REITs can correlate with equities in the short-term, but long-term returns come from genuine bricks-and-mortar.

Real Estate Investment Trusts (REITs), and other listed real-estate securities, are equities. They are listed on stock exchanges and included in equity indices such as the S&P500, the Russell 1000 and the FTSE 250. Some investors are put off by this. They prefer to try to build their real estate portfolios by investing privately and directly in bricks and mortar. In this paper, we want to challenge and alleviate those concerns. We argue that listed real estate securities are fast becoming the only efficient way to build truly global, diversified exposure to the asset class, and that returns have historically diverged quite quickly from those of the broad equity market, reflecting the performance of the underlying real-estate assets. Moreover, we observe that listed securities offer a level of liquidity that is simply unavailable from direct real estate or even real-estate open-ended funds. We believe the resulting short-term correlation with equity-market volatility should be regarded as a source of opportunity to invest in genuine real-estate returns at sometimes deep discounts.

At A Glance

  • Listed real estate is the most convenient way for most investors to build a truly global property portfolio; however, many remain skeptical that returns come from real estate risk and cash flows rather than equity market risk.
  • The relationship between listed real estate returns and broad equity market returns has grown over the past 37 years
  • However, what has not changed is that the closeness of that relationship breaks down substantially for holding periods of around three years (Fig.1).
  • The relationship has tended to strengthen again for longer holding periods, as macro forces dominate (Fig.1).
  • Other equity sectors do not exhibit this weakening relationship of their returns with broad equity market returns over medium-term holding periods (Fig.3).
  • The correlation of short-term returns to listed real estate and the broad equity market is a function of the asset class’s liquidity, which is much more reliable than that offered by alternative vehicles for real estate investment.
  • This liquidity can be vital for those who need to adjust portfolios during market dislocations, and the correlation creates opportunities to buy genuine real estate returns at sometimes deep discounts.

A Globalizing Sector

Two years ago we were writing about how a rush of IPOs had transformed European listed real estate securities into a multi-billion euro sector. A similar dynamic is at work worldwide. REITs are no longer solely a U.S. phenomenon.

This is such an important revolution because real-estate cycles tend to be highly-localised. The diversification benefits that come from a practical global approach to real-estate investing are, therefore, considerable.

There are relatively few global or even pan-regional open-ended real estate funds, and even the world’s largest institutional investors struggle to build a truly global portfolio from direct, private investments. We believe the far reach and diversified holdings of listed real-estate companies makes them the perfect vehicle for creating this kind of exposure, for any kind of investor.

Why, then, do so many remain skeptical?

The main concern seems to be that listed securities are equities. They worry that investing in REITs means buying the risk and return of the equity market, rather than real estate. They prefer to try to build their real estate portfolios by investing privately and directly in bricks and mortar, or via open-ended property funds.

Intuitively, this is questionable. Listed real-estate companies buy, develop, rent-out and sell real estate around the world, just as pharmaceutical companies develop, test and sell drugs and medicines. While one might expect a pharma stock to move somewhat in synch with the broader equity market over a short time horizon, no one would assume that a company that is good at developing medicines would deliver the same longer-term returns as one that is bad at it, or the same longer-term returns as a mining company or a bank. Why should the performance of real-estate stocks be any different?

Let us go beyond intuition and look at the evidence.

Correlations Have Changed Over Time

The first thing to acknowledge is that the relationship between the listed real-estate sector and the broad equity market has changed over time.

Since 1980, we calculate that the monthly total returns to the FTSE NAREIT U.S. Real Estate Composite Index have exhibited a beta of 0.66 relative to those of the Russell 1000 Index. But before 2004 that beta was just 0.43, and since then it has been 1.20. That change is due to a gradual rise in correlation between 2004 and 2011, and the big spike in volatility experienced during the financial crisis of 2007-09.

A similar picture emerges when we look at how closely the cumulative total returns to real estate securities, and to the broad equity market, map onto one another over a variety of holding periods. The R-squared value measures, on a scale of zero to 1.00, how predictive one set of returns is of the other: it ranges from 0.03 for a three-year holding period to 0.54 for a six-month holding period, when we look at the returns to real-estate securities and broad equities from 1979 to 1989. Move forward to the 2007-2017 period, however, and the range goes up to 0.51-0.79.

