By Erin Corcoran

No matter which investments are included in a portfolio, investors can do better by replacing one of them with REITs. That's the conclusion of new research conducted by Brad Case, NAREIT's vice president, research and industry and information.

Case constructed every possible combination of three assets drawn from the 468 domestic investment benchmarks for which monthly total return data are available dating back to July 1992 and through December 2007. That amounts to approximately 17 million possible three-asset universes—from super-conservative choices (such as one stable value fund index, one 30-day Treasury bill index and one index for certificates of deposit) to super-risky choices (such as a micro-cap index, a tech sector index and a petroleum index) along with more common choices in between.

The exercise demonstrated that the benefit of adding REITs to an investment portfolio doesn't depend on other combined assets in the portfolio or which benchmark is used to represent them. For example, without REITs, an aggressive investor could still construct efficient high-risk, high-return portfolios using a substantial allocation to mid-cap value stocks (represented by the Russell Mid-Cap Value Index), a smaller allocation to tech stocks (the NYSE Arca Tech 100) and smaller allocations to a third asset such as micro-cap stocks (Dow Jones Wilshire Micro-Cap), commodities (Dow Jones AIG Energy), bonds (Citi USBIG Corporate AAA/AA 1–3 year) or stable value funds (Morley Stable Value).

At optimal portfolio weights, each of these aggressive portfolios would have the same volatility as a more traditional aggressive allocation of 94 percent to the stock market (Dow Jones Wilshire 5000) and 6 percent to the bond market (Lehman Brothers U.S. Aggregate), but returns would be substantially higher—between 14.93 percent and 15.64 percent per year over the modern REIT era, compared to just 11.03 percent per year for the optimal traditional portfolio.

Replacing the third asset with REITs and adjusting the portfolio allocations produces a much higher average annual return of 16.33 percent at exactly the same volatility. Over a 15-year investment horizon, the portfolio with REITs would have generated twice as much wealth as the traditional portfolio, and 10 percent to 20 percent more than the best portfolios that could be constructed without REITs.

The analysis indicates that a conservative investor could realize similar improvements with REITs. For example, without REITs, a conservative investor could construct efficient low-risk portfolios using a substantial allocation to stable value funds, a small allocation to tech stocks and small allocations to a third asset such as value stocks (MSCI US Small-Cap Value or MSCI US Small&Mid Cap 2200 Value), commodities (Dow Jones AIG Petroleum) or even sector stocks (Dow Jones US Consumer Goods).

At optimal portfolio weights, each of these conservative portfolios would have the same volatility as a more traditional conservative allocation—75.4 percent to bonds (Lehman Brothers US Aggregate), 16.3 percent to stocks (Dow Jones Wilshire 5000), and 8.3 percent to cash (30-day T-bills)—with higher returns between 8 percent and 8.47 percent per year over the modern REIT era, compared to just 7.15 percent per year for the optimal traditional portfolio. By replacing the third asset with REITs and adjusting the portfolio allocations, an investor could generate an 8.87 percent average annual return at exactly the same volatility—enough to increase wealth by 27 percent over the traditional portfolio, and 6 percent to 13 percent over the best portfolios that could be constructed without REITs.

Optimal Portfolio Growth
Growth of Six Optimal Portfolios Each Including Tech Stocks,
Stable Value Funds and One of the Six Investments Listed Below