If you're pondering the next step in your investment journey, choosing between ETFs (exchange-traded funds) and REITs (real estate investment trusts) might be on your mind. Whether you're starting to build or looking to refine your portfolio, understanding these two popular investment vehicles is beneficial.

Both ETFs and REITs come with distinct advantages and considerations, tailored to different investment goals and risk appetites. This article will walk you through each, comparing their benefits and drawbacks. This way, you can make more informed financial decisions that align with your long-term investment strategy. Now, let’s get started.

What are ETFs?

Exchange-traded funds (ETFs) have become a staple in the portfolios of many long-term investors, including those in the Pearler community. That’s thanks to their versatility and ease of use. A basic understanding of how ETFs work can help you make more informed investment decisions as you build your portfolio.

So, what exactly is an ETF? At its core, an ETF is a type of fund that holds multiple assets like stocks, bonds, or commodities. Much like a traditional managed fund, it pools money from many investors. However, unlike managed funds, an ETF trades on a stock exchange (like the Australian Securities Exchange ), similar to individual stocks. This means you can buy and sell shares of an ETF throughout the trading day at market prices.

There are several types of ETFs available, each catering to different investor needs, including:

1. Stock ETFs: invest in a collection of stocks and aim to mirror the performance of a specific index, like the S&P/ASX 200 .
2. Bond ETFs: focus on investments in government or corporate bonds, offering a more stable income return, which can be attractive to risk-averse investors.
3. Commodity ETFs: invest directly in physical commodities, like gold or oil.
4. Sector ETFs: targeted at specific sectors of the economy, such as technology or healthcare, these ETFs allow investors to bet on sector-specific performances.
5. International ETFs: for exposure to foreign markets, these ETFs invest in stocks across global exchanges.
6. REIT ETFs: specialise in real estate investments by pooling various REITs (more on them shortly).

For long-term investors, ETFs aim to offer a solution to build and maintain a diversified portfolio with lower overhead costs and high flexibility. Their wide range of types also means that, whatever your investment goal or risk appetite, there’s likely an ETF that aligns with your needs. Whether you’re looking to invest in broad market indices, specific sectors, international opportunities, or real estate, ETFs can be worth considering for your investment portfolio.

What are real estate investment trusts?

REITs are companies that own, operate, or finance income-producing real estate across various sectors such as retail, residential, office, and industrial spaces. They seek to offer a straightforward path for long-term investors wanting exposure to the property market without the headache of direct property management.

Investing in a REIT is like buying shares in a portfolio of properties. This makes it particularly appealing if you’re keen on real estate but prefer not to deal with the hassles of being a landlord. It’s the property equivalent of collecting dividends, as REITs are required for taxation to distribute at least 90% of their taxable income to shareholders annually in the form of dividends. This regulation means that, if the REIT performs well, investors can enjoy a regular income stream.

REITs typically fall into three categories:

1. Equity REITs: these own and operate income-generating properties.
2. Mortgage REITs: they provide financing for real estate by originating or purchasing mortgages and mortgage-backed securities.
3. Hybrid REITs: a combination of the two, owning properties and holding mortgages.

Investing in REITs can be a compelling option for investors looking to diversify their investment portfolios with real estate. They aim to offer a blend of regular income through dividends and potential for capital growth. They also achieve this whilst providing the liquidity not usually associated with owning direct property . From expanding your investment horizons to seeking stable, income-generating assets, REITs can often find a home in a balanced long-term investment strategy.

What are the pros and cons of investing in ETFs vs REITs?

Understanding the pros and cons of ETFs versus REITs can help you make informed decisions. Here are some of the advantages and disadvantages of investing in both asset types:

Pros of ETFs vs REITs

ETFs

REITs

Diversification - ETFs provide exposure to a wide range of assets within a single transaction, reducing the risk associated with individual investments. Cost efficiency - lower management fees due to passive management (typically tracking an index rather than actively trying to outperform it). Flexibility - ETFs can be bought and sold like stocks during trading hours, offering flexibility and liquidity. Transparency - holdings are disclosed daily, allowing investors to see exactly which assets are included.