In other words, this change in relationship is not confined to short-term volatility (beta). Longer-term cumulative returns have become more closely-related, too.

There are a number of factors that may explain this. The FTSE NAREIT Index had far fewer securities with much less diversification during the 1980s than it does today, for instance. In addition, top-down returns drivers, such as the long period of near-zero interest rates and central bank activism, have been unusually important for many asset classes in the years since the financial crisis.

We believe the high-water mark for this higher correlation may have passed, as central banks begin to reduce their balance sheets and withdraw liquidity, and as the market adapts to real-estate securities getting their own, dedicated categorization in the Global Industry Classification Standard (GICS)SM industry sectors.

More importantly, we note that the growing relationship between real-estate securities and broad-equity returns over time has not changed two crucial facts: first, that the relationship tends to weaken significantly as holding periods are extended; and second, that the relationship is significantly weaker for real-estate securities than it is for other industry sectors.

Real Estate is Different from Other Equity Sectors

In Figure 1 we show the total returns to the S&P500 Index and the FTSE NAREIT US Real Estate Composite Index, over rolling one, three and five-year holding periods, during the 2007-2017 period. The more scattered the dots appear, and the lower the R-squared value is, the lesser the predictive value of S&P500 returns has been for FTSE NAREIT Index returns. The same pattern was evident when we used the returns of the S&P500 Real Estate Sector Subindex.

Figure.1: Listed Real Estate Returns Show Relatively Low Correlation With The Broad Equity Market, Especially For 3-5 Year Holding Periods

One-year holding periods

Three-year holding periods

Five-year holding periods

Source: Bloomberg. Data from May 2007 to May 2017. Total returns to the S&P500 Index and the FTSE NAREIT US Real Estate Composite Index, over rolling one, three and five-year holding periods, showing the R-squared measure of fit to a linear regression line.

The plot points become more scattered as we move from the one-year to the three-year holding period. This is the story of equity-market price volatility dominating the total return over the short-term, and fundamental real-estate cash flows beginning to dominate over the medium-term.

It is interesting to note, from figure 1, that the returns re-converge as the holding period stretches out to five years. This is not surprising. The longer the holding period, the less likely it is that returns are dominated by the fundamental differences between real-estate businesses and other businesses within a single business cycle, and the more likely it is that they begin to be driven by long-run macroeconomic factors such as GDP growth and inflation. Ultimately, a portfolio of shopping malls and offices, and a portfolio of widgets, are both collections of real assets that are similarly exposed to long-run macroeconomic factors.

What is perhaps surprising is that other industry sectors simply do not experience this ebb and flow.

The charts in figure 2 show the total returns to the S&P500 Index and the S&P500 Industrials Sector Subindex. The dots remained tightly-packed around the linear regression line of best fit, regardless of the holding period. This shows that the returns to the broad-equity market have historically been highly predictive of the returns to the industrial sector.

The table in figure 2 shows this is not anomalous. Four other industry sectors all exhibit a significantly closer relationship with the broad-equity market than the real-estate sector does, over all holding periods, with no clear evidence that holding for longer weakens the relationship. Moreover, this is not about the size of the sector in the broad index: real estate and materials both account for quite a small proportion of the S&P500, at 3-4%, but the materials-sector returns are much closer to those of the bigger sectors than they are to real estate.

In short, listed real estate securities, and real-estate businesses, appear to be very particular and idiosyncratic stocks—and that idiosyncrasy is expressed through a divergence of cumulative returns over the medium-term.

Figure.2: Other Sectors Show Higher Correlation With The Broad-Equity Market, With A Smaller Holding-Period Effect

Industrial Sector Versus Broad-Equity Market

One-year holding periods

Three-year holding periods

Five-year holding periods

A Range of Sectors versus the Broad Equity Market

Source: Bloomberg, S&P. Data from May 2007 to May 2017. The charts show the total returns to the S&P500 Index, the S&P500 Industrials (Sector) Subindex, and the FTSE NAREIT US Real Estate Composite Index, over rolling one, three and five-year holding periods, showing the R-squared measure of fit to a linear regression line. The table shows the R-squared measure of fit to a linear regression line of the total returns to each of the seven pair of indices shown, over rolling six-month, and one, three and five-year holding periods.

