Active vs. passive in listed real estate

The active versus passive debate continues to be alive and kicking in many asset classes. Deciding whether to use an active or passive vehicle for the different allocations within an investment portfolio is an important decision that investors need to make at the end of the day.

It can have a significant impact on a portfolio’s risk/return profile and on the long-term investment outcomes that an investor receives from an absolute and relative standpoint. While this issue has been covered across many asset classes, this article will explore the topic specifically for listed real estate funds, both Australian, or AREITs, and global, or GREITs, focused strategies.

Key takeaways

• The average total return of active AREIT and GREIT strategies has been less than passive strategies over the last decade, but it's not all bad news for active strategies.
• A considerable number of AREIT managers have been able to outperform the average total return of passive strategies over the long term, while most GREIT managers have struggled.
• See Exhibits 5 and 6 for a list of top-performing active and passive AREIT and GREIT strategies that have a Morningstar Medalist Rating of Bronze or above, as well as Morningstar's view on analyst-covered strategies.
• Whether or not an investor opts to use an active or passive listed real estate strategy in their portfolio, Morningstar's research can assist with the investment-selection process.

What does empirical data tell investors about active and passive REIT performance?

Exhibit 1 below is a snapshot from Morningstar's Active Passive Barometer. It shows that the average total return of both active AREIT and GREIT managers was less than passive strategies on a trailing 10-year time frame to June 2023.

Many active managers across both categories failed to outperform the average total return of passive strategies over the same period, with survivorship and merged funds considered. It's important to note that the sample size of both categories is relatively small: AREITs had 27 active and seven passive strategies, while GREITs had 16 active and five passive strategies.

On the surface, the average underperformance of active strategies relative to passive strategies in both categories is a disappointing result for investors. Particularly given that they are paying active management fees and expect some level of outperformance over a reference index or passive strategy that aims to track a benchmark in the long term. But as we delve deeper into these simple average figures, we see that it's not all bad news.

Looking beyond the simple average

Exhibit 2 below shows the number and percent of active strategies that have outperformed the average total return of passive strategies in their respective category over the last decade to June 2023.

It was a respectable result in the AREIT category, with 12 out of 27 (around 44%) active strategies delivering a positive excess return relative to the average total return of passive strategies.

Excess return is simply calculated by subtracting the total return of an active strategy from the cumulative average total return of passive strategies in a category over a specified time frame. On an annualized basis, the top-performing active AREIT strategy returned 8.8% and the lowest returned 4.6%, while the best-performing passive strategy returned 7.7% and the worst returned 6.4%, as shown in Exhibit 3.

Despite the wide range between the upper and lower bands in the category, the variability in returns was relatively low. Passive strategies in the category track the highly concentrated S&P/ASX 300 or 200 AREIT indexes.

A reminder that Morningstar has written about the concentration risk associated with these indexes in the past, which remains true at the time of writing. Many active AREIT managers address this risk and the limited opportunity set by allowing a portion of their portfolio to be invested in offshore, nonindex and/or smaller domestic stocks.

On the other hand, a disappointing four out of 16 (25%) active GREIT strategies only managed to beat the average total return of passive strategies. The diversity of real estate subsectors within the index has proven to be a challenge for most active managers to beat, despite U.S. domiciled REITs and stocks accounting for more than half of the FTSE EPRA Nareit Developed Index over the last decade.

On an annualized basis, the best-performing active strategy returned 7.3% and the lowest returned 3.2%, while the best-performing passive strategy returned 6.7% and the worst returned 2.7%. The variability in returns was also fairly low in the GREIT category, as seen in Exhibit 4, although the difference between the upper and lower bands was wider compared with the AREIT category.

One factor driving this and a critical point to note, is that the category consists of currency-hedged, unhedged, active, and passive vehicles because of the small number of available GREIT strategies. Foreign currency performance relative to the Australian dollar, but mainly the United States dollar, has had a sizable impact on performance over the 10-year time frame to June 2023, with the AUD depreciating relative to the USD over this period.

It's also crucial to point out that not all passive GREIT strategies in the category track the FTSE EPRA Nareit Developed Hedged AUD Index, which is the benchmark assigned as the Morningstar Category Index. There are several passive strategies that track an iteration of the core index, the FTSE EPRA/NAREIT Developed ex Australia Rental Index.

Having said all that, it's vital for investors to be aware of the inherent risks in the real estate sector, such as interest-rate risk and susceptibility to broader economic activities, to name a few.

