Real Estate Investment Trusts (REITs) are often viewed as alternatives, though Morningstar doesn’t characterize them as such, since they are now mainstream. Though private, non-traded REITs have very high loads and ongoing expenses, low-cost REITs can have a place as alternatives in our clients’ portfolios.
REITs performed spectacularly during the internet bubble but, of course, horribly during the more recent real estate bubble. How they will perform during the next market downturn is anyone’s guess. However, a recent 10-year forecast by Vanguard predicts REITs will earn an expected 6.2% annually with a 14.2% standard deviation. This compares to an expected return for U.S. equities of 7.7% annually with a 17.2% standard deviation. The real benefit from REITs comes from their lower 0.6 correlation.
To be sure, a negative correlation means a likelihood REITs will go up when stocks go down. Unfortunately, the only asset classes with negative correlations to stocks also have negative expected returns.
But we can look to the recent past to show the benefit of REITs. Over the past five years, the Vanguard REIT Index Fund (VGSLX) earned 22.3% annually, while the Vanguard Total Stock Index Fund (VTSAX) earned a similar return of 19.4%. The similarity by year wasn’t as strong with stocks besting REITs by over 30 percentage points in 2013. But this year, as of May 18, 2014, REITs are topping stocks by nearly 15 percentage points. Thus, a balanced portfolio smoothed out some returns even though correlations were positive.
Allan S. Roth, a Financial Planning contributing writer, is founder of the planning firm Wealth Logic in Colorado Springs, Colo. He also writes for CBS MoneyWatch.com and has taught investing at three universities.