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Overweighting REITs: Why Don’t More Experts Recommend It?

A reader writes in, asking:

“My husband & I are on a pension & SS. We have been retired for 17 years but inflation has been fairly low. However we can see our medical bills & insurance going up just about every year. I learned about REITS from reading on the internet. You mention them in your book but almost as an afterthought. With interest rates so low & getting lower why wouldn’t you want more of your money in REITS if the majority of your income is guaranteed?

Why do REITS seem to be a secret? Money columnist in the paper never mention them.”

Because REITs are stocks, they are already included (at their market weight) in a “total stock market” sort of index fund. So the primary question with REITs — as with any subcategory of stocks (e.g., value stocks, small-cap stocks, or any other industry-specific category of stocks) — is whether overweighting them in a portfolio improves the portfolio’s performance.

That’s a trickier question than it might appear at first, because performance can be measured in a number of different ways and because results vary considerably depending on what period we look at. But in most cases, the answer seems to be “no, it doesn’t particularly improve the portfolio to overweight REITs.”

For instance, here’s a paper from Vanguard that looked at whether adding a tilt to REITs (or commodities) would improve their target-date funds (or target-date funds in general). Here’s what they found:

“The results suggest that when adding commodities or a REIT overweight relative to the Vanguard glide path, the improvements are minimal at best. Of the outcomes generated by the addition of REITs, for example, those in the 5th percentile see a 0.20 increase in the wealth multiple, while those in the 95th percentile see a 2.77 decrease in it.” [Mike’s note: by “wealth multiple” here, they are referring to wealth at age 65, as a multiple of the hypothetical person’s ending salary.]

Or later in the paper:

“Our analysis suggests that even if alternatives can be used at a low cost and with limited administrative complexity (and participant confusion), these strategies are likely to deliver modest benefits at best. Our conclusions are consistent with earlier Vanguard research, which finds that any improvement in participant outcomes produced by changes in sub-asset class allocation is likely to be small compared with what can be achieved through other strategies such as reducing investment costs, increasing savings amounts, adjusting retirement age, and managing the desired replacement ratio.”

Or, here’s a relevant paper from Jared Kizer of Buckingham Strategic Wealth and Sean Grover of Georgetown University. The paper looks at a broad set of questions about REITs, but here is what the authors had to say on the topic of adding a specific allocation to REITs in a stock/bond portfolio:

“Utilizing tests of mean-variance spanning, we also examine the diversification properties of REITs on a statistically inferred basis. These tests suggest that REITs do not reliably improve the mean-variance frontier when added to a benchmark portfolio of traditional stocks and bonds.”

(If you’re interested, you can also find a somewhat easier-to-digest summary of that research in an article from Larry Swedroe here.)

The point isn’t that overweighting REITs makes a portfolio worse. But it doesn’t seem to make it clearly-better either.

An important aspect of this conversation is that, while REITs provide a higher level of income than most other stocks, income from investments is not, in itself, a useful goal. Rather, it’s total return that matters, because capital appreciation can be used to fund living expenses just as well as income can. For instance, in a given year, if a given mutual fund provides an 8% total return, it does not matter whether the return is 8% from income and 0% from capital appreciation, 8% capital appreciation and no income, or any other combination in between.

An important exception is that if we’re talking about a taxable account (as opposed to retirement accounts such as IRAs or 401(k) accounts), income is actually detrimental relative to capital appreciation, because it results in an immediate tax cost rather than a deferred tax cost. And as a result, it can even make sense to underweight REITs in taxable accounts.

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