Many investors think of real estate investment trusts (REITs) as a distinct asset class, because in aggregate they have historically had relatively low correlation with stocks and bonds, and their returns were not well-explained by the single-factor CAPM model.
For example, during the period January 1978 through September 2016, the monthly correlation of the Dow Jones U.S. Select REIT Index with the S&P 500 was 0.58, and with five-year Treasurys, it was just 0.07.
Looking At REITs
With the advancement of modern financial theory and the development of more sophisticated multifactor asset pricing models, my colleagues at Buckingham Strategic Wealth and The BAM Alliance, Jared Kizer and Sean Grover, decided to take another look at REITs in their May 2017 paper, “Are REITs a Distinct Asset Class?”
Their research was motivated by the observation that many studies treat REITs as a distinct asset class based on correlation alone, and that many investors overweight REITs in their portfolios on a market-capitalization basis. Their data sample covers the period January 1978 through September 2016.
Kizer and Grover began by establishing criteria an asset class must meet to be considered distinct:
- Low correlation with established asset classes, such as broad market equities and government bonds.
- Statistically signiﬁcant positive alpha with respect to generally accepted factor models.
- Inability to be replicated, on a co-movement basis, by a long-only portfolio holding established asset classes.
- Improved mean-variance frontier when added to a portfolio holding established asset classes.
Prior research had shown that, in terms of equity risk, REITs have significant exposure not only to market beta, but to the size and value factors. In addition, they have been shown to have exposure to the term premium.
In their analysis, Kizer and Grover employed a six-factor model comprising the market, size, value and momentum equity factors as well as the term and credit fixed-income factors. The credit factor (referred to as IGDEF) subtracts the return of a duration-matched portfolio of Treasuries from the total return of the corporate bond index.
Their regression analysis included not only REITs, but 12 other industries available on Ken French’s website. Following is a summary of their findings: