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Moringstar’s Samuel Lee warns “that REITs' diversification powers are down and so are their expected returns.” Maybe, but it’s premature to dismiss the asset class, particularly as part of a broadly diversified asset allocation plan. Nothing is static in the financial markets and so today’s profile of risk and return is sure to change.

The challenge with REITs is the simple fact that these securities — a liquid proxy for tapping real estate — have had a strong run. Lee sums up this stellar history and considers the investment implications going forward:

A common argument for REITs is a simple appeal to long-run historical returns. From the beginning of 1972, when the FTSE NAREIT US Equity REIT Index data begin, to the end of August 2013, REITs returned 11.9% annualized. U.S. stocks returned about 10.3% annualized over the same period. REITs earned high returns because their yields were high. It bears repeating that almost all of the real return REITs have produced can be attributed to dividends. Price appreciation only kept up with inflation. Something about REITs changed in the early 2000s. My theory is that for most of their existence REITs were a small, illiquid asset class, neglected by the mainstream and known largely to a small set of venturesome investors. The asset class gained mainstream acceptance as the real estate bubble inflated. Even though the bubble eventually popped, REITs were established as a major asset class, easily accessible, and now ensconced in the big, conventional market indexes like the S&P 500. The abundant accessibility and liquidity surrounding REITs seem to have permanently altered their risk-return characteristics.

A simple way to test this is to see how REIT's comovement to the market has changed over time. I calculated a rolling three-year market beta, controlling for REITs' exposure to size, value, momentum, and interest-rate risks, to better isolate pure market exposure. The change is striking: REITs went from an average market beta of 0.5 to over 1 in the early 2000s and have stayed there since. Over this period, REITs went from small-cap, deep-value stocks to larger-cap, growthier stocks.

But let’s review some basic numbers for another perspective. It’s no surprise that REITs have had a rough time lately. The shares, after all, are interest-rate sensitive investments. Accordingly, recent history hasn't been particularly supportive for REITs, thanks to the beginning of the end of the Federal Reserve’s bond-buying program -- a change in the monetary weather that has pushed interest rates up recently, albeit gently so far. The benchmark 10-year Treasury yield has climbed to around 3%, up from 1.7% last spring. The headwind with rates has weighed on REITs, with the MSCI REIT Index advancing a sluggish 2.5% in 2013, or far below the nearly 34% total return for stocks (Russell 3000).

But disappointing performance is the foundation for better days ahead when it comes to asset classes. At some point down the road, REIT yields will be higher and the prospective outlook for the securities will look brighter. Lee’s cautious outlook for the sector shouldn’t be dismissed, but let’s not throw the baby out with the bathwater by thinking that today's analysis is written in stone.

The same applies for correlations. Consider the history of rolling three-year return correlations for REITs and US stocks (S&P 500), based on one-year returns via average monthly prices. As you can see in the chart below, the high correlation period between REITs and stocks of recent years has fallen sharply over the past year. This is a byproduct of the performance divergence between the two asset classes of late. But unless you think that stocks are REITs are now destined to move in lockstep from now on, the diversification potential for the two asset classes is still intriguing.

(click to enlarge)

True, it’s tempting to write off REITs in favor of stocks given last year's performance history. But the outsized gains for equities won’t last forever — ditto for the comparatively depressed returns for REITs. Risk and return are forever changing for each asset class, and not necessarily on an identical time schedule, as 2013's performance record reminds.

The bigger problem is that correlations generally, across all asset classes, are likely to rise in the years ahead. The danger for investors, as William Bernstein explains in his recent e-book, is that we’re all “Skating Where the Puck Was.” Ours is a world where tapping into a broad set of formerly obscure asset classes and trading strategies is now easy and inexpensive (think ETFs). The average investor can build and manage multi-asset class portfolios to a degree that was once the exclusive province of institutions. As a result, the low-hanging fruit of low correlations has probably been picked.

The bottom line: risk premiums will be lower, in part because correlations will be higher. As such, you’ll have to work harder (and smarter) to keep portfolio returns from sliding at a given risk level. That’s hardly a reason to abandon asset allocation -- doing so may end up making your job that much harder. But it’s a reminder that we’ll have to do better job in managing the mix. Rebalancing, in other words, is destined to become even more important as a factor in the investment solution in the years ahead. Most investors will still need a wide spectrum of asset classes to achieve respectable results, but it's not going to get any easier to turn water into wine.

Source: REITs, Asset Allocation And The Correlation Headwind