By Erin Corcoran
Risk-Adjusted Performance and Diversification benefits of REITs OutShine Other Market Sectors and Investment Strategies
New research helps drive home a simple fact: when it comes to delivering performance, stability, and portfolio diversification, no part of the stock market even comes close to REITs.
“An investor constructing a high-quality investment portfolio should look for assets with three key attributes,” says Brad Case, NAREIT’s vice president, research and industry information. “You want strong performance, stability and low correlations, because that’s what gives you diversification.”
REITs have all three key attributes, Case says, “but some investment advisors don’t realize how rare that combination is. They assume they can find the same qualities somewhere in the stock market, perhaps with small-cap value stocks. But they can’t.”
Economists combine numbers on investment performance and stability into a measure of risk-adjusted performance called the “Sharpe ratio.” The ratio divides the average excess return for each asset by its average return volatility to represent the reward that the investor receives for each unit of risk in the portfolio.
REIT total returns have averaged approximately 15.6 percent over more than 15 years since the modern REIT era began. That’s approximately 45 percent higher than the 10.7 percent per year in total returns realized by the S&P 500. However, at the same time REIT volatility was almost identical to the stock market’s—meaning that REITs have shown much stronger risk-adjusted performance. The Sharpe ratio for REITs is approximately 23.3 percent, much higher than the 13.7 percent for the S&P 500.
Diversification potential is even more important than returns. “Every asset is going to have its ups and downs, but a well-diversified portfolio combines assets with low correlations so those fluctuations iron each other out,” Case says. A high correlation coefficient between the S&P 500 and any other asset would mean that the second asset provides essentially no diversification to a portfolio already containing the S&P 500, while a lower correlation coefficient indicates a good diversifier.
Since the early 1990s, the correlation between REITs and the S&P 500 has been only about 30 percent. “That means that when the S&P 500 is down, REITs are not likely to be down at the same time,” Case says. “The result is that the portfolio as a whole will have less volatility, even if each of the individual assets is volatile.”
A Picture Worth a Thousand Words
NAREIT plotted the Sharpe ratios for four REIT indexes against their correlation coefficients to represent the three key attributes that investors want in their portfolio—performance, stability and diversification. “Strong risk-adjusted performance is shown by being near the top of the graph,” Case says. “Diversification potential is on the left side. An investor who owns large-cap stocks wants assets that are in the top left corner.”
The graph includes every index that extends back to the beginning of 1993 representing U.S. stock market sector. The result exemplifies how unique REITs are in the investment portfolio. “For risk-adjusted performance and diversification, nothing in the stock market even comes close to what REITs offer,” Case says.
“The biggest takeaway from this research is because REITs have both high risk-adjusted return and clear diversification benefits. They are a different asset class,” says Glenn Mueller, a professor at the University of Denver and real estate investment strategist at Dividend Capital Group. “REITs provide great diversification for investors to use in their portfolios.”
Hardly any sector of the stock market had a correlation less than 50 percent, for example, compared to just 30 percent for REITs. The only exception, utility stocks, had a Sharpe ratio of just 10.3 percent, with average returns of just 9.6 percent per year and about 14 percent more volatility than REITs. Conversely, hardly any sector of the stock market had a Sharpe ratio greater than 20 percent, compared to about 23.3 percent for REITs. The exceptions, micro-cap and small-cap value stocks, provided little diversification, with correlation coefficients of 65 percent to 80 percent.
“The chart that summarizes these results provides a lot of information and illustrates how REITs stand in a completely separate place than other publicly traded investments,” Mueller says. “This is a great step forward to explain the benefits of REITs in an investment portfolio.”
Erin Corcoran is the managing editor of Portfolio.
