REITs in Target-Date Portfolios

NAREIT has been promoting a study from Wilshire Associates touting the benefits of including REITs as a specific allocation in target-date funds.  I read about it in a story from Pensions & Investments website, pionline.com.  The white paper is available on reit.com, the NAREIT website.

The conclusion that a portfolio with a REIT component will be more efficient (higher return with the same volatility, or lower volatility in delivering the same return) is intuitive: The introduction of a distinct investment opportunity set with its own risk and return characteristics should add value on a portfolio level.  Thus, Wilshire was able to find that the addition of global REITs could add about 30 basis point of return to a portfolio with a given expected risk, and that domestic REITs could add up to 60 basis points of return.

The study stands only as a suggestion of efficacy though. The statistical analysis is thorough, but neglects to account for the changes in the structure and operation of the capital markets over the past 35 years.  For example, the correlation of REITs to the domestic stock market was relatively low during the 70s and 80s, approximately 0.35 to 0.40.  By the mid 90s, that correlation had risen to about 0.60.  And while I have not seen any statistics on recent performance, I would expect that the correlations have become stronger, given the general convergence of the equity markets.

Another point to recognize is that REITs are added to portfolios at the expense of high yield and non-US bonds and TIPS.  Recognizing that much of a REIT's return comes from dividends, REITs are still equities, often carrying significant leverage.  The mean-variance analysis does not necessarily pick up the equity risks of investing in REITs that are not expressly demonstrated in its volatility of returns.

The last item of note is that by adding a distinct REIT allocation, an overweight to REITs is being deliberately adopted, if not explicitly.  REITs are a part of the equity market, whether domestic or global.  They typically are included in the small-cap sector, where they might represent 10% of capitalization.  Thus, any REIT allocation will duplicate or amplify the market allocation, if no adjustment to the equity allocation is made.  Even if the equity allocation is adjusted, any allocation in excess of 2% or so is an overweight relative to the global capital market.

The paper cites a number of asset managers and retirement plan sponsors that have indicated that the inclusion of REITs in these target-date portfolios.  These changes may make the portfolios more diversified, but investors may not experience additional efficiency.