portfolio versus what actually happened to the portfolio.

Process

I use three (paid) services to track a growing list of active fund managers: MFO Premium, Y Charts and Portfolio Visualizer. I’ve set up templates with all the funds (and some stocks) I follow. I sort the funds by year-to-date returns and pick 4 categories of funds: best absolute returns, worst returns, top benchmark outperformers, and some self-selected funds where I might have met the managers or heard about their investing prowess. I include the bottom performers because when times are tough, fund managers open up with greater willingness than usual to share their thoughts and processes.

It’s easy to be carried away and be judgmental. I find that exercise not helpful. I have invested long enough to know it’s really difficult to do it well, to be consistent, and to perform in the public eye. I try to learn when I can from those who are on the front lines of the battlefield, and if there is nothing to learn, we can move on to the next fund.

Nature of Fund Manager/CEO Letters

The qualitative part of most fund manager letters are configured in three parts: the manager’s perspective of the macro environment, portfolio construction that’s hurt or helped, and individual security analysis that the manager feels confident in sharing.

I usually focus just on the macro-outlook and portfolio construction. I avoid reading too much about individual securities because a good stock or credit analyst can pretty much convince me of anything they want to convince me of. We know the fund managers know how to analyze securities; we want to know how well they were able to use that knowledge to make money.

The first time I read a letter from a fund manager, I want to match the fund’s performance to portfolio construction. If I think the manager is good at setting up a framework and laying out a portfolio that lives by that framework, I then go back into the archives and read from 6 months, 12 months, and 24 months ago. How was the portfolio constructed at those points compared to the fund manager’s thought process? I like to know if the fund manager investment picks worked well when they called the market well. And I want to know what happened to the fund when they didn’t call the market well. I don’t believe anyone can see the future; but good investors can pick investments where the odds are in their favor, regardless of the future.

When I read a letter where the fund is struggling, I want to see if the fund manager is reducing risk or adding to positions. What are they rooting for? Are they pragmatic? If not, is it because the incentives are not set up right? For example, is a growth manager always going to tout growth stocks no matter what the season. Is that stubborn touting helpful to me as an investor? Are there growth managers who raised cash when valuations got excessive? Do they have a habit of making such wise decisions or was this one off?

Finally, many fund managers have fantastic websites with lots of information. On the opposite end, some managers have very dry websites. I think it’s very important for fund managers to communicate with current and prospective investors. Fund managers should write for themselves (and then post it online so others can benefit). Even if we investors don’t learn anything, you will become a better fund manager by writing out your thoughts and trying to present them more clearly to us.

Berkshire Hathaway’s annual shareholder letter is a great starting point for acquiring wisdom on investing and the markets. With the Annual meeting televised since the last few years, I found myself glued to CNBC watching Buffett and Munger tackle questions for a great part of the morning and afternoon on the 1^st of May. He talks a lot about companies self-selecting shareholders and has done a particularly good job in laying out his framework. I think this kind of framework showcasing is very important for active fund managers to attract the right kind of fund shareholders, and I hope more managers will be involved in this process. Without the lack of thoughtful reading from the manager’s desk, the end investor can only rely on performance chasing, which is the worst way to accumulate assets and investors.

Here are some other handpicked comments and charts from a smattering of MFO Profiled funds I have started following. The Total Returns for each fund are as of May 24^th, 2022.

The Outperformers

Invenomic Fund: (BIVIX, formerly Balter Invenomic) +49.73% YTD (commentary as of mid-May). The fund is closed to most new investors.

Our short portfolio drove performance for the fund again in April. Year-to-date through April, our short portfolio has contributed approximately 36.6% to our returns on a gross basis…. Given the sharp selloff in risk assets, our net exposure has drifted higher from the end of April to mid-May. One of the main reasons for the increase in net exposure is our shorts getting smaller as they fall toward our price targets. We are also adding new longs to the portfolio as stocks drop and hit our buy targets…. We are finding opportunities to buy attractive assets at fantastic valuations, while continuing to short, overvalued companies likely to disappoint investors, in our opinion. We expect the volatility in the market to remain elevated for the foreseeable future.

Aegis Value Fund (AVALX) +13.29% YTD (Commentary for H2 2021)

Conventional investors, intoxicated on recent returns, have been ignoring increasingly precarious financial conditions… While pundits laud these mostly mega-cap technology investments as the new safe havens, given the nose-bleedingly high valuations to which these stocks have ascended, we suspect that owning these stocks has become a massively overcrowded trade… At the Aegis Value Fund, we have worked to hitch our own wagon to equities that we believe are among the most undervalued in the market today.

