Real estate investment trusts, or REITs, first gained widespread appeal as a hedge against the stock market. While publicly traded like stocks, REITs’ returns were supposedly uncorrelated with those of conventional operating companies, and could thus provide useful diversification in an investment portfolio. Unfortunately, REITs have become victims of their own success in a key way: As the big REITs grow and become part of market indexes, the correlation between the asset class and stocks has intensified.
Now, while REITs present a solid method for everyday and institutional investors alike to diversify into the real estate asset class, they offer little value as a hedge against the stock market. Let’s take a closer look at REITs’ performance in bear markets, and why investors should look elsewhere for a hedge.
Higher correlation creating problems
REITs’ apparent lack of correlation with the broader stock market have drawn in many investors. During the severe bear market of 2000 to 2003, REITs really shone. While the S&P 500 index was down 42.5% over the course of the bear market, REITs were up an amazing 28.3%. That is a staggering divergence, and it is hardly surprising that such a performance would win over a host of converts.
But a lot has changed since 2003, as we discussed in a research note several months ago. The addition of Equity Residential (EQR, Financial) to the S&P 500 index (the second REIT to ever be included in the index) marked a turning point. An explosion of growth among the biggest REITs saw a cavalcade of further additions to the S&P 500 in the following years. Now there are more than 30 included in the index.
Thus, it should hardly be surprising that REITs would become increasingly correlated with the stock market, a fact that has become readily apparent in recent years. During the most recent financial crisis, REITs failed to offer a respite to battered stock investors. Indeed, during the ensuing bear market between 2007 and 2009, REITs did worse than stocks, falling 63.2% while the S&P 500 fell 51.0%.
Track record not promising
The problem of increasing correlation has been magnified in the past few years, but it is not the only issue facing REITs as a hedge against a bear market in stocks. A deeper dive into REITs’ historical performance reveals a patchy track record of success.
A survey of returns to various asset classes across three decades shows REITs to be unreliable hedging assets even before recent explosion of index inclusions. Between 1986 and 2016, REITs showed positive returns during just 35% of months in which stock returns were negative. That is not much of a batting average and offers little to support the case for REITs as an effective hedge. Indeed, REITs’ average negative returns across all down months, losing 2.1%. That is better than stocks’ average loss of 3.6%, but it is hardly a source of confidence.
REITs appear to fare even worse during severe corrections. During each of the 10 worst months for stocks in the dataset, REITs were also down every time. And the average loss to REITs was almost identical to stocks’ average loss of 11.8%.
What REITs are good for
REITs are still a great way to gain exposure to a diverse range of property types and strategies. Certainly, they are much less expensive (and far more liquid) than owning properties ever could be, at least for all but the very wealthiest of investors.
But many investors still consider REITs to be not only a source of diversification, but also a viable hedge against a bear market. REITs undoubtedly do provide diversification into an asset class every investor ought to have at least some exposure to. But their value as a hedge against a downturn in stocks is much exaggerated.
Investors worried about a bear market should look elsewhere for a hedge.
Hedging against a bear market
While REITs may not be up to the task of hedging against a bear market, investors are not without other options. Indeed, investors have ready access to a number of tools and asset classes that can offer relief in a bear market.
We have discussed the pros and cons of gold for this purpose in a previous research note. While gold works fairly well as a hedge during full-blown crashes, it is not all that hot in run-of-the-mill bad months. The only near-perfect hedge is provided by the safest assets of them all: Treasury bonds and bills (or equally secure foreign government bonds, such as those of Switzerland). They are not sexy, but they do the job.
If allocating to extremely safe and boring assets fails to generate an investor’s interest, there are also somewhat more exotic hedges that could work well in a downturn. Buying some FAANG stock puts would be one way of doing so, given that any broad correction would almost certainly hit the hot high valuation-multiple tech stocks hardest.
Verdict
Ultimately, there are many ways to hedge against a potential bear market. Relying on REITs is not the way to go.
Disclosure: No positions.
Read more here:Ă‚