Listed Real Estate Correlation to Private Real Estate

Research from the National Association of Real Estate Investment Trusts (NAREIT) and the European Public Real Estate Association (EPRA) shows the other side of this coin: increasing correlation between listed real estate securities and private, unleveraged core real estate, as holding periods extend (figure 3). NAREIT and EPRA explain that this convergence happens as short-term REIT mispricing and appraisal errors in the private markets are both corrected.

Figure.3: Private Real Estate Returns Correlate More Strongly With Listed Real Estate Returns as Holding Period Extends

Source: NAREIT, EPRA. Data from Janary 1978 to March 2017. Quarterly total returns to the FTSE NAREIT All Equity REITs Index and the NCREIF Property Index.

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The good news is that we believe there is a viable solution for income investors, with three elements:

  1. Seeking higher yields from alternative sources of income
  2. Exploiting the risk-reducing power of diversification to the full
  3. Managing asset allocation dynamically

In this paper we will look beyond investment-grade bonds to find income available at higher yields from sectors of the credit and equity markets, and from sophisticated investment techniques such as equity-index options strategies.

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“This is not simply adding risk to portfolios, but rather exchanging one type of risk for a range of others.”

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“This is not simply adding risk to portfolios, but rather exchanging one type of risk for a range of others”
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These alternative sources of income are undeniably less secure than the income from investment-grade bonds—and we would advocate replacing only a portion of the investment-grade allocation in an income portfolio. However, it is important to understand that this is not simply adding risk to portfolios, but rather exchanging one type of risk for a range of others: we will show that combining alternative sources of income diversifies away a lot of the extra risk associated with holding them individually. We will also show how investors can use sophisticated investment strategies and instruments to enhance that portfolio diversification and further reduce total-portfolio risk.

Higher Yields from Alternative Sources of Income

Over recent years yields from alternative sources of income have come down just as surely as they have from investment-grade bonds. As figure 2 shows, however, yields from investments such as high yield bonds, bank loans and high-dividend equities remain compelling on a relative basis.

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Liquidity Brings Both Convenience and Opportunity

This evidence of genuine real-estate returns over the medium-term is encouraging, given the fact that the broad-equity market return has been around 75% predictive of REIT returns over shorter time horizons, and that beta has been high over recent years. It means that, for patient investors, short-term volatility on the downside, driven by equity-market risk, is a potential source of opportunity to buy those real-estate returns at sometimes considerable discounts.

Moreover, critics of listed real estate often fail to recognize that this short-term price volatility and higher correlation is a function of the fact that investors are all but guaranteed access to liquidity in this asset class, even during periods of acute market stress.

Outside the very largest institutional investors with very long investment horizons, most investors need to reconsider their portfolio positions during these periods: they may need to access liquidity to sell down volatile real-estate sector exposures; or they may wish to exploit the opportunity to add to positions at a discount. While it has never been a problem to buy shares in property unit trusts (PUTs) or authorized investment funds (PAIFs) during periods of market stress, the suspended redemptions, gates, swing pricing and extremely wide bid-offer spreads experienced by investors in UK property funds in the aftermath of the 2016 Brexit vote reminded us that it can sometimes be difficult or impossible to sell shares.

In short, illiquid assets do not become liquid just because they are held in open-ended vehicles ostensibly offering daily liquidity; but closed-ended real-estate securities are, in themselves, liquid assets—the price for which is some short-term volatility disconnected from underlying real-estate fundamentals. We think it makes sense to accept (and take advantage of) the volatility that comes with genuine liquidity, rather than try to avoid it and rely on daily liquidity that may turn out to be unavailable.

Should REITS investors worry about rate hikes?

Although listed real estate can be shown to exhibit genuine real-estate returns over a medium-term holding period, historically, the broad-equity market return has been around 75% predictive of REIT returns over shorter time horizons, and beta has been high over recent years. With this in mind, some investors express concern that, should interest rates continue to rise from their very low current levels, the prices of risky assets in general, and income-generating assets such as real estate, in particular, are set to decline. By contrast, we note that, even over short, one-year periods, four of the past five rate-hiking cycles have in fact been rather positive for real-estate securities. This was the case even in 2000, when rate hikes accompanied the major sell-off of the dotcom crash.

