Use REITs To Add Portfolio Diversification
That’s understandable, because those indexes are ubiquitous in the media. U.S. investors can be forgiven for believing that the S&P 500 and the Dow – which track large-cap domestic stocks – are the only indexes worth tracking.
It’s true that the S&P 500 represents about 80% of the investable U.S. market, so it’s worth owning, for that reason.
But it’s far from the only game in town.
In the second quarter, real estate investment trusts, as an asset class, outperformed global equity markets.
The S&P Global ex US REIT Index, which tracks 396 publicly traded equity REITs listed in developed and emerging markets, showed a net decline of 4.29% in the third quarter, net of dividends. That outpaced the S&P 500, whose total return was negative 6.44%.
But the Dow Jones US Select REIT Index boasted a total return in positive territory, ending the quarter up 3.09%.
Why is this important for investors to know?
Publicly traded REITs are not a substitute for other equity assets. However, because REITs are not always highly correlated to stocks, they offer portfolio diversification. In particular, investors may want to consider equity, rather than mortgage REITs.
Equity REITs own commercial properties directly. Their portfolios typically include shopping malls, medical centers, public storage units and office buildings.
Mortgage REITs don’t own the hard assets, but finance their ownership. For that reason, mortgage REITs should be considered debt instruments.
When discussing REITs to add diversification, I’m referring to equity REITs. Most investors understand that some kind of exposure to real estate is a good idea, but who wants that call in the middle of the night that the pipes burst?
Instead, REITs are that a truly passive investment. By law, a REIT must pay at least 90% of income to shareholders. The owners of the hard assets receive rental income, which they may increase over time. In addition, because REIT valuations are tied to real estate, whose prices move more slowly than stock prices, they tend to be less volatile.
Now, does all of this mean REITs are somehow guaranteed to top the S&P during any given time frame? Of course not. Despite the third-quarter performance of the overall asset class, the largest REIT exchange-traded fund, the Vanguard REIT Index Fund ETF (ticker: VNQ), is down 5.63% year-to-date. The S&P 500, meanwhile, is showing a decline of about 1.46 percent.
Lack of correlation is exactly the point of diversification, and the reason to add REITs to a globally allocated stock-and-bond portfolio.
It should be noted: At times, REITs have high correlations to either stocks or bonds. However, as it’s impossible to predict when REITs may show similar returns to either asset class, it’s important to hold REITs at all times. For example, in a portfolio that’s invested invested 50% in stocks and 50% in fixed income, equity REITs may represent about 3% of total holdings.
Investors run into trouble when trying to predict how any given asset class will perform. That’s as true of REITs as with any other asset.
For example, some investors believe there is forecasting value in a “worst-to-first” scenario. If an asset class is at the bottom of the pile one year, the theory goes, it should bubble up to the top in the following calendar year.
Unfortunately, things don’t always work out so neatly. In 2007, as the real-estate market and broader economy were taking a hit, U.S. REITs underperformed 11 other stock and bond asset classes. The following year, when anything that even resembled a stock was demolished, U.S. REITs skidded 39.2%, a slightly worse performance than domestic large-cap stocks.
Another illustration of the inherent difficulty of so-called “tactical” allocation (which is really just making economic bets) as it applies to REITs occurred in 2011. In 2010, U.S. REITs outpaced 11 other stock-and-bond asset classes. That was no small feat, as both equities and fixed income enjoyed good returns that year.
Investors who tried to outsmart markets by selling U.S. REITs were disappointed in 2011, as the asset class was once again a top performer, returning 9.4%.
While the benefits of diversification through publicly-traded entities is apparent, investors should realize that not all REITs are the same. Earlier, I noted the difference between equity REITs and mortgage REITs.
However, there is another important distinction when it comes to REITs: Non-traded REITs are, almost by definition, less transparent than their exchange-listed counterparts. In addition, these investments are usually illiquid. Investors are required to leave their money in place for some specified period of time, usually no less than seven years. In addition, brokers often receive a hefty commission for selling these investments, which is why they are popular with salespeople.
Source: forbes.com
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