Real estate investment trusts (REITs) and exchange-traded funds (ETFs) are commonly touted as “low-risk” investments that offer the potential to generate passive income and make your money work harder for you.
But which is a better investment, especially for those who are new to investing?
To answer that, let’s take a more detailed look at both investment types to determine which is more suitable for your overall investment portfolio.
REITs in a nutshell
What is it?
A REIT is a collective investment scheme that pools money from various investors to buy and manage real estate assets, ranging from retail, residential, office, industrial, healthcare, hotels and resorts, and more. They allow investors to invest in large-scale, income-generating real-estate without the headaches and hassles associated with the expense of property ownership.
- Liquidity: REITs provide investors with a liquid stake in real estate compared to property ownership.
- Diversification: REITs typically own multi-property portfolios with diversified tenant pools. So, compared to direct ownership in one property, owning REITs reduces the risk of relying on a single property and tenant for income.
- Income investments: REITs are considered income investments because of their high dividend yields and long-term capital appreciation.
- Tax Benefits: Individual investors enjoy a tax-exempt distribution which comes in the form of dividends in the REITs structure.
- Market risk: REITs focus on just one industry segment (real estate) and may lack diversification in the broader industry segment. REITs listed on stock exchanges are also exposed to market volatility and can tumble significantly if the market falls. This is especially true if your entire REITs portfolio is vested within one country.
- Management fees: REITs investments involve management fees, which could include sales commissions, manager fee, organisation and acquisition expenses and so forth.
- Lower returns compared to direct investments: Management fees associated with REITs investments can significantly lower your overall returns.
- Lack of control: Investors do not have direct control over properties managed by REITs, as all investment and property management decisions are made by the portfolio manager.
What to look out for when investing in REITs?
Dividend payouts offered need to be high enough to beat inflation if you’re serious about long-term capital appreciation and preservation.
You also need to look at potential growth at the management companies. For instance, are they actively acquiring and improving their assets? Lastly, do keep a lookout for companies that holds REITs from diverse industries to mitigate market risk.
ETFs in a nutshell
What is it?
Similar to mutual funds, ETFs offer investors exposure to a group of assets. However, are traded on an exchange like stocks. Because of this, ownership of ETFs can be easily bought, sold or transferred.
ETF shareholders are entitled to a proportion of the profits, such as earned interest or dividends paid, and they may get a residual value in the event that the fund is liquidated.
- Diversity: Buying a share of an ETF is similar to buying a very small piece of every asset that ETF holds (they could be shares of stock, bonds, oil futures, gold bars, foreign currency, etc.). In that, ETFs let investors diversify their portfolio, without managing a large account.
- Reduced volatility: ETFs provide exposure to an impressive range of markets, niche sectors, commodities, hedge funds and bonds, so ETF investors lower the odds that all their investments will lose at once.
- Liquidity: An ETF investor can sell his or her holdings with little difficulty and easily retrieve money from the sale.
- Lower management fees: ETFs typically have lower fees and charges than mutual funds due to their passive investment strategy nature. Expenses typically range from 0.10% to 1.25%. The average mutual fund charges around 1.3% to 1.5%.
- Market orders may be used: ETFs are traded like stocks and so they may be sold through market orders such as stop-loss orders, market or limit orders to limit potential losses.
- Trading fees: Every time you buy or sell an ETF, you pay a commission (similar to publicly traded REITs). These fees can quickly add up and reduce your investment’s performance. However, this will not be a big problem for long-term investors who are buying an ETF to hold.
- Tax liabilities: In some cases, an ETF will distribute capital gains to shareholders. This isn’t always ideal as shareholders need to pay for capital tax gains. Hence, it is usually better that the fund retains the capital gains and invests them, as distributing them can create a tax liability for the investor.
- Foreign exchange risk: You are exposed to foreign exchange risk if you buy an ETF from a market whose currency is different from your own. Some ETFs may also trade in a currency that’s different from that of the underlying assets.
- Limited growth opportunities: In some markets, investors might be limited to large-cap stocks due to a narrow group of stocks in the market index. This will limit the available exposure to mid- and small-cap companies, and leave potential growth companies out of reach for ETF investors.
What to look out for when investing in ETFs?
To determine this, you first need to identify why you are buying an ETF. Are you looking for some broad market exposure or do you want to focus on a certain industry? Are you looking to hedge a segment of your portfolio?
Also, how long do you plan to hold this ETF? ETFs can be used in both short-term and long-term investment strategies. Determining the most suitable investment strategy for you will set you on the right path of picking the most effective ETF.
Once that is clear, research your chosen ETF and all of its holdings. Even if you are looking for overall country, market or sector exposure, it doesn’t mean you shouldn’t examine the equities within an ETF.
Your overall investment portfolio
Think of REITs as a portfolio of assets in the real estate/property segment, and ETFs as a portfolio of stocks across various industry segments. Often, instead of taking a pick, new investors are recommended to include both investment types into their investment portfolio to achieve greater diversification.
The bottom line for investors looking for stable, long-term returns is to first understand the expenses and risks associated with any specific REIT or ETF that they are considering, as well as the level of income to expect and tax considerations in order to maximise investment gains.