It's also paramount to be mindful that passive strategies are generally not designed to offer downside protection when the relevant sector and/or broader markets are falling. In that type of environment, active strategies may be better designed to protect capital, like some skilled active managers demonstrated during the sector (and market) drawdowns of 2020 and 2022.

Notwithstanding the highlighted underperformance of most active strategies across both categories, Morningstar understands that some investors may still have a preference to use an active strategy over a passive one for their portfolio's listed real estate allocation. Whether or not an investor opts to use an active or passive real estate strategy in their portfolio, Morningstar's research can assist with the investment-selection process.

Morningstar's top-performing analyst-rated strategies

Exhibit 5 below lists the top-three-performing active and passive AREIT strategies over the last decade to June 2023 that have a Morningstar Medalist Rating of Bronze or above, as well as Morningstar's view on fully analyst-covered strategies.

Resolution Capital Real Assets topped the active list and receives a Morningstar Medalist Rating of Gold. Its People and Parent Pillars are assigned by analysts and the Process Pillar is algorithmically assigned. The strategy gives investors access to a professionally managed portfolio of AREITs and can invest up to 20% of assets in global real estate and infrastructure securities listed on international stock exchanges.

Ironbark Paladin Property Securities secured second place and is fully analyst rated by Morningstar, with a Morningstar Medalist Rating of Silver. This is a strong domestic listed real estate offering thanks to its stable and impressive investment team, combined with its differentiated approach. Portfolio manager Chris Robinson, co-portfolio manager Todd McFarlane, and small-caps specialist Eloise Blake have delivered a strong track record by employing a consistent approach since the investment process was enhanced in 2013. Each member’s skill set plays well to the process that seeks to generate alpha from three distinct sources: stock selection in large-cap AREITs, active investment in small-cap AREITs, and selective participation in international deal flow. Importantly, the team exhibits a competitive edge in each area of focus, maintaining an advantage over peers. In the large-cap space, the team analyzes relative valuations and quality characteristics within each subsector, minimizing factor and style bets while maximizing the returns from superior stock selection. With Robinson doubling as head of listed real estate securities Asia-Pacific, the team leverages its position within global asset manager DWS to take advantage of opportunistic deal flow (usually placements and IPOs) across the globe. The total weight of international holdings isn’t expected to exceed 3%-5% at any point in time. Blake’s focus on small-caps ensures that the team is ready to capitalize on opportunities in emerging, less-efficient, and under-researched areas of the market.

Pendal Property Investment ranked third and is fully analyst rated by Morningstar, with a Morningstar Medalist Rating of Silver. Its seasoned portfolio management duo and practical, valuation-focused approach makes it an impressive offering. The strategy is helmed by Pete Davidson and Julia Forrest, who boast more than 30 years each in the investment industry 

with broad experience over numerous economic cycles. The duo has consistently applied the diligent and repeatable process rooted in fundamental bottom-up analysis. The portfolio managers use a variety of valuation techniques depending on the company and the point in the economic cycle. A sharp focus on continuous engagement with corporates and property inspections is another strength of the process. The strategy's benchmark-aware nature doesn't allow it to stray too far from its index, which at times can result in low active share. While the portfolio typically holds 15-30 names and resembles its benchmark, it can opportunistically hold overseas listed property investments, nonindex names, unlisted property, and infrastructure stocks.

In the passive space, the top three strategies from highest to lowest were Silver-rated Macquarie True Index Listed Property, Gold-rated Vanguard Australian Property Securities, and Silver-rated SPDR S&P/ASX 200 Listed Property.

Exhibit 6 below shows the top-performing active hedged, active unhedged, and passive GREIT strategies over the last decade to June 2023 that have a Morningstar Medalist Rating of Bronze or above, as well as Morningstar's view on fully analyst-covered strategies. There were only two unhedged strategies because of the criteria and size of the category. It's also worth reiterating that the global real estate category contains currency-hedged and unhedged vehicles, and not all passive strategies in the category track the AUD-hedged version of the FTSE EPRA Nareit Developed Index (the Morningstar Category Index).

Starting with hedged vehicles, Resolution Capital Global Property Securities' hedged vehicle took first position and is fully analyst rated by Morningstar, with a Morningstar Medalist Rating of Gold. Highly experienced and perceptive portfolio managers combine with a sturdy investment process to receive our highest conviction. Resolution utilizes a multi-portfolio-manager approach to mitigate key-person risk and provide rigorous diversity of opinion on stock selection and portfolio construction. The four portfolio managers are CIO Andrew Parsons, Marco Colantonio, Robert Promisel, and Julian Campbell-Wood. The team uses detailed fundamental analysis combined with a top-down overlay, reflecting the dynamics of various real estate markets, to search for investable property companies and trusts that operate in high-barrier-to-entry markets where landlords have pricing power and there is a high level of recurring earnings, low debt, and strong stewardship.