Figure.4: Listed Real Estate Has Performed Well During Many Past Periods Of Rate Hikes

Returns During Calendar Years that Include More Than One Rise In The U.S. Federal Funds Rate

Source: Bloomberg. The x axis shows the number of rate rises, and the resulting change in the Fed Funds Rate, in percentage points. The chart shows total returns. Government Bonds are represented by the Barclays U.S. Government Index, Equities by the S&P500 Index and REITs by the FTSE NAREIT All Equity REITs Index.

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Should REITS investors worry about rate hikes?

Although listed real estate can be shown to exhibit genuine real-estate returns over a medium-term holding period, historically, the broad-equity market return has been around 75% predictive of REIT returns over shorter time horizons, and beta has been high over recent years. With this in mind, some investors express concern that, should interest rates continue to rise from their very low current levels, the prices of risky assets in general, and income-generating assets such as real estate, in particular, are set to decline. By contrast, we note that, even over short, one-year periods, four of the past five rate-hiking cycles have in fact been rather positive for real-estate securities. This was the case even in 2000, when rate hikes accompanied the major sell-off of the dotcom crash.

LISTED REAL ESTATE HAS PERFORMED WELL DURING MANY PAST PERIODS OF RATE HIKES Returns During Calendar Years that Include More Than One Rise In The U.S. Federal Funds Rate

Source: Bloomberg. The x axis shows the number of rate rises, and the resulting change in the Fed Funds Rate, in percentage points. The chart shows total returns. Government Bonds are represented by the Barclays U.S. Government Index, Equities by the S&P500 Index and REITs by the FTSE NAREIT All Equity REITs Index.

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Fig.2 PRIVATE REAL ESTATE RETURNS CORRELATE MORE STRONGLY WITH LISTED REAL ESTATE RETURNS AS HOLDING PERIOD EXTENDS

CORRELATION OF THE FTSE NAREIT ALL EQUITY REITs INDEX WITH THE NCREIF PROPERTY INDEX, 1978-2017

Source: NAREIT, EPRA. Data from Janary 1978 to March 2017. Quarterly total returns to the FTSE NAREIT All Equity REITs Index and the NCREIF Property Index.

It is interesting to note, from figure 1, that the returns re-converge as the holding period stretches out to five years.

This is not surprising. The longer the holding period, the less likely it is that returns are dominated by the fundamental differences between real-estate businesses and other businesses within a single business cycle, and the more likely it is that they begin to be driven by long-run macroeconomic factors such as GDP growth and inflation. Ultimately, a portfolio of shopping malls and offices, and a portfolio of widgets, are both collections of real assets that are similarly exposed to long-run macroeconomic factors.

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Conclusion: A Solution for All Investor Types

Investors really are buying bricks and mortar when they buy REITs and other real-estate securities – just as investors really are buying the revenues from developing and selling medicines when they buy pharmaceutical equities. In fact, we have shown that real estate is an especially idiosyncratic sector: listed real-estate companies exhibit much lower correlation with the broad equity market than companies from other sectors, particularly over the medium-term.

Some short-term correlation with the broad equity market is the price investors pay for the convenience of getting exposure this way. But that convenience is considerable: it makes global exposure possible for all types of investor; it virtually guarantees the ability to sell quickly and simply when required; and it even offers opportunities to buy assets at discounts during periods of market volatility.

Open-ended funds seem to us to be the least satisfactory way to invest: they offer less regional diversification and a less-than-reliable promise of liquidity during periods of market stress when it is most valuable.

Investors that really want to avoid short-term equity market correlation can buy, rent-out and sell real estate assets directly. But this is akin to choosing to set up a pharmaceuticals business instead of simply buying a portfolio of pharmaceutical stocks, just to avoid broad equity-market correlation: it can be done, but it is very risky, not diversified, much more capital- and resource-intensive, and much less liquid.

For all these reasons, we believe that listed real estate securities are an excellent solution for most types of investor.

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Fig.3 OTHER SECTORS SHOW HIGHER CORRELATION WITH THE BROAD-EQUITY MARKET, WITH A SMALLER HOLDING-PERIOD EFFECT

INDUSTRIAL SECTOR VERSUS BROAD-EQUITY MARKET

Source: Bloomberg, FactSet, Alerian

Investors who expand their high-yield exposure to include bank loans can benefit from cash flows that actually rise with interest rates: loan rates are usually re-set every 90 days at a spread over 3-month Libor, as long as Libor itself is over 100 basis points. As Libor recovers from its post-financial crisis lows, loan income will generally rise, and potentially the capital value, too.

