By Todd Canter, Keith Pauley, and William Morrill
Illustration by Susan LeVan
Over one year ago, we published a report that quantified the diversification benefits of REITs and demonstrated the meaningful role that REITs played in a mixed-asset portfolio. Using historical total return data, we found that an optimal mixed-asset portfolio would have included REITs at nearly every point along the risk/return spectrum.
Our study further illustrated the high negative correlation between REITs and several sectors, including technology stocks (-0.51) and communication services (-0.48), over a six-year time horizon. The study demonstrated that a portfolio consisting of 50 percent REITs and 50 percent technology stocks would have delivered a higher risk-adjusted return than a portfolio of technology stocks alone. We concluded our study by suggesting that large-cap portfolios should consider investing in REITs as a hedge against risk.
When Techs Wrecked
So how did our study withstand the test of time over the past 12 months? Quite predictably, as technology stocks began to fall, REITs began to rise. Year-to-date, as of September 21, 2000, the tech-heavy Nasdaq was off 5.8 percent vs. an increase of 14.7 percent for REITs. Communication services, the other sector with a large negative correlation to REITs, was off 29.7 percent year-to-date through September 21.
| Incremental Benefits from REITs: 1993 to 1999 | |||||
|---|---|---|---|---|---|
| Annual Return | 10% | 20% | 30% | ||
| Risk Level With REITs | 2.63% | 5.98% | 11.32% | ||
| Risk Level Without REITs | 2.70% | 6.20% | 12.43% | ||
| Basis Point Difference | 7 | 22 | 111 | ||
Expanding last year’s study to include seven years of total return data, we find that REITs continue to play a meaningful role in the composition of an optimal portfolio (i.e., the portfolio with the best risk-adjusted returns). As the table on this page illustrates, REITs would have been included at nearly every point along the risk/return spectrum, the same conclusion drawn in last year’s study.
However, upon closer examination of the data, at intermediate levels of risk, REITs comprised an even larger position in the portfolio (approximately 10 percent) than in our previous study (at 8 percent). At higher levels of risk and return, REITs would have received a 35 percent allocation, up from 28 percent in our previous study.
So how much of a diversification benefit did REITs contribute to the mixed-asset portfolio? To quantify the diversification power of REITs, we created two portfolios, one with REITs and one without REITs, and measured the difference in risk between the two.
At higher levels of risk and return, REITs reduced overall portfolio risk by as much as 111 basis points. Like the results uncovered in last year’s study, REITs continued to play the diversifying role better than any other sector or asset class during the time horizon studied. From these results, one would expect the diversifying benefits of REITs to be more pronounced in time periods of more normal returns on technology stocks, given that low to negative correlations persist.
Bottom Line
Over one year ago, we demonstrated a negative correlation between REITs and certain large-cap growth sectors, such as technology and communication services. Using a six-year time horizon we quantified the risk-reducing power of REITs in a mixed-asset portfolio and concluded that large-cap growth funds should consider including REITs as a hedge against risk.
Over one year later, REITs continue to play a powerful role as a portfolio diversifier. This is demonstrated by REITs’ high negative correlation to several large-cap stock sectors. Assuming more modest returns from tech stocks and, in turn, more favorable relative returns from real estate securities, the prospective impact from diversification in the future should be dramatically enhanced.