Tag Archives: REITs

Am I Effectively Diversified?

This is the sixth installment in our series on how individual investors can assess their financial health.

Diversified FolioDiversification is a perennial topic among investors, and if it seems controversial at times, that may be due to the fact that people don’t always share the same understanding of what it means. But diversification isn’t about investing in a certain number of securities or funds. And it’s not about investing in every possible security under the sun.

 

Diversification and Risk

Simply put, diversification is the process of combining investments that don’t move in lockstep with each other. For example, Treasury bonds tend to do well when stocks are falling, and vice versa.  Combining stocks and bonds thus helps to limit risk.  Bonds also reduce the risk of a portfolio because they tend to be less risky on a standalone basis than stocks.

This brings us to an important point: the aggregate risk/return properties of a portfolio depend not only on the risk and return of the assets themselves, but also on the relationships between them.  Determining the right balance among these three factors (asset risk, asset return, and diversification benefit) is the challenge of diversification.

A Diversification Self-Assessment

The starting point in the determining whether your portfolio is properly diversified is to come up with a risk level that matches your needs.  I discussed risk estimation in last week’s blog.  Assuming you have a target risk level for your portfolio, you can then attempt to determine how to combine assets so as to achieve the maximum expected return for this risk.

The word “expected” is crucial here.  It is easy to look back and to see, for example, that simply holding 100% of your assets in U.S. stocks would have been a winning strategy over the past five years or so.  The trailing five year return of the S&P 500 is 15.7% per year and there has not been a 10% drop in over 1,000 days.  Over this period, holding assets in almost any other asset class has only reduced portfolio return and risk reduction does not look like a critical issue when volatility is this low.  The problem, of course, is that you invest on the basis of expected future returns and you have to account for the fact that there is enormous uncertainty as to what U.S. stocks will do going forward. Diversification is important because we have limited insight into the future.

Many investors think that they are diversified because they own a number of different funds.  Owning multiple funds that tend to move together may result in no diversification benefit at all, however.  A recent analysis of more than 1,000,000 individual investors found that their portfolios were substantially under-diversified.  The level of under-diversification, the authors estimated, could result in a reduction of lifetime wealth accumulation of almost one fifth (19%).

Additional Diversifiers

Aside from a broad U.S. stock index (S&P 500, e.g., IVV or VFINX) and a broad bond index (e.g., AGG or VBMFX), what other asset classes are worth considering?

  • Because the S&P 500 is oriented to very large companies, consider adding an allocation to small cap stocks, such as with a Russell 2000 index (e.g. IWM or NAESX).
  • There is also considerable research that suggests that value stocks—those stocks with relatively low price-to-earnings or price-to-book values—have historically added to performance as well. A large cap value fund (e.g. VTV, IWD, VIVAX) or small cap value fund (e.g. VBR, RZV) may be a useful addition to a portfolio.
  • In addition to domestic stocks, consider some allocation to international stocks (e.g. EFA or VGTSX) and emerging markets (e.g. EEM or VEIEX).
  • Real Estate Investment Trusts (REITs) invest in commercial and residential real estate, giving investors share in the rents on these properties. There are a number of REIT index funds (e.g. ICF, RWR, and VGSIX).
  • Utility stock index funds (e.g. XLU) can be a useful diversifier because they have properties of stocks (shareholders own a piece of the company) and bonds (utilities tend to pay a stable amount of income), but have fairly low correlation to both.
  • Preferred shares (as represented by a fund such as PFF) also have some properties of stocks and some of bonds.
  • Another potential diversifier is gold (GLD).

 

Diversification Example

To help illustrate the potential value of diversification, I used a portfolio simulation tool (Quantext Portfolio Planner, which I designed) to estimate how much additional return one might expect from adding a number of the asset classes listed above to a portfolio that originally consists of just an S&P 500 fund and a bond fund.

Diversification

Risk and return for a 2-asset portfolio as compared with a more diversified portfolio (source: author’s calculations)

The estimated return of a portfolio that is 70% allocated to the S&P 500 and 30% allocated to an aggregate bond index fund is 6.4% per year with volatility of 13%.  (Volatility is a standard measure of risk.)  Compare that to the more diversified portfolio I designed, which has the same expected volatility, but an expected return of 7.3% per year, as estimated by the portfolio simulation tool.  The diversified portfolio is not designed or intended to be an optimal portfolio, but rather simply to show how a moderate allocation to a number of other asset classes can increase expected return without increasing portfolio risk.[1]

The process of analyzing diversified portfolios can get quite involved and there are many ideas about how best to do so.  But the range of analysis suggests that a well-diversified portfolio could add 1%-2% per year to portfolio return.

Conclusions

I have observed that the longer a bull market in U.S. stocks goes on, the more financial writers will opine that diversifying across asset classes is pointless.  We are in just that situation now, as witnessed by a recent article on SeekingAlpha titled Retirees, All You Need is the S&P 500 and Cash.

