Why most investors are under-allocated to this asset
by Gregg S. Fisher Gregg S. Fisher, CFA is Chief Investment Officer of Gerstein Fisher. He is responsible for the management and oversight of the firm’s investment process, including portfolio management, trading, research, risk control, and investment strategy development. Visit gersteinfisher.com. Reprinted with permission.
I recently wrote a column making a case for including a helping of global Real Estate Investment Trusts (REITs) in a diversified portfolio. I noted that most investors are under-allocated to this asset class, and explained why I prefer global real estate securities to US-only REITs . (For more information on the basics of REITs, read Why We Believe Your Portfolio Needs Global REITs).
REITs have been on somewhat of a roll recently. In the year from March 1, 2014 to February 28, 2015, the S&P Global REIT Index returned 17.9%, more than 10 percentage points ahead of the performance of the MSCI All Country World Index of global equities. When we look over extended market periods, REITs tend to perform similarly to equities, with similar or slightly higher levels of volatility. During the ten years from March 1, 2005 to February 28, 2014, global REITs returned 6.7% annualized, compared to 6.4% for global stocks (Sources: S&P, MSCI).
REITs as a Diversifier
Apart from the potential for attractive returns, REITs are a nice diversifying asset class in a portfolio due to their relatively low correlation with both equities and fixed income.
This makes intuitive sense when you consider how these asset classes generate returns. For instance, the bulk of REITs’ returns come from their dividends (they are required to distribute 90% of income to investors), while the lion’s share of equities’ returns are accounted for by capital appreciation. Bonds with fixed coupons tend to suffer during periods of unexpected inflation, while real estate’s rental rates and underlying property values tend to rise during inflationary periods, producing higher REIT income.
But that leaves the questions of the extent to which adding REITs to portfolios boosts risk-adjusted returns, and how much to allocate to the asset class. We recently conducted detailed research on how much the returns and volatility of three different equity/fixed income portfolios would have been impacted by adding 5%, 10% and 15% global REIT allocations to the portfolios from January 1, 1990 to December 31, 2014.
Exhibit 1, below, presents some of the findings of this study. As you will see, the addition of REITs led to improvement in risk-adjusted returns, particularly for the all equity and 80% equity/20% fixed income portfolios.
Global REIT Accessing REITs Let’s turn now to how to invest in REITs. As with equities (US and international), I favor a quantitative approach that targets investment factors (such as momentum and low leverage) that have been demonstrated by academic research to explain differences in returns.
For example, our research concluded that lower-levered REITs generated 3.1% higher 10-year cumulative rolling returns when compared to high-levered REITs during the 2000-2014 period.* Just as with equities, independent research shows that actively managed REIT funds have great difficulty outperforming indexes (perhaps due to factors such as high fees or portfolio turnover) over extended time spans.
For example, Standard & Poor’s SPIVA year-end report from 2014 shows that over both three- and five-year trailing periods, 91% of active real estate funds failed to beat their benchmarks. To learn more about investing in this important asset class, I invite you to read our recently published research paper Investment Insights: Taking a Global Approach to Investing in Public Real Estate.
A portfolio allocation to Global REITs provides additional diversification and potentially higher expected returns when combined with traditional equity and fixed income asset classes. We believe that investors can enhance their REIT returns by tilting portfolios toward certain investment factors that have been identified by academic research to explain differences in average REIT returns.
*Sources: Gerstein Fisher Research, MSCI Barra. Securities are divided into three groups each month based on market leverage ratios, with the bottom 30% representing low-leverage REITs and the top 30% representing high-leverage REITs. Portfolio returns are value-weighted. Data are potentially subject to survivorship bias associated with bankrupt companies no longer belonging to the database. This is likely to be a larger issue for higher-levered REITs.