(Table as of March 31, 2022)

[Ed. Note: Look at the contributions to Energy and Materials coming into the year for the fund! Genius or too risky?]

AXS Market Neutral Fund (COGMX, formerly Cognios Market Neutral): +5.63% (commentary as of March 2022)

Our conclusion is that while the stock market as a whole is expensive, there is increasingly a group of extremely expensive stocks and an oasis of very reasonably priced stocks, providing an opportunity for both long-only, value-oriented investors and those investors interested in the arbitrage opportunity between these cheap and expensive stocks in a long-short/market-neutral fashion.

RiverPark Short Term High Yield (RPHIX) +0.24%

The Fed is using higher interest rates and quantitative tightening to quell inflation. Whether they will be successful, we have no opinion….

For a manager who says we have no opinion I find it fascinating how this bond fund is UP this year given the brutal selloff in the entire fixed income universe. The Q1 2022 letter is full of details explaining investment process, portfolio construction, the SPAC redemption strategy, and the macro environment.

Funds where the going is tough right now

Riverpark Long Short Opportunity (RLSIX) -50.38% (Q1 2022 Commentary)

Although many of these companies were “COVID Winners” that helped propel strong results for the Fund in 2H20 (and remain amongst the most exciting growth businesses we own), investors have aggressively rotated away from these (and many other) high growth names in a “risk off” reaction to the current macro and geopolitical landscape.

Rather than follow the market’s so-called “de-risking” strategy, we “leaned in”… Given the impressive fundamentals throughout the long portfolio, our current long book now represents the highest revenue and earnings growth portfolio that we have owned since the fund’s inception in 2009.

Artisan Small Cap Investor (ARTSX) -34.99%

But market rotations away from growth can make this a “self-correcting problem,” leaving us with a more attractively valued portfolio (which we believe we have been able to upgrade during the rotation) that has performed well over full market cycles. We perhaps don’t say this frequently enough—it is our clients’ trust and patience that have allowed us to maintain this long-term perspective during periods of underperformance.

Seafarer Overseas Growth and Income (SIGIX) -8.24% (outperforming EM benchmark indices)

David Snowball introduced me to Andrew Foster at the Morningstar Investor Conference, and I had the opportunity to ask him many questions on EM investing. I walked away wanting to read a lot more of his writing because he said, “Our research pieces seem to be inconclusive and not prone to one word Buy or Sell recommendations.” Mr. Foster’s anti-twitter philosophy of investing clicked with me. Later, upon doing research I noticed that Seafarer had beaten the benchmarks handily because it had managed to avoid Chinese internet stocks and Russian stocks. It took me a while to go through the various articles and come across this gem of a theory the fund manager labels Control Party Analysis.

In my work, I utilize an analytical technique that I call “control party analysis” to determine which person or entity controls a company. Experience has taught me that it is problematic to assume that a large shareholder, founder, or executive board is in control of a company, regardless of public perception. Instead, I prefer to create a hypothesis as to the identity of the control party, and then use the company’s historical transaction record (i.e., financial statements, and major corporate actions and decisions) as evidence to test the hypothesis….

These facts, when taken together, suggest the government enjoys material sway over the sector. Further, the facts suggest that the government exercises control not only via ad-hoc restrictions and censorship, but also over cash flows and capital allocation. Given the government’s past record of intervention in the banking sector, this gives me pause. At best, I know that despite the public image of the Chinese internet sector, it is not made up of growth-seeking companies piloted by visionaries. At worst, I wonder whether the future of the sector will fall short of the potential that investors currently ascribe to it, and whether such inflated valuations will persist. (Commentary from Q2 2017)

The challenge for investors and fund managers

Some active fund managers are working hard to differentiate themselves from index hugging. Investors looking for alpha may be tempted to eschew indices and instead look for a growth fund here, a value fund there, or an international small cap fund somewhere. This product hunting is a mistake. When investors go product hunting, they get married into innovation, ESG, crypto, etc. Instead, spend time focusing on the manager.

When you read letters, read about how the managers thinks. If you like the way they think based on their current commentary and performance, go back into the archives, and read more.

Maybe after reading hundreds of letters, we might be lucky to find a few good managers. We hope they will be smarter than us, more tenacious, lucky in investing, skilled in their craft, and determined to invest in the markets despite the tough love markets dish to all who come to it.