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“Income investors should look to diversify regionally, too”
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“Income investors should look to diversify regionally, too.”

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Income investors should look to diversify regionally, too. Emerging markets debt still offers compelling yield relative to developed market bonds, even after adjusting for slightly lower credit quality. Again, emerging markets assets have tended to perform well while global interest rates have been going up—although some benefit can be lost when rising rates coincide with a stronger U.S. dollar, in which many emerging market sovereign and corporate liabilities are denominated.

As we have observed, rising rates are often a sign of a growing economy, which tends to be positive for high yield and emerging markets debt. The same is true for equity markets. Strip out the year 2000, when three rate hikes coincided with the dotcom crash, and the S&P 500 Index has posted positive returns in each of the last eight calendar years in which U.S. rates went up.

Equities are considerably more volatile than bonds, and high dividend yield can be a sign of low valuation—often a powerful source of long-term returns, but sometimes a reflection of problems at the company in question. For income investors, therefore, we would advocate a strategy that seeks the best combination of high yield and dividend sustainability. MSCI’s High Dividend Yield indices implement this kind of approach and, as figure 4 shows, such an approach still delivers substantial excess yield compared to broad equity or bond markets.

We also encourage investors to consider specialist equity-market sectors exposed to underlying assets that generate high levels of income. Examples are Real Estate Investment Trusts (REITs, or listed companies that own income-generating property) and Master Limited Partnerships (MLPs, which operate businesses in the income-generating corners of the natural-resources sector).

Figure 4: Equity Dividend Yields Offer High Spreads Against Most Core Government Bonds

Government Bond Yields vs. Equity Index Dividend Yields

Source: FactSet. Data as of September 30, 2016. There is no MSCI High Dividend Yield Index for Switzerland.

Finally, investors can look beyond simple asset classes and sectors and deploy sophisticated income-generating strategies. Selling (or “writing”) options is a good example. Because there tend to be more buyers than sellers in option markets, especially for put options used to hedge downside risk, the upfront premiums that sellers collect tend to be larger than the volatility of the underlying assets suggests they ought to be.

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“Investors can look beyond asset classes and deploy sophisticated strategies such as writing options”
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“Investors can look beyond asset classes and deploy sophisticated strategies such as writing options.”

Several different strategies can be pursued. Covered call writing involves selling call options on shares already owned: the buyer pays up for the right to buy underlying stock at a specified price, while the seller accepts a limit on capital appreciation in return for enhanced portfolio income. Collateralized put writing, on the other hand, generates premium income from allowing the put buyer to sell a stock or index back to the put seller at a specified price.

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The Risk-Reducing Power of Diversification

Keep in mind that investors who replace some investment-grade bond exposure with allocations to alternative sources of income are not simply adding risk to their portfolios. Rather, they are exchanging one type of risk (interest rate sensitivity, or “duration”) for a range of other risks (credit, equity, complexity and so on).

Take a look at Figure 5. The yield of a naïve benchmark portfolio constructed from these alternative income assets and a component of government bonds (based on the average allocations of commercial multi-asset income funds) is considerably higher than the yield of an investment-grade portfolio, but its interest-rate sensitivity is considerably lower. In the current low-yield environment, that helps to solve both of our key problems: lack of income and potential downside risk to capital.

Figure 5: A Diversified Portfolio of Alternative Sources of Income Currently Offers a Compelling Duration-For-Yield Trade-Off

Yield and Duration

Portfolio Benchmark

IndexWeight (%)
MSCI USA High Dividend Yield 23
MSCI World ex-USA High Dividend Yield 12
Alerian MLP 5
FTSE EPRA/NAREIT US 5
Barclays US High Yield 15
S&P/LSTA US Leveraged Loan 100 15
JPMorgan EMBI Global Diversified 15
Barclays US Long Government Credit 10

Source: Bloomberg, FactSet, Alerian. Data as of September 30, 2016.

The price is higher volatility. But recall that creating this portfolio entails moving from one major exposure to several—economic growth, energy, emerging economies, real-asset capital appreciation—which not only diversify against investment-grade bonds, but also against one another.

