An increasingly popular movement across the investing world is to shun active investing in favor of passive investing. It is the practice of putting your fund into a broadly diversified ETF that tracks a particular market index.

It is called passive investing as opposed to active investing because there is no decision making or trading being done to reconfigure the portfolio other than to continue mirroring its target index as accurately as possible.

The reason that an increasing number of investors choose this approach is because:

Because of the combination of these three qualities, ETFs are widely perceived as generating comparable, if not superior, risk-adjusted returns relative to active investing strategies despite requiring much less time, effort, and expertise.

I am myself a big proponent of passive investing for most market sectors, including large cap stocks. However, when it comes to REITs, I believe that this movement is grossly mistaken. This is one of the only sectors where I believe that active investors are well-rewarded in the long run.

Below we explain why we favor active strategies vs. passive strategies for REIT investments.

Almost all REIT ETFs are market cap-weighted, meaning that they create an inordinate amount of blind demand for large-cap REITs. In other words, large REIT ETFs such as VNQ, which has over $60 billion in assets under management, buy enormous positions in large-cap REITs regardless of how well the current price correlates to underlying performance. This has the obvious effect of creating a price premium in large cap REITs relative to small-cap REITs.

Today, this has reached a rather extreme point, with small-cap REITs valued at a ~40% discount to larger peers without regard to actual underlying fundamentals.

As a result of this clear disconnect within the sector, long-term active investors are given a great opportunity to outperform their passive peers given the principle that, in the long run, the market is a weighing machine (according to Benjamin Graham, anyway).

ETFs are almost always cheaper than investing in mutual fund counterparts. There are several REIT ETFs that have very low annual expense ratios (0.5% or lower).

However, owning individual publicly-traded REITs is even cheaper than investing in REIT ETFs. After the initial purchase is made, individual REITs will always have an expense ratio of 0.00%. There is no cost to hold a REIT, regardless of the holding period.

Even small fees add up in the long run and can lead to large disparities in total performance.

You cannot hand-select which REITs you own with a REIT ETF. REIT ETFs give you no control over your portfolio. You cannot buy or sell individual REITs, which means you cannot sift the wheat from the chaff in your portfolio. By purchasing REIT index ETFs, you are forced to own the junk along with the jewels in the sector:

I could go on and on. The point is that there are a lot of REITs that are not worth owning. Some are overleveraged. Others own highly risky properties. And some are so conflicted that you wouldnt want to entrust your capital with them.

With ETFs, you have no option. You will own all REITs including those that are poised for more disappointing results in the long run.

Because REIT ETFs (VNQ; IYR) invest heavily in overpriced large cap REITs, they will typically pay out a very small 3 to 4% dividend yield. For a real estate investment, this is not acceptable for us.

Real estate is supposed to provide high and consistent income within a portfolio. ETFs fail to achieve this goal by investing its capital in richly-valued low-yielding REITs.

Even putting total returns aside, many investors would rather target a higher - yet sustainable - dividend yield for meeting passive income needs.

Before we move on to present our market-beating approach, we want to make it clear that it's not suitable for everyone. We have access to superior resources, do this full time and have access to management teams because we represent more than 1000 REIT investors at High Yield Landlord.

Now that this disclosure is out of the way, this is what we do to target better investment results:

Back in May 2017, Spirit Realty Capital (SRC) traded at an estimated ~30% discount to NAV and a nearly 10% dividend yield. In hindsight, this was a fantastic opportunity for active REIT investors:

It's not a widely followed large cap. It owns alpha-rich specialty assets. It traded at a hefty discount to NAV despite strong qualities.

Since presenting our thesis on Seeking Alpha, SRC has returned 77% in just two years - close to 4x more than the VNQ ETF.

It is by targeting this type of situations that we aim to outperform the VNQ ETF. SRC was our largest position then and remains a sizable holding to this day.

Our Core Portfolio currently has a 7.75% dividend yield with a comparable 69% payout ratio despite a yield that's almost double the index. Beyond the dividends, the core holdings are trading substantially below intrinsic value at just 9.5x FFO - providing both margin of safety and capital appreciation potential (REITs trade on average at over 18x FFO).

In this sense, our alpha is expected to come from many different angles (higher yield, deeper value, better sectorial composition, strong managements, etc).

Note that other active REIT investors have been implementing similar strategies for decades with great success. The annual outperformance after fees has been 100-200 basis points per year on average, with the best investors reaching up to 22% per year compared to "just" ~10% for indexes:

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But most importantly to us, we generate high income while we wait. It gives us the feeling of being a "Landlord" collecting rent checks, rather than a stock market trader who speculates on appreciation. ETFs and their low yields do not satisfy the needs of retirees and other income-driven investors.

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Disclosure: I am/we are long SRC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Read more here:
Why I Won't Invest In REIT ETFs - Seeking Alpha