There are many rivers in India but only one considered to be the holy Ganga. All rivers are important, and we need every one of them, but it takes a special kind of river to help get us to where we want to be.

Real estate investing has always been haunted by charlatans and scandals. Timeshare condominiums, swampland (ummm … critical wetlands) in Florida, bridges near Manhattan … heck, the whole reason that Greenland is called “Greenland” and not “utterly f’ing desolate wasteland covered with 1000 carnivores who scare even grizzlies land” was a real estate marketing scam.

The cold coast of Greenland is barren and bare,
No seed-time nor harvest is ever known there.
And the birds here sing sweetly in mountain and dale
But there’s no bird in Greenland to sing to the whale.

There is no habitation for a man to live there
And the king of that country is the fierce Greenland bear.

                                “Farewell to Tarwathie,” ca 1850

At the same time, Americans and their English forebears are especially passionate are owning their own little patch of ground. Fewer of us think about real estate as a part of our investment portfolios; we consign that sort of thing to the Trumps of the world. (Though the former president no longer makes The Forbes 400 List, two dozen others on the list are there by dint of their real estate holdings.)

While 60 million investors own REITs directly or through their funds, they represent a fairly small slice of the average portfolio and are still held by a minority of investors. Morningstar, which is pretty dispassionate about such things, concluded that a well-diversified portfolio would gain from a 13% allocation to real estate. That was news to me.

Normally I write about subjects I’m familiar with. This is a little different. It’s a piece about real estate funds, a sector I don’t have much experience with. But some people here have raised questions about the sector. So it seemed like a good opportunity to gain some knowledge on the subject and pass along what I find.

We’ll see how well I simultaneously read about a less familiar subject and write about it. I even throw in a little ‘rithmetic. For the most part what follows is fairly basic. It considers what it means to invest in real estate (and funds in particular), what makes the sector attractive, and how the investments work. It concludes with a list of representative funds and what makes them interesting.

Types of real estate investments

What is real estate and what does it mean to invest in real estate? Black’s Law Dictionary defines real estate as “Land and anything permanently affixed to the land, such as buildings, fences, and those things attached to buildings such as light fixtures, plumbing, and heating fixtures …” That comports pretty well with one’s common sense.

At first blush, investing in real estate suggests investing in buildings that one can operate and rent out to tenants. Apartment buildings, office space, shopping malls, lodging (hotels/motels), maybe even individual houses. More specialized or “modern” types of buildings that can be rented out include infrastructure (cell towers, etc.), data centers, self-storage facilities, and healthcare space.

Going in the opposite direction, rather than “improving” the land with specialized buildings, one could acquire and rent unimproved land to farmers. Or one could rent out land, trees, and facilities for lumber production.

The common theme is that all these types of land-associated properties are rented out by the owners/investors and generate income streams. If the property isn’t somehow associated with land, then buying it isn’t considered a real estate investment. So car rental companies don’t count.

REITs for income, REOCs for growth

Oh my!

One may invest for income, for growth (appreciation), or for both. The types of real estate investments presented above are income oriented. One owns these properties primarily for the income they generate. This is similar to investing in “equity income” funds, where one owns companies for the profits they distribute as dividends.

A Real Estate Investment Trust (REIT) is a legal structure created to invest in real estate for income. Like a mutual fund, it passes its earnings through to its owners in the form of dividends. So it doesn’t pay taxes itself. And because it doesn’t retain its earnings, it can’t easily plow those earnings back into more properties.

A different form of real estate ownership, the Real Estate Operating Company (REOC) is oriented more toward growth. It isn’t required to pass earnings through to its investors. But someone is still responsible for the taxes on those earnings. It is the REOC that pays the tax bill.

What all of this has to do with real estate mutual funds is that mutual funds are generally limited to owning securities, not land. They can invest in real estate only indirectly. So they invest in REITs, REOCs and other forms of land ownership that are considered securities.

Looking at the portfolio composition of Vanguard Real Estate Index Fund (VGSLX / VNQ) we get a good sense of just how much of the real estate market is wrapped up in REITs. The various REIT sectors in the fund add up to 95.5% of the portfolio. While it is not entirely accurate to call real estate mutual funds “REIT funds”, for all practical purposes, most are.

Reasons to invest (or not) in real estate

Returns, diversification, inflation protection, and income are often given as reasons to invest in the sector. Typical arguments against investing in real estate are that you already have a large real estate investment if you own a home and also that the sector is more volatile than equities. All of these considerations can be scrutinized. There’s some truth in them, but they are not as one-sided as they seem.