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“A simple alternative income portfolio can provide a higher yield than investment-grade bonds, with lower interest rate sensitivity, helping to solve two key problems: lack of income and potential downside risk to capital.”

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“A simple alternative income portfolio can provide a higher yield than investment-grade bonds, with lower interest rate sensitivity, helping to solve two key problems—lack of income and potential downside risk to capital”
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As a result our naïve benchmark portfolio would have experienced slightly higher volatility than investment-grade bonds, historically, but a much better return-to-volatility ratio. In short, history strongly suggests it is possible to raise the yield of an income portfolio without taking on substantially higher volatility.

Investors able to access additional diversifying strategies, including alternative risk premia, can improve the risk profile of an income-oriented portfolio even further.

Alternative risk premia are exposures to risk “factors” such value, momentum and carry, which, if captured in isolation, have been shown to be both compensated and highly diversifying against traditional stock, bond and inflation-sensitive investments.1

In order to capture the factors and include them in a multi-asset income portfolio, an asset manager generally needs to use alternative investment techniques such as shorting (to isolate the factors using long/short strategies) and derivatives (to make strategies capital-efficient enough to benefit from their strong diversifying characteristics without reducing overall portfolio income). Where suitable, investors able to adopt these sophisticated approaches can make alternative risk premia a powerful tool for managing the volatility of higher-yielding income portfolios.

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Managing Asset Allocation Dynamically

Diversification is not only beneficial in itself. When asset classes perform differently over time it creates opportunities for tactical and dynamic asset allocation. Figure 6 shows how the relative yields available on different income asset classes are constantly changing rank—and note that these year-end yields do not capture the windows of opportunity that open briefly during bouts of market volatility.

For these reasons, we believe yields from a multi-asset income portfolio can be maintained and returns significantly enhanced by opportunistic asset allocation informed by top-down views on business and credit cycles, as well as bottom-up security selection within one’s chosen asset classes.

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Should REITS investors worry about rate hikes?

Although listed real estate can be shown to exhibit genuine real-estate returns over a medium-term holding period, historically, the broad-equity market return has been around 75% predictive of REIT returns over shorter time horizons, and beta has been high over recent years. With this in mind, some investors express concern that, should interest rates continue to rise from their very low current levels, the prices of risky assets in general, and income-generating assets such as real estate, in particular, are set to decline. By contrast, we note that, even over short, one-year periods, four of the past five rate-hiking cycles have in fact been rather positive for real-estate securities. This was the case even in 2000, when rate hikes accompanied the major sell-off of the dotcom crash.

Figure 4: Listed Real Estate Has Performed Well During Many Past Periods of Rate Hikes

Returns during Calendar Years that Include More Than One Rise in the U.S. Federal Funds Rate

Source: Bloomberg. The x axis shows the number of rate rises, and the resulting change in the Fed Funds Rate, in percentage points. The chart shows total returns. Government Bonds are represented by the Barclays U.S. Government Index, Equities by the S&P500 Index and REITs by the FTSE NAREIT All Equity REITs Index.

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Conclusion

Today, yields from the investment-grade bonds at the heart of traditional income portfolios are simply too low to allow most individual savers to maintain their cash flows and lifestyles. Low yields also increase the risk of substantial capital loss: the higher bond prices are, the further they can fall, and the more sensitive they become to changes in interest rates.

In this environment replacing a portion of a traditional investment-grade bonds portfolio with some alternative sources of income begins to make sense for some investors. While this can add to portfolio volatility it is important to remember that the process does not simply add risk, but rather exchanges one type of risk for a range of others. Because these other risks are mutually diversifying, much of the additional volatility of the individual exposures can be diversified away and the overall portfolio’s yield-to-volatility ratio can be substantially improved.

In this paper we have briefly outlined some of the alternative income-generating assets available to investors. Everyone will bring their own parameters, preferences and tolerances to the challenge, and many will seek out well-designed, dynamically managed multi-asset income solutions rather than attempt to pull these exposures together themselves.

We do believe that every investor needs to consider how to adapt to today’s low-rate fixed income environment. Investment-grade bonds will still meet some investors’ specific requirements. But for many others, adding an alternative approach to income-generation will be a much better option—and, as we have seen, there are alternatives available.

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