UBS CBRE Global Property Securities placed second and is fully analyst rated by Morningstar, with a Morningstar Medalist Rating of Silver. It is a solid option for global real estate exposure because of its resourced team and proven process. The fund is subadvised by CBRE Investment Management, which has an experienced team of investment professionals who analyze global listed real estate. More than a dozen people work on this fund: three portfolio managers (averaging more than 20 years with the firm), plus a roster of analysts who are based around the world. Thorough bottom-up fundamental analysis of global REITs is at the core of the fund’s process, but CBRE also incorporates top-down elements more explicitly than many of its peers do.

Principal Global Property Securities ranked third and is fully analyst rated by Morningstar, with a Morningstar Medalist Rating of Bronze. It is run by a seasoned, capable team using astrategy that has been effective over the long term. The team behind this strategy is one of its biggest strengths. Portfolio managers Kelly Rush and Simon Hedger have managed the fund since its 2007 inception; each has more than 30 years of industry experience. The other manager, Anthony Kenkel, has been on the fund since 2010. They're supported by four local portfolio managers and eight global REIT analysts located around the world. Principal's real estate investment arm as a whole is one of the largest in the industry, with plenty of resources. The team tries to identify opportunities where its expectations differ from the market's consensus and to generate excess returns through a lot of small bets rather than a few big ones. Most ideas come through bottom-up research by the analysts, who present them to their regional teams for discussion and debate. Analysts develop valuation models that take into account the present value of the assets a company holds as well as the future value-creation potential of those assets. The managers generally prefer stocks that are trading at a discount to the present value of their assets, but what they ultimately look for are cases in which the gap between a stock's current price and its NAV has changed in a way that's not justified by the fundamentals, and for which a "recognition catalyst" (something that's likely to boost the stock price) is in place.

From an unhedged perspective, Resolution Capital Global Property Securities' unhedged vehicle claimed the top spot and is fully analyst rated by Morningstar, with a Morningstar Medalist Rating of Gold as highlighted above.

From an unhedged perspective, Dimensional Global Real Estate occupied second place and is fully analyst rated by Morningstar, with a Morningstar Medalist Rating of Bronze. It is a distinctive systematic strategy that blends international real estate exposure with AREITs. To a large extent, the strategy is managed as a two-sleeve portfolio—one for the global REITs (ex-Aus) and a separate one for the domestic Australian investments. As a result, in combination with the market-cap-weighting methodology, the fund has an indexlike quality. However, the active nature of the portfolio comes through in the distinct investment universe. DFA includes certain REIT types in its portfolio, which are not yet recognized by the reference indexes, such as cell tower REITs. In general, the portfolio is more diversified than the average category peer. This reduces turnover and adds to trading efficiency. DFA is known for its expertise in trading, which relies on an in-house trading team and flexible trading policies. Its low fee competes with the traditional passive products while providing the benefits of active management.

In terms of passive strategies, Macquarie True Index Global Real Estate Securities' unhedged vehicle achieved top position. The strategy receives a Morningstar Medalist Rating of Bronze. Its Parent and People Pillar ratings are analyst-assigned, and its People Pillar is algorithmically assigned. It is also available in a currency-hedged version. Vanguard International Property Securities Index's unhedged and hedged vehicles ranked second and third, respectively. The strategy is fully analyst rated by Morningstar, and both vehicles have a Morningstar Medalist Rating of Bronze. It is a compelling option because of its well-established indexing capabilities, low cost, and sensibly diversified portfolio. However, the strategy tracks the FTSE EPRA/NAREIT Developed ex Australia Rental Index rather than the FTSE EPRA Nareit Developed Hedged AUD Index.

The bottom line

Historical data based on simple average returns indicates that passive strategies have outperformed active strategies in both the AREIT and GREIT categories in the long term. At face value, this makes somewhat of a compelling case for passive strategies over active strategies within an investor's portfolio allocation to listed real estate. Regardless of this, Morningstar's Manager Research believes that certain active strategies, including the ones highlighted above, have the potential to outperform their passive counterparts. However, the allocation decision to use an active or passive strategy ultimately sits with the end investor. Given the complexity involved with this matter, investors should seek professional financial advice for assistance if required.