If a truly diversified portfolio is your objective, don't ignore real estate. An analysis of the volatility and correlation of real estate investment trusts, compared with the broad equity markets, shows that over periods of five years or more, REITs are less correlated to the overall stock market than any other equity sector.
“People are radically underestimating how much they should be investing in real estate, and they are overestimating how much they should be investing in stocks,” said Brad Case, an economist with the National Association of Real Estate Investment Trusts.
According to his analysis, real estate often is disregarded as a portfolio diversifier because the correlation to stocks can be high over short periods of time. Longer-term, however, the correlation shrinks.
Between January 1990 and October of this year, the average one-month performance correlation between REITs and the S&P 500 was 56.3%.
But by measuring the correlation over the same period in five-year increments, Mr. Case found that stocks and REITs moved in tandem just 7.1% of the time.
Meanwhile, the various sectors of the broad equity market indexes, which are often used by financial advisers as portfolio diversifiers, actually became more correlated to the broad market over longer holding periods.
The utility sector of the S&P 500, for example, had a 45% correlation to the overall index over one-month intervals dating back to 1990. But when studied on a five-year basis, the correlation jumps to almost 70%.
SIMILAR PATTERNS
Over the same period, other sectors showed similar patterns.
Consumer staples had a one-month correlation of 65% but an 88% correlation to the broader market over five years. Health care stocks showed a 61% correlation on a monthly basis but were more than 90% correlated on a five-year basis.
The analysis also shows that some sectors, regardless of market interval, tended to be highly correlated to the broad market index on a constant basis. Industrials, for example, had a one-month correlation of about 91% and a five-year correlation of 96%.
“Long-term investors are making investment decisions based on data that day traders should be using, because they're using short-horizon data,” Mr. Case said.
Fee-only planner Bert Whitehead, who is president of Cambridge Connection Inc., is among those advisers who see real estate as a crucial tool for balancing risk.
“Asset allocation is based on the function of the assets, and in a truly diversified portfolio, there will always be something going up while something else is going down,” he said.
Although Mr. Whitehead likes the leverage that can be tapped by owning real estate directly, he also likes the liquidity and diversification that come with owning REITs. Regardless of how it is held, he said he generally recommends that his clients allocate between 20% and 40% of their portfolio to real estate.
Mr. Case acknowledged that the correlation between stocks and REITs has gone up along with an increase in overall market volatility. On a 12-month-rolling-average basis, for example, the Dow Jones REIT Index has a 93% correlation to the Dow Jones Industrial Average.
Keep in mind that high correlation doesn't necessarily mean equal performance. It just means that both stocks and REITs are moving in the same direction by the same relative proportion.
For example, if stocks gained 2% one year and 3% the next, while REITs gained 4% one year and 6% the next, the correlation would be 100% even though the performance differed.
There are a number of factors driving the correlation between stocks and REITs higher, such as the use of REITs in exchange-traded funds and the inclusion of REITs in broad market indexes.
But Mr. Case said that his long-term analysis remains valid and that measuring correlation on something as short and confined as a 12-month rolling average doesn't do justice to a long-term investment strategy.
“A rolling model is fine — as long as nothing happens in the markets during that period,” he said.
The research, which Mr. Case is developing with additional sets of criteria, shows the beneficial noncorrelated nature of stocks and real estate.
An example is the monthly Consumer Price Index. If the CPI surprises the market by showing that inflation is higher than expected, the reaction is negative for stocks, but it is positive for REITs because real estate is considered an inflation hedge.
Questions, observations, stock tips? E-mail Jeff Benjamin at jbenjamin@investmentnews.com