Regular income - REITs must distribute at least 90% of their taxable income to shareholders, which can equate to high dividend yields during periods of strong performance. Real estate exposure - provides investors with exposure to the real estate market without the need to manage properties. Potential tax benefits - special tax considerations can apply, often reducing the tax burden on earned dividends.

Cons of ETFs vs REITs

ETFs

REITs

Market risk - As they are traded throughout the day, prices can fluctuate significantly due to market volatility. Tracking errors - Some ETFs may not perfectly replicate the performance of their underlying index. Brokerage fees - Buying and selling ETFs comes with brokerage fees, which can add up, especially with frequent trading.

Sector concentration - REITs are solely focused on real estate, which can be a disadvantage during downturns in the property market. Interest rate sensitivity - REITs can be negatively impacted by rising interest rates, as this typically increases their borrowing costs and may reduce property values. Less capital appreciation - compared to stocks, REITs generally offer less opportunity for capital growth, since a large portion of earnings is paid out as dividends.

Both ETFs and REITs have distinct features that make them appealing to different types of investors. ETFs are particularly valued for their diversification and flexibility, allowing investors to spread risk across various sectors and asset types easily. They tend to suit investors who value the ability to quickly adjust their portfolio in response to market changes. However, the variability in daily trading can introduce a higher level of market risk. As a result, many long-term investors aim to hold their ETFs for several years or more, and eschew short-term trading.

On the other hand, REITs offer an easier way to enter the real estate market. They come with the potential benefit of regular income through dividends, which can be particularly attractive in stable or rising markets. REITs can work well for investors looking for regular income streams and want to own real estate without the direct challenges of property management. However, their focus on a single sector means their performance is closely tied to the health of the property market. This can be less appealing during economic downturns or periods of high interest rates.

As with all investments, both ETFs and REITs also bear performance risks.

Choosing between ETFs and REITs will largely depend on your individual investment goals, risk tolerance , and the economic environment. Each offers unique advantages and considerations, making them valuable components of a diversified investment portfolio.

Building long-term wealth with ETFs vs REITs

Investing in ETFs and REITs can pave distinct paths to achieving long-term financial goals. Let’s explore how two fictional investors, Emma and Luke, have used these vehicles to build their wealth over time.

Case Study 1: Emma’s diverse portfolio with ETFs

Emma, a 35-year-old marketing executive, has always prioritised financial security and the potential for growth in her investments. She started investing in ETFs to take advantage of their broad market access and diversification. Emma chose a mix of stock ETFs that track major global indices, and bond ETFs for stable income. She also chose sector-specific ETFs to capitalise on growth in the tech and healthcare sectors.

Over the years, despite bear market periods, her ETF investments have benefited from the overall growth of the markets they track. The liquidity of ETFs has allowed her to adjust her holdings as her financial goals and market conditions have changed. These adjustments help Emma keep her portfolio aligned with her long-term objectives. Emma’s strategy has not only spread her risk but has also seen her investments grow steadily, helping her build a robust nest egg for retirement.

Case Study 2: Luke’s income-generating strategy with REITs

Luke, a 45-year-old consultant, chose REITs for their potential to generate consistent income while still offering possible capital appreciation. He invested in a diverse mix of equity REITs that own properties in the healthcare, retail, and residential housing sectors. These REITs distribute most of their taxable income as dividends, giving Luke a reliable income stream.

By choosing individual REITs with a history of stable or increasing dividends, Luke has secured a steady flow of income that complements his consulting earnings. This strategy has not only provided him with financial comfort but also allowed him to reinvest some of the dividends to grow his portfolio further. The focus on properties in stable or growing sectors minimised his exposure to downturns in any single real estate market. However, as he has only invested in REITs, he may be exposed to potential concentration risk. This means that, by only investing in real estate, his portfolio isn't diversified across other industries and sectors, which may expose his portfolio to more risk and volatility.

Different paths for long-term investing

Emma and Luke’s strategies highlight the flexibility and diverse approaches available through ETFs and REITs. Emma’s use of ETFs for growth and adaptability fits her dynamic career and financial goals. Meanwhile, Luke leverages REITs for steady income and potential property value appreciation, aligning with his need for financial stability and growth. Both approaches can be effective ways to build and sustain long-term wealth, each tailored to personal financial circumstances and life stages. Whether targeting growth, income, or a mixture, ETFs and REITs provide strong platforms for reaching Financial Independence.

