REIT Investing for Strong Risk-Adjusted Returns and Diversification

| About: Vanguard REIT (VNQ)

The beginning of any year is a good time to revisit strategic portfolio allocations, and that's especially true at a time of great market dislocation. Here's an analysis that I did originally back in 2007 (and that I update every month) whose conclusions may be useful for portfolio reallocation--and which didn't change throughout the market crisis.

The cornerstone of any equity-oriented investment portfolio is the broad U.S. stock market, and investors then ask which assets can be added that will (1) provide strong returns, (2) expose the investor to only reasonable volatility, and (3) reduce the volatility of the total portfolio through the benefits of diversification. The first two criteria can be combined by looking at the Sharpe ratio as a measure of risk-adjusted returns; diversification potential can be measured by each asset's correlation with the broad U.S. stock market.

In this first graph, I show the Sharpe ratio (vertical axis) and correlation (horizontal axis) for literally every benchmark of a U.S. equity investment for which I could get monthly data since 1990--including value, growth, large cap, small cap, and other style indexes as well as broad market indexes. The green dots on the left are four different indexes of publicly traded U.S. REITs; the blue dots on the right are 62 different indexes of non-REIT stocks.

click to enlarge

You want strong risk-adjusted returns and low correlation? So you want to be near the upper left of the graph. REIT investments accomplish that, with strong returns (averaging 9.95% per year for the FTSE NAREIT All REITs index, compared to just 8.72% for the Dow Jones Total Market), moderate volatility, and a low correlation of 57.7% because, through REITs, investors are accessing commercial real estate, which is an entirely different asset class than non-REIT stocks.

Investors look to global equities largely to diversify their domestic equity holdings, and also for the potential of stronger returns. In the next graph, I've added 12 indexes of global and regional REIT investments, plus 14 indexes of non-U.S. but country-specific REIT investments.

Perhaps surprisingly, global and regional (including ex-U.S.) REIT investments--the green crosses--are good diversifiers against a U.S. stock market allocation--but not better diversifiers than U.S. REITs, even though U.S. REITs are traded through the U.S. stock market. Moreover, global and regional REITs have generally provided both weaker returns and higher volatility (on a U.S. dollar basis), so lower risk-adjusted returns than domestic REITs. Not surprisingly, non-U.S. country-specific REITs generally have lower correlations relative to the U.S. stock market--but they, too, generally have lower returns and higher volatility, so markedly lower Sharpe ratios. (The two outliers on the left are Switzerland and France.)

In the last graph, I've added 249 benchmarks of global stock market investments--all styles, regional, country-specific, ex-U.S., you name it. (68 of them have negative Sharpe ratios--meaning returns less than you could get on one-month Treasury securities, on average--so are not shown.)

What's really surprising is how very few global stock market investments come even close to providing the combination of strong returns, moderate volatility, and diversification for U.S. stock market investors that U.S. REITs provide. Most global stock market investments have provided really very, very poor risk-adjusted returns--meaning relatively low returns with relatively high volatility. More shocking, most non-U.S. stock market investments actually have higher correlations with the U.S. stock market than U.S. REITs do--even though U.S. REITs are traded through the U.S. stock market and included in the Dow Jones Total Market index.

(The outliers on the left represent stock markets in Pakistan, Nigeria, and Jordan. The only other countries where at least one index showed a combination of strong risk-adjusted returns with low correlations against the U.S. stock market over the historical period were Argentina, Brazil, Chile, Denmark, Finland, Hong Kong, Mexico, South Africa, and Switzerland--meaning that if you can identify the right specific countries, and the right specific segments of those markets, then you may be able to do as well as you could by investing in U.S. REITs.)

The lesson, I think, comes in three parts. First, it's much more important to diversify your investment portfolio into different asset classes--such as commercial real estate--than to diversify geographically. Second, U.S. equity investments generally have provided stronger risk-adjusted returns than non-U.S. equity investments, partly because U.S. companies are very good at generating profits and partly because the volatility of non-U.S. investments is really pretty high.

The third lesson is that U.S. REITs are really very, very good at what they do. That's consistent with lots of evidence (posted, for example, here and here) showing that publicly traded REITs are much better than other real estate investment managers; it also fits with a general perception that publicly traded REITs are likely to see strong earnings growth over the next few years partly by taking advantage of their less accomplished competitors on the private side of the real estate market.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. Author is long Vanguard REIT Index Fund.

Disclaimer: The opinions expressed in this post are my own and do not necessarily reflect those of the National Association of Real Estate Investment Trusts ((NAREIT)). Neither I nor NAREIT are acting as an investment advisor, investment fiduciary, broker, dealer or other market participant, nor is any offer or solicitation to buy or sell any security investment being made. This information is solely educational in nature and not intended to serve as the primary basis for any investment decision.