On the other hand, there is a large body of research that demonstrates that, over longer periods, diversification is valuable in managing risk and enhancing returns.  That said, a simple allocation to stocks and bonds has the virtue of simplicity and can be attained with very low cost.  Diversifying beyond these two assets can meaningfully increase return or reduce risk, but an increase in average return of 1%-2% per year is not going to take the sting out of a 20%+ market decline.  What’s more, a diversified portfolio is quite likely to substantially under-perform the best-performing asset class in any given time period.

But over long periods of time, the gain of 1%-2% from diversification is likely to increase your wealth accumulation over 30 years by 20%-30%.  This is consistent with the analysis of 1,000,000 individual investors cited above, from which the authors concluded that under-diversified portfolios were likely to reduce lifetime wealth accumulation by 19%.

For investors seeking to diversify beyond a low cost stock-bond mix, there are a number of simple portfolios that include a range of the asset classes discussed here and that have fairly long track records.  These are worth exploring as a template for further diversifying your own portfolio.

[1] For details on how the model estimates risk and return for different asset classes and for portfolios, see the whitepaper I wrote on the subject.

 

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REITs and the Rally of 2014

There have been a number of surprises for investors in 2014.  Bonds have markedly out-performed stocks for the year-to-date.  The S&P500 is up 2.4% since the start of 2014, as compared to the Barclays Aggregate Bond Index, which is up by 3.5%.  Even more striking, the iShares 20+ Year Treasury Bond ETF (TLT) is up by 12.5% YTD and the Vanguard Long-Term Bond fund (VBLTX) is up by 11.4% YTD.  Interestingly, REITs have been also experienced a substantial run-up in 2014 so far.  The Vanguard REIT Index fund (VGSIX) is up 16.1% YTD and the iShares U.S. Real Estate ETF (IYR) is up by 14.4% YTD.

To understand the rally in REITs, it is useful to start with an overview of this asset class.  REITs are neither stock (equity) nor bond (fixed income).  A REIT uses investor money, combined with borrowed money, to acquire real estate.  The properties that they acquire can be office buildings (BXP, SLG), apartment buildings (EQR, UDR), healthcare facilities (HCP, HCN), or even digital data centers (DLR).  The returns vary between the specific types of property owned.  REITs make money from renting their facilities out.  Please note that I am discussing only equity REITs (those which own property).  There is a secondary form of REITs that buy baskets of mortgages.  These are called mortgage REITS (mREITs).

REITs are classified as ‘pass-through’ or ‘flow-through’ entities and pass at least 90% of their taxable income to their shareholders each year.  For this reason, REITs are often favored by income-oriented investors.

REITs have their own unique measures of value and drivers of performance.  Rather than price-to-earnings ratio, a measure of the valuation of stocks, the preferred measure of valuation for REITs is price-to-funds from operations (FFO).  A notable feature of REITs is their exposure to interest rates.  In general, stocks go up when interest rates rise, while bonds fall.  When interest rates decline, the reverse tend to be true: stocks decline and bonds rise in value.  REITs tend to have a fairly neutral response to changes in interest rates, although this varies.  To the extent to which REITs need to borrow in the future due to rolling credit or new financing, their costs rise when interest rates rise.  REITs often also have the ability to raise rents, however, so that their revenue can also rise when the costs of residential or commercial real estate rise with inflation.  In addition, because REITs own a physical asset (property), the value of the assets owned by the REIT tend to go up with inflation.

An examination of the performance statistics of REIT funds illustrates their properties quite clearly.

Chart 1

REIT funds vs. major asset classes (10 years through April 2014)—Source: Author’s calculations

The returns above are the arithmetic average of returns over the past ten years, including reinvested dividends.  Beta measures the degree to which an asset tends to amplify or mute swings in the S&P500.  The betas for VGSIX and IYR show that these funds tend to rise 1.3% for every 1% rise in the S&P500 (and vice versa).  These broad REIT funds tend to do well in rising stock markets and will also tend to perform worse than the S&P500 when the market crashes.  The S&P500 fell 36.8% in 2008, for example, and IYR fell 39.9%, for example.  The high beta is only one factor that determines the returns from these REIT index funds, however.  Despite a massive decline in real estate in 2008, the average annual return for these two REIT funds has been very high over the past ten years.  The volatility levels exhibited by these REIT funds is, however, very close to that of emerging market stocks, as shown above.

The best way to understand the unique features of REITs is to look at the correlations in the returns between asset classes, bond yields, and the returns from a traditional 60/40 portfolio (60% stocks, 40% bonds).

Chart 2

Correlations between monthly returns over the past ten years (through April 2014) for major asset classes, 10-year Treasury bond yield, and the returns from a 60/40 portfolio—Source: Author’s calculations

Equity indexes tend to have positive correlations to Treasury bond yields (because yield goes up when bond prices go down, and vice versa).  This effect is evident in the table above.  S&P500 stocks (represented by SPY) have a +30% correlation to the 10-year Treasury yield.  The same relationships hold for the other major equity classes in the table above (EFA, EEM, QQQ, and IWM), with correlations to the 10-year Treasury yield ranging from 20% (EFA) to 36% (IWM).  In 2013, Treasury bond yields rose and stock indexes gained substantially.  By contrast, the returns of bond funds (AGG, TLT) are negatively correlated to the 10-year Treasury bond yield.  The returns from these funds tend to be positive when Treasury yields are falling and vice versa.

