When was the last time you took a leap of faith? Maybe you slid down a giant waterslide, skied the double-black diamond trail, changed careers, or ate snails for dinner. A leap of faith involves some level of risk in exchange for a potential reward.

Investors also must consider risks versus rewards. For example, how can investors gain exposure to commercial real estate? There’s direct investment in private real estate, but many investors can’t gain access for various reasons—cost and liquidity, to name two. Because of such barriers blocking entry to direct real estate investment, some investors turn to real estate investment trusts (REITs) as an alternative.

REITs are companies that own income-producing real estate. They are sources of publicly traded equity and represent one of the standard 11 equity sectors. However, the publicly traded REIT market only represents a sample of the commercial real estate market, not the complete real estate universe.

REITs have a strong correlation to equity over the short term.1 But, over the long term, REITs have a stronger correlation to private real estate and their correlation to the equity market diminishes. As a result, we are often asked, “Why don’t you overweight REITs to increase exposure to real estate in your Target Retirement Funds?”

The question that all plan sponsors must address before selecting a TDF is whether any added alternative investment, or strategy, such as an overweight to REITs, will deliver a benefit over the long term that justifies their higher cost, greater complexity, and more limited transparency and liquidity compared with TDFs that don’t include these strategies. When it comes to REITs, the short answer is that Vanguard Target Retirement Funds maintain a broad-based exposure to global equities.

Therefore, investors have exposure to real estate through REITs, albeit a market-cap-weighted exposure of approximately 4% of equity market. Similarly, all other equity sectors are market-cap-weighted. Any additional overweight would be an active decision implying that an investor believes the investment characteristics of REITs, whether used as a proxy for private direct real estate or not, can deliver enhanced return or reduced volatility at the expense of underweighting the other ten sectors. We discuss REITs in more detail, along with other common investment alternatives, in our recent research paper Assessing the inclusion of alternatives in target-date funds.

While an overweight to REITs may have improved investors’ outcomes, such as risk-adjusted returns, in hindsight there have been other equity sectors that did just as good a job or better. In fact, historically there have been four equity sectors that have a lower correlation to global equities than REITs. They include the utilities, telecom, health care, and consumer staples sectors.

As illustrated in the bar chart below, if we just consider U.S. equities represented by the S&P 500 Index, only the utilities sector had a lower correlation than REITs to the S&P. But, interestingly, the consumer staples sector exhibited both higher returns and lower volatility than that of REITs. In addition, the health care sector also had higher risk-adjusted returns than REITs. So while there will always be sectors that outperform, or other portfolio tilts that could have improved the outcomes for investors in the past, it would be extremely difficult to know in advance.

Diversification benefits and risk-adjusted returns of REITs similar to other sectors

Sources: Vanguard, Standard & Poor’s, data from October 1989 to July 2017.

In the end, having a global exposure to real estate represented by REITs is a desirable diversification objective. Yet, any strategic overweight to the REIT sector would be nothing more than a leap of faith. Without a crystal ball we can’t know that this one equity sector will provide risk/return characteristics that are better than any of the other equity sectors. REITs are simply one sector in the equity universe and they may or may not continue on a future path that generates risk/return characteristics similar to the past. Always look closely before you leap.

1Source: Chris Tidmore, CFA; Scott J. Donaldson, CFA, CFP®; Daniel B. Berkowitz, CFA; Daren R. Roberts., 2017. Assessing the inclusion of alternatives in target-date funds. Valley Forge, PA.: The Vanguard Group.

I’d like to thank my colleague, Daren Roberts, for his contributions to this blog.

Notes:

  • All investing is subject to risk, including the possible loss of the money you invest.
  • Past performance is no guarantee of future returns.
  • The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.
  • Diversification does not ensure a profit or protect against a loss.
  • Funds that concentrate on a relatively narrow market sector face the risk of higher share-price volatility.
  • Investments in stocks or bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk. These risks are especially high in emerging markets.
  • Investments in Target Retirement Funds are subject to the risks of their underlying funds. The year in the fund name refers to the approximate year (the target date) when an investor in the fund would retire and leave the workforce. The fund will gradually shift its emphasis from more aggressive investments to more conservative ones based on its target date. An investment in a Target Retirement Fund is not guaranteed at any time, including on or after the target date.