As you can see, the replicating portfolio dominates REITs in almost every way—it earns higher compound returns, has lower volatility, achieves a higher Sharpe ratio, has lower kurtosis and wins on most historical risk characteristics.
A skeptic might note the replicating portfolio has a 33% allocation to long-term corporate bonds during a period in which interest rates have declined signiﬁcantly, but the regression results show the term factor loading for the replicating portfolio is lower than the term factor loading for REITs. Thus, interest rate risk exposure can’t account for the results.
Kizer and Grover then tested REITs against their fourth criteria, and concluded REITs fail to improve the mean-variance frontier, on a statistically inferred basis, when added to a portfolio holding established asset classes.
After first establishing a pragmatic list of criteria for considering asset classes, Kizer and Grover found that, while REITs do indeed exhibit relatively low correlation with traditional equity and ﬁxed income, a deeper dive into their returns reveals shortfalls in their qualiﬁcations for asset class distinction.
They found that multifactor regression analyses revealed no statistically reliable alpha generation in REIT returns and that REIT returns are well-explained by traditional risk factors. They also found that a long-only replication of REIT returns with small value equities, and long-term corporate bonds produces a portfolio that co-moves well with returns to REITs and exhibits historical return and risk characteristics generally better than REITs.
Finally, they found REITs do not reliably improve the mean-variance frontier when added to a benchmark portfolio of traditional stocks and bonds. These results, and the associated failure to satisfy their asset class criteria, led Kizer and Grover to conclude that REITs are not a distinct asset class.
It’s important to note the results did not lead Kizer and Grover to recommend excluding REITs from equity portfolios.
Instead, the results of this study led them to suggest that REITs, as an equity security with marginal diversiﬁcation beneﬁts, shouldn’t receive a weighting in investor portfolios that signiﬁcantly deviates from market-capitalization-based weights. Data from Morningstar shows REITs represent approximately 3.5% of the iShares Russell 3000 ETF (IWV) on a market-capitalization basis, which is a valid starting point for a REIT allocation in a diversiﬁed portfolio.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.