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Industry Voices

Commentary: Improving diversification of target-date funds with direct real estate

As target-date funds move to the mainstream of retirement investing, there have been notable innovations.

One new allocation for plan sponsors to consider, adding direct real estate investments to target-date funds, offers the potential to improve outcomes. Our research has shown that adding even just a 5% allocation to direct real estate improved risk-adjusted returns and retirement accumulations in most scenarios.

Until recently, no target-date mutual fund offered exposure to direct real estate. For those target-date funds that include real estate exposure, nearly all invest in shares of publicly traded real estate investment trusts, which generally have similar returns and volatility to other equities.

Adding direct real estate as an allocation, may offer four key advantages for multiasset portfolios:

A track record of higher risk-adjusted returns

Returns in direct real estate tend to be more stable than stock returns because income, derived from long-term property leases, represents a much larger proportion of total returns. As a result, real estate's income returns have been largely consistent over market cycles, even during periods of extreme market turmoil. Despite low volatility, direct real estate has outperformed most asset classes over the long term (Figure 1).

Direct real estate outperformed both equity and fixed income by wide margins for the 20-year period ended Dec. 31, 2016, based on absolute returns. Although REITs' absolute returns outperformed by 36 basis points, direct real estate had higher risk-adjusted returns (0.55 vs. 0.40). This is mostly the result of its lower volatility.

Figure 1:
Performance, volatility and risk-adjusted returns
Annualized performance for the 20-year period ended December 31, 2016.
U.S. equitiesNon-U.S. equitiesU.S. bondsDirect real estateREITs
Annualized returns7.86%5.05%5.29%9.31%9.67%
Standard deviation of returns18.4621.863.6311.3719.59
Sharpe ratio0.310.170.430.550.40
Asset classes reflect returns for the following indexes: Russell 3000 (U.S. equity); MSCI ACWI-ex USA IMI (non-U.S. equity); Bloomberg Barclays U.S. Aggregate Bond (U.S. bonds); NCREIF Property Index-Open End Funds (NPI-OE) (direct real estate); NAREIT All Equity REITs (REITs). Performance for indexes does not reflect investment fees or transaction costs.
Source: Macrobond

Potential for greater diversification, lower correlation

Direct real estate has low correlations with traditional asset classes. As private investments, direct real estate is less correlated to market movements than publicly traded vehicles, such as REITs. It also can serve as a natural hedge against inflation, as commercial rents and property values are highly correlated to rising prices.

Figure 2 shows direct real estate's correlations of 0.23 and 0.12 with U.S. and non-U.S. stocks, respectively, and a negative correlation (-0.03) with U.S. bonds. The correlations with stocks are significantly lower than REITs' correlations with stocks.

Figure 2:
Correlations between direct real estate and major asset classes
For the 20-year period ended December 31, 2016.
Non-U.S. equitiesU.S.
Direct real estateREITs
U.S. equities1.000.84-0.340.230.45
Non-U.S. equities0.841.00-0.470.120.41
U.S. bonds-0.34-0.471.00-0.030.09
Direct real estate0.230.12-

Managing liquidity

Private investments in direct real estate are relatively illiquid — the source of its low volatility and low correlation advantages. Nonetheless, fund managers can rely on net cash inflows from defined contribution plan participants for monthly rebalancing to target allocations. In addition, affiliated real estate managers working closely with target-date fund managers can reduce the level of REITs and/or cash required for daily liquidity to 5% or less, allowing a higher level of direct real estate exposure in target-date funds.

Boosting potential outcomes while reducing risk

To assess the outcomes of a 5% direct real estate allocation, we ran Monte Carlo simulations to see how funds might perform in different scenarios.

We found the 5% allocation increased total savings by more than $2,500 for the median simulated outcome. Diversification benefits were even greater under poor market performance scenarios, as simulated downside outcomes improved by nearly $5,000.

When equity markets performed very well, however, the outcome was more than $2,500 lower for portfolios with direct real estate. This is because direct real estate replaces a portion of equity exposure, which tends to outperform in bull markets. Investors give up some of the potential upside for better overall outcomes and reduced downside risk.

In sum, direct real estate allocations within target-date funds demonstrate a record of high returns, low volatility and low correlations. This suggests they have the potential to provide superior portfolio diversification than public REITs, the dominant form of real estate exposure in target-date funds at present.

John Cunniff is TIAA-CREF Lifecycle Funds portfolio manager with TIAA Investments and Alice Breheny, Global Head of Research, TH Real Estate. TIAA Investments and TH Real Estate are both units of Nuveen. This content represents the views of the author. It was submitted and edited under P&I guidelines, but is not a product of P&I's editorial team.