Real estate contribution to a portfolio – returns, diversification, volatility

Depending on the time frame analyzed, real estate has returned a bit more, a bit less, or about the same amount as the stock market. The graphs below show performance between 1991 and 2021. They come from Cohen and Steers, a granddaddy of real estate mutual funds. Its first fund, Realty Shares (CSRSX), started in 1991.

Over these 30 years, domestic real estate modestly outperformed stocks, while globally real estate ever so slightly underperformed stocks. Had the time frame selected been 15 years (2006 – 2021) instead, real estate would have fared worse than stocks. One can see a large real estate peak in 2006, after which it fell much more sharply than stocks. It is not unreasonable to say that real estate and stocks have performed similarly, though by following different paths, over the long term.

Real estate has been more volatile than stocks over the long term. Portfolio Visualizer reports that between 1994 and 2021, REITs had a standard deviation of 19.13%, while the standard deviation of the US stock market was significantly lower, at 15.22%. Meanwhile, the returns of each asset class were close together: 12.07% for REITs vs. 11.91% for stocks.

Despite the volatility of real estate being higher than that of stocks, adding real estate to a pure stock portfolio can reduce its volatility while increasing expected returns. This magic happens because the correlation between the two asset classes over the same time period was just 60%. Portfolio Visualizer shows the potential efficient frontier map, and reports that a roughly 75/25 stock to REIT mix would give the highest Sharpe ratio.

Such analyses can only go so far. Portfolio Visualizer reports that the optimal (maximum Sharpe ratio) blend of US stocks, US bonds, and REITS over the same period is 84% bonds, with the rest being stocks. That’s not a portfolio typically suggested for anyone including retirees.

Income and inflation protection

Real assets provide substantial inflation protection due to intrinsic value independent of money supply. Further, when it comes to land, they aren’t making more of it. So disregarding short term fluctuations, real estate should hold its value if not appreciate in real terms.

That expectation is borne out by a comparison of equity and REIT returns over the 50 years between 1972-2022.

Source: REIT.com

But wait, there’s more than just price gains. Unlike an investment such as gold, land actually generates income. You get rent from it. In this sense, real estate resembles businesses. This is why Warren Buffett grouped it together with businesses and farms as productive assets in his 2011 annual letter to Berkshire Hathaway shareholders.

That rental income results in a relatively high dividend rate for REITs and the mutual funds that invest in them. To the extent that the dividends represent rent, they are taxed as ordinary income. But there are a couple of tax quirks that reduce this impact. The 2017 Tax Cuts and Jobs Act introduced a 20% tax deduction for dividends of REITs and of funds that invest in them. That ends (sunsets) after 2025. REITs are also able to depreciate their investment property. On paper, that reduces their taxable income. So some of part of the dividends may be characterized as nontaxable return of capital.

For those looking for even more income, there’s something called a mortgage REIT (mREIT). Instead of investing in real estate, they invest in mortgage-backed securities. Since these are related to ownership of real estate, they’re still considered real estate investments. And since these are actually bond investments, usually leveraged, they tend to have even higher yields than equity REITs. These mREITs are used more often in real estate mutual funds focused specifically on income.

Source: REIT.com

Owning a home

Is a home an investment? What Cohen and Steers writes:

A house is generally considered a consumption item, not an investment. Rather than generating income, a primary residence consumes it in the form of mortgage interest, real estate taxes, insurance payments, utility expenses and the costs of repairs and maintenance. In contrast, REITS generate rental income from real estate such as commercial, industrial and multi-family residential, which is then distributed to shareholders via tax-advantaged dividends.

That’s one take. My view is aligned with the Bureau of Labor Statistics. In calculating the inflation component of housing, it deconstructs real estate into an investment component and a shelter component.

If you buy a house, rent it out for $3K/month that’s an investment. But you have to live somewhere, so you rent an identical house and pay the same $3K/month to live in it. That is equivalent to living in your own house and paying yourself that $3K rent. It sounds silly, but economically there’s no difference. Either way your cost of “consuming” shelter is $3K and your house is an investment asset that brings in rent (sort of) and should appreciate over time.

On the other hand, your house is much less liquid than a REIT or a real estate mutual fund. And you could be forced into a fire sale if your job relocates and the market is swooning. There are ways to mitigate these effects, but with costs and effort.

