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NEW YORK (CNNMoney.com) -
REIT funds have enjoyed a great run over the last few years. But now that interest rates are beginning to climb, is it time to pull out of REITs?
-- Craig, Chantilly, Virginia
Funny, but a year ago I was hearing from people who were: a) supremely confident that interest rates would rise; and, b) just as sure that, as a result, funds that invest in real estate investment trusts (REITs) and other real estate-related securities would be devastated.
So how did those oh-so-certain predictions work out?
Well, they got it right on interest rates, sort of. Short-term rates did climb as the Fed kept nudging the target federal funds rate.
Long-term rates, as evidenced by 10-year Treasury bonds, were a more complicated story. Their rates started up early in the year, then came back down and then rose again, so that as of early December, 10-year T-bond yields were just about where they were at the first quarter of the year.
But the big jump everyone was so sure of never materialized. Nor did the devastation in REIT fund returns. In fact, REIT fund gains are solidly in double-digit territory, ranking among the top domestic stock-fund categories for the year-to-date, according to Morningstar's figures.
That doesn't mean, of course, that REIT funds have a lock on top performance. Maybe interest rates will climb much higher over the coming year and perhaps those rising rates will spell the end of the real estate boom (another certainty people have been warning about for years) and send REIT returns plummeting back to earth.
Or maybe not. The fact is we don't know. And, based on most investors' lousy records at predicting the path of interest rates, I don't think it's a good business for individual investors to get into. Ditto for predicting which sectors are going to do well and which will get creamed.
I'm as wary as anyone that REIT funds will be able to continue their amazing run. Three-year annualized returns greater than 25 percent just aren't sustainable, in my opinion. But that doesn't mean I think REIT returns will come crashing down overnight.
Reasons to own REITs
So if you're looking for someone to sound the alarm on fleeing REIT funds, you've come to the wrong person. For me, the rationale for having some real estate funds in your portfolio isn't because they may turn out to be the hot sector for yet another year.
Rather, I see two reasons for owning them. The first is that they've shown they have the potential to deliver competitive long-term returns, and, while those returns will inevitably involve some ups and downs, I don't see any reason that their long-term prospects have fundamentally changed.
The second reason to own REIT funds is that they don't move in lock-step with the rest of the stock market. In technical terms, they have a low correlation to other equities. When stocks are going down, REITs might go up, or at least not down as much. And when stocks go up, REITs might go down, or at least not up as much.
So by adding REIT funds to your portfolio, you benefit from this sort of zig-zag effect. Your portfolio tends to be less jumpy, which means you can get the same level of returns you would without REITs with less risk, or higher returns with the same level of risk.
Don't forget to rebalance
And you don't need to own a lot of REIT funds to get this effect. Maybe 10 percent, 20 percent tops will do it. Ibbotson Associates has done a couple of studies demonstrating the diversification benefits of REITs.
So as far as REITS are concerned, my recommendation is simple. Consider investing 10 percent or so of your portfolio in REIT funds. If you're looking for specific REIT funds, you can certainly begin your search with the two that are on our MONEY 50 list of recommended funds: Cohen and Steers Realty Shares and the Vanguard REIT Index.
And once you've invested whatever share of assets you feel is appropriate, rebalance your portfolio each year to bring your REIT holdings (as well as your other positions) back to their original proportions.
If REITS have a great showing like they've had in the past few years, you'll take some profits and plow the proceeds into fund categories that are lagging. Or if REITs stumble, you'll put enough money into them to bring them back to 10 percent of your portfolio, or whatever level you started with.
By taking this approach, you'll benefit from the long-term returns and diversification that REITS have to offer. And best of all, you'll do this without having to engage in that futile (and possibly expensive) guessing game about where interest rates are headed and what REITs and other sector might do as a result.
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Walter Updegrave is a senior editor at MONEY Magazine and is the author of "We're Not in Kansas Anymore: Strategies for Retiring Rich in a Totally Changed World."
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