What if I told you that REITs were not that unique of an investment? What if they added nothing beyond some exposure to the small and value effects? What if there inflation hedge was overrated?
Somewhere in the early 2000s, it became conventional wisdom to add an explicit REIT allocation to portfolios. A quick hint why:
When the tech bubble burst, equity REITs were positive every year during that time-period. As usual, investors noticed, and starting adding REITs hand over fist. As we all know looking back now, real estate in general became the thing of the 2000s. Real Estate can’t lose money…
It was great. Here was an investment that had low correlations to stocks, solid returns, and provided a hedge against inflation. What’s not to like?
Thanks to Eugene Fama and Ken French, we now have the tools to measure investment returns and where they (Mostly) come from. This is useful for all sorts of reasons, especially when designing a portfolio. It can help keep us from adding redundant investments.
When REITs get put to the test, we find something interesting. A lot of REITs returns can be explained by the small and value effects. Here is what I mean:
- When SMB is positive it means that investment has exposure to the small effect.
- When HML is positive, it means that investment has exposure to the value effect.
The one last thing we notice is that Rm-Rf, which tells us how much exposure an investment has to the market (Total Stock Market has a Rm-Rf score of 1). REITs have a lower exposure to the market compared to most stock funds.
So what happens if we built a portfolio with small-cap value stocks and bonds and compare it to a REIT fund?
Funny how this stuff works.
Turns out that a mix of small-cap value stocks with short-term bonds would have provided identical returns to a REIT fund over the last 23-24 years. This is a great example of how useful the Fama-French framework can be when thinking about what to invest in.
Alright then, so what, real estate is still a great hedge against inflation. REITs help with that more than stocks anyways…right?
A good period to test this in would be 1973-1982. This was the last time we had persistent high inflation. Surely REITs performed better than stocks right?
As we see above, REITs did outperform inflation during this period while the S&P 500 did not. A big win for REITs…unless…
Those damn small-value stocks again. The small-value stocks performed even better than REITs in this inflationary environment. There was a trade-off though. The small-value stocks performed much worse in the bear market of 1973-1974. To combat that, I added a 50% Large-Cap Momentum allocation (Similar to the strategy discussed in an earlier post).
When we do this, not only do the bear-market losses become more in line with REITs, we still handily beat the REIT returns in this high inflation environment.
Sooo, REITs have done worse than value and momentum stocks during high inflation periods & they have the same returns as a portfolio of value stocks and bonds?
What the hell…
When the facts come out we can see that adding REITs to a portfolio should be done on a case-by-case basis.
For example, I would still be in favor of adding a REIT investment for those that use market-cap index funds (Something like a Three-Fund Portfolio). It is a way to get small-cap value exposure through an investment more people seem to be emotionally comfortable with (Behavioral Finance for ya).
But for those that already have exposure to value and/or momentum stocks, I would re-consider an explicit REIT investment. Depending on your tilt towards value and momentum, adding a REIT fund may just be adding redundancy and provide little to no benefit.
Remember folks, more funds doesn’t necessarily mean more diversification. Keep it as simple as it needs to be!