So, owning your home does give you some exposure to the real estate market, but it isn’t the same as a pure real estate investment. Home ownership is just another factor to consider when investing in real estate.

A few funds to consider

The funds below are mostly the usual suspects. They are accompanied by brief descriptions of why these particular funds are included here.

1. Index funds

Vanguard Real Estate Index (VGSLX / VNQ) – the elephant in the room, about nine times as large as the next largest fund (excluding TIAA, below). Broadly diversified in subsectors and in quantity (160+), middle of the pack, high trailing yield (2.9%).

State Street Real Estate Select Sector SPDR (XLRE) – broad subsector diversification while concentrated (30+ holdings), excellent performance (MFO Great Owl, Morningstar 5 star fund), high trailing yield (2.7%).

2. Actively managed funds

Cohen and Steers Realty Shares (CSJAX / CSJIX) – Cohen and Steers is the actively managed fund family elephant, running this and similar sibling funds, ETFs, and other real estate vehicles. This retail fund is still open to new investors and dates back to 1991, so it is useful as a benchmark. Because it and its siblings are actively managed, its large size and concentrated portfolio (30+ holdings) is a concern. Nevertheless, the fund and the firm have stood the test of time. The fund is currently rated 4 or 5 star by Morningstar depending on share class. Trailing yield is a respectable 1.6%-1.8%.

TIAA-CREF Real Estate Securities (TCREX / TIREX) – a pretty standard fund with low expenses (ER), fair trailing returns (1.2% – 1.4%) and a solid 5 star performance.

TIAA Real Estate Account (QREARX) – a unique investment. It is not a mutual fund, but an account that is available within some TIAA annuities. Unlike mutual funds, it owns real estate directly. In a sense it is itself a giant REIT, one that invests only in “traditional” real estate – offices, apartments, retail, etc.

This apparently gives it a distinctive performance profile. The account operates as an almost pure diversifier, with a ten-year negative correlation to the stock market. TIAA reports:

Returns are largely unaffected by movements in stock or bond markets since returns are generated by rental income and changes in property values. For the 10-year period ended September 30, 2021, REA correlation to the S&P 500 Index and Barclay’s Aggregate Bond Index was -0.03 and -0.09, respectively. Over this same period, correlation between the FTSE Nareit All Equity REIT Index and the S&P 500 Index was 0.71.

The account has returned 6-9% annually over periods between three and 30 years. While 6.58% – its annualized return since inception – doesn’t seem like much to write home about, its independence of the stock market means that it may be your sole stalwart when other assets falter. By way of illustration, it has returned 9.68% YTD as of Memorial Day, 2022. In comparison, the best YTD performance of open- end real estate funds on Morningstar’s site is -5.91%. That may explain my colleague David Snowball’s decision to devote 20% of the TIAA-CREF slice of his retirement account to the real estate account, though he warns that it suffered a bloody fate in the 2008 real estate market implosion.

Our colleague Devesh Shah released a great investing video series on real estate, with the second half of this video focused on the TIAA account. Devesh notes that it can be purchased directly from TIAA.

If you have a 403(b) with TIAA, you probably have access to this fund. If you are in the same family as someone with a TIAA 403(b) you can open an IRA with access to the same accounts including this Real Estate Account.

3. Income oriented real estate funds

Fidelity Real Estate Income (FRIFX) – a usual suspect, included as an example of a fund that may invest a substantial portion of its portfolio outside of equity REITs. It currently holds about half its assets in fixed income, largely commercial mortgage-backed securities. And yet its trailing 1.4% yield is not enough to stand out.

iShares Mortgage Real Estate Capped ETF (REM) – a pure play in mortgage REITs. Higher yield (7%) than equity oriented real estate funds, and a lower total return.

4. Fund with significant REOC and other real estate management holdings

Baron Real Estate (BREFX) – the focus is on growth, not on income. This is reflected in its trailing yield – a perfect 0%. Excellent long term growth: an MFO Owl, a Morningstar 5 star rating. A high octane fund, atypical of real estate funds.

For readers looking for the Great Owls in the bunch, here are the six funds (and two benchmarks) that earned Great Owl status from 2015-2022.

Conclusion

In limited doses, real estate funds have the potential to temper a portfolio’s volatility and generate a fair amount of dividends. The vanilla (equity REIT focused) funds are likely to best serve this purpose. Alternatives exist if one is more focused on income or if one is more interested in real estate-related growth.