Treasury bond yields follow interest rates and inflation.  When rates or inflation rise, bond yields rise because investors sell Treasury bonds to avoid getting caught with relatively low-yield bonds in a higher rate environment.  The selling continues until the yield on the bonds is in line with new rates.  This is why returns on the two bond funds are so negative correlated to Treasury yield.  When yields go up, bond prices fall and vice versa.

VGSIX and IYR have 6% and 7% correlations to the 10-year Treasury yield—which means that these REIT funds are not highly sensitive to movements in bond yields.  While investors were betting on rising yield in 2013, opinion seems to have shifted in 2014.  If you are looking for asset classes that don’t require a bet on whether interest rates will go up or down, REITs look pretty attractive.

The correlations between the returns from each asset class and the returns from a 60% stock / 40% bond portfolio show the degree to which adding these asset classes to a simple stock-bond mix is likely to provide diversification benefits.  The higher the correlation, the less diversification benefit you can expect.  The key idea in diversifying a portfolio is to combine assets with low correlations so that when one is losing money, others are likely to be doing something different (hopefully rising in value).  As compared to the major equity asset classes, the REIT funds have a lower correlation to the 60/40 portfolio.  This, in turn, suggests that REITs can provide more diversification benefit than equities to a portfolio that currently holds stocks and bonds.

In summary, the basic narrative to explain the rally in REITs goes something like this.  REITs provide substantial income compared to bonds and equities, as well as being essentially interest rate neutral.  While REITs are a volatile asset class, the relatively low correlation between REITs and equities provides diversification benefit to a portfolio of domestic stocks and bonds, as well as providing some modest protection from rising interest rates.  REITs appear have come back into favor after being sold off during and after the so-called taper tantrum of 2013, with yield-hungry investors leading the charge.  In a slow-growth environment, with the Fed indicating that they foresee an extended period of low rates, REITs look quite attractive.  The caveat to the positive view on maintaining an allocation in REITs is that there are substantial differences between the yield, risk, and interest rate exposure and that REITs have historically been a volatile asset class.  Unless you firmly believe that you can outsmart the broader market, REITs should be thought of as a long-term income producer and diversifier.  For those investors who have maintained a strategic allocation to REITs, the gains in 2014 YTD have helped to bolster portfolio returns as equities have provided very little to investors beyond their dividends.  The downside to this positive narrative, however, is that increased prices for REITs translate to lower yields for today’s buyers.

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REIT Yield as a Predictor of Future Returns

The yield of an asset is a key component of predicting future returns.  This is true for the yield on Treasury bonds as well as the dividend yield for stock indexes.  The yield on aggregate bond indexes is considered a good proxy for future expected returns.  The dividend yield of broad stock indexes has been shown to provide significant value in predicting future stock index returns.  In both cases, low yields tend to predict high future returns, and vice versa.  These arguments that yields predict returns are not without critics, especially for equitiesContinue reading

What Happens in A Nation of Renters?

Time magazine has a new article on changes in the home ownership in America.  The article, titled A Nation of Renters: Should We Be Worried That Fewer Americans Own Homes?, explores the substantial decline in the fraction of Americans who own their own homes.  I have followed this issue for quite some time and the implications for investors may be substantial.  Continue reading

What Are the Core Asset Classes for Income Portfolios?

In a recent post, I presented a list of the ‘core asset classes’ that investors need in order to build portfolios that fully exploit available diversification opportunities.  That article focused on portfolios designed for total return potential, the combined return from price appreciation and income generated by the assets in the portfolio.  For investors focusing on building income-generating portfolios, the core asset classes are somewhat different.  In this article, I present a proposed set of core asset classes for income-focused investors, along with examples of representative funds.  Continue reading

What Are the Core Asset Classes for Total Return Portfolios?

One of the most important questions for investors and advisors is identifying a set of asset classes that will be considered for inclusion in a portfolio.  Some people will decide that all they need or want is one broad stock market index fund and one bond fund.  Others will choose to include Real Estate Investment Trusts (REITs) and commodities.  There are well-thought-out arguments that inflation-protected government bonds (TIPS) are a major core asset class.  It is also quite common for investors or advisors to break stocks out into value vs. growth and small cap vs. large cap.  Continue reading

Managing Your Portfolio’s Exposure to Interest Rates

Today, the yields on ten-year Treasury bonds are at a fifty-year low, and no period prior to the last few years reflects yields that even come close.  From 1962 to 2005, the lowest the 10-year Treasury bond yield ever got to was just below 4%, more than twice the current yield.

The chart below shows how unusual our current environment is.  The vertical axis is the yield from 10-year Treasury Bonds and the horizontal axis is time and we are looking at a period from 1962 to present.  From 1980 to today, we have seen the yield of 10-year Treasury bonds go from about 12% per year to below 2%.  The 10-year Treasury yield is considered a benchmark measure of bond yield and interest rates.  The Fed funds rate and the 10-year bond yield are very closely tied to one another.  For another illustration of how interest rates, the Fed funds rate and 10-year bond yield are related, see here. Continue reading