NOTE: in these fictional examples, Emma and Luke's investments performed well. However, there are no guarantees in the world of investing, and all investments carry risk. Before you invest your hard-earned money, ensure you're familiar with the risks involved, and speak to a financial adviser if in doubt.

Best of both words – REIT ETFs

What if you like the sound of both ETFs and REITs? The two aren’t mutually exclusive, so you can also choose to invest in both. Alternatively, you can consider what’s called REIT ETFs (real estate investment trust exchange-traded funds). As the name suggests, REIT ETFs are funds that mainly invest in REITs. By investing in a REIT ETF, you buy shares in a fund that holds a portfolio of different REITs.

Some benefits of investing in REIT ETFs versus individual ETFs or REITs may include:

• Diversification within real estate: REIT ETFs provide diversification within the real estate sector itself. Instead of investing in one type of property or a single REIT, you get exposure to a variety of REITs. This can include commercial, residential, healthcare, and retail properties. This spreads the risk across different types of real estate.
• Simplicity and ease: investing in a REIT ETF can simplify the process of diversifying your real estate holdings. Instead of researching and selecting multiple REITs to invest in, you can achieve this with a single transaction.
• Liquidity: like all ETFs, REIT ETFs are traded on stock exchanges, which means they can be bought and sold throughout the trading day. This provides liquidity, allowing you to easily adjust your investment as needed.
• Cost-effectiveness: REIT ETFs typically have lower fees compared to buying several individual REITs because they are passively managed.
• Dividend income: like individual REITs, REIT ETFs sometimes offer attractive dividend yields because the underlying REITs are required to distribute at least 90% of their taxable income to shareholders as dividends. However, these dividend yields are not guaranteed, and are contingent on performance.

REIT ETFs aim to combine the benefits of ETFs (like liquidity and cost-effectiveness) with the real estate exposure and high dividend potential of REITs. With this in mind, they usually attract investors looking to enhance their exposure to the property market while maintaining the ease and flexibility of ETF investing.

ETFs or REITs – choosing the right investment for you

When selecting between ETFs and REITs, carefully consider your personal situation and reason for investing. Here are a few factors to think about before you make a choice.

Firstly, identify your primary financial objectives. Are you seeking regular income, aiming for capital growth, or perhaps a balance of both? Your goals can significantly influence your choice between ETFs and REITs. For example, if consistent income is a priority, especially in retirement, REITs may be more attractive because of their dividend payouts. But if you're looking for broad market exposure and long-term growth, ETFs might be better suited to your needs. In both cases, though, neither outcome is guaranteed, so ensure you're comfortable with the risk involved first.

Additionally, consider your investment horizon. How long you plan to invest can impact your risk tolerance. Long-term investors might be more comfortable with the short-term fluctuations associated with ETFs, given their potential for higher returns over time. In contrast, if you're nearing retirement, you might prefer the relative stability and regular dividends offered by REITs.

Diversification is key to managing risk in your investment portfolio. ETFs inherently provide diversification across various assets, which can protect against significant losses if one sector underperforms. Including ETFs in your portfolio can help balance risk, especially if you're heavily invested in specific sectors or asset classes. REITs, though more focused on real estate, can supplement an investment portfolio and contribute to its diversification. This is especially true if your existing investments are mainly focused in stocks or bonds. Adding individual REITs can also obviously provide exposure to real estate, which often moves differently than other markets. This can balance your portfolio's performance through different economic cycles. However, it's worth noting that only holding REITs in your portfolio would only expose you to one sector – property – which would in turn increase your risk . In which case, it may be worth diversifying across other asset classes and industries.

Choosing the right type of investment – ETFs, REITs, both, or neither – depends on your financial goals, and how long you plan to invest. It's also crucial to consider how these investments fit within your broader financial strategy. Evaluate each option in the context of your personal circumstances and consider how they could help achieve your goals. Speaking with a financial adviser can also provide personalised insights and help fine-tune your decision.

There’s no right or wrong investment, only what’s right for you.

Happy investing!