(PUB) Investing 2015

REITS Where’s the Diversification?

not moved in lockstep. For instance, in February and April when REIT Index sold off, down 3.6% and 5.9%, respec- tively, Global ex-U.S. Real Estate Index gained ground, returning 3.5% and 5.6%, respectively. The reverse occurred in July and September as the foreign fund declined and the domes- tic fund gained ground. Those months where the funds went in opposite direc- tions helped smooth the ride for the 50/50 portfolio. I am not writing off Global ex-U.S. Real Estate Index yet. The past five years have favored U.S. financial assets in a big way— Total Stock Market has grown 14.0% a year for the past five years, while Total International Stock

IT’S BEEN A LACKLUSTER first five years for Global ex-U.S. Real Estate Index . Investors in the fund, which launched on Nov. 1, 2010, have sacri- ficed returns when diversifying away from REIT Index —and have only recently seen a small reduction in risk. Anyone who expected more in the form of diversification has been disappointed. Any way you slice the data, in a head-to-head comparison, REIT Index has dominated Global ex-U.S. Real Estate Index. Since inception, the latter’s 28.0% return trails REIT Index’s 74.3% gain. But it’s not just about the returns; REIT index has delivered those supe- rior returns with equal or lower risk— depending on how you want to calculate it. Over the past five years, both real estate index funds had a standard devia- tion (a measure of volatility) of 16%. That’s what I call the “Greek alphabet” of risk. But what about how risk impacts your portfolio’s value? Let’s consider rolling returns. Twelve-month returns for the global fund have ranged from -16.7% to 41.5% compared to a range of 0.3% to 33.3% for REIT Index. So, at its worst, investors suffered double-digit declines over a 12-month period in the foreign fund, but never a single losing year in the domestic fund. Another way to look at risk is the maximum drawdown since incep- tion. Global ex-U.S. Real Estate Index dropped a full 21.7% between April 2011 and September 2011, while REIT Index’s worst decline over the same period was just 17.5%. It’s a given that there will be years when overseas real estate investments will underperform those in U.S. mar- kets, so that alone isn’t the disappoint- ment. It is entirely possible Global ex-U.S. Real Estate Index will win out over the next five years. Where Global ex-U.S. Real Estate Index has disap- pointed is as a diversifier. Consider a 50/50 mix of the two real estate funds. Over the past five years, the 50/50 mix returned 49.4%, lagging

Going Global Hasn’t Muted Risk

0%

-5%

-10%

-15%

-20%

REIT Index Global ex-US REIT Index 50/50

Max Cumulative Loss

-25%

3/11

9/11

3/12

9/12

3/13

9/13

3/14

9/14

3/15

9/15

REIT Index because the global fund underperformed. No surprise there. But at the very least, the 50/50 investor might have expected a smoother ride. Alas, that wasn’t the case: As you can see in the max cumulative loss chart above, over the past five years, REITs have seen three separate corrections, or draw- downs, of at least 10%, and only once has there been a diversification benefit to holding both real estate funds. The first correction, which I mentioned above, hit its low point in September 2011 and saw the 50/50 portfolio decline 19.4%— worse than REIT Index. The second cor- rection saw REIT Index decline 13.4% from April 2013 to August 2013. Over that stretch, Global ex-U.S. Real Estate Index fell 13.8% and the 50/50 portfolio declined 13.6%. Not much diversifica- tion benefit there, either. The two real estate funds are pres- ently working their way out of a third correction. However, this time around, the 50/50 blend is holding up better than either fund is individually. REIT Index hit a recent drawdown of 13.1% between January 2015 andAugust 2015. Global ex-U.S. Real Estate Index hit a low decline of 12.9% from April 2015 through September 2015. Meanwhile, the 50/50 portfolio only hit a maximum decline of 9.5% in August—better than either of the two components. How did this happen? Well, over the past 10 months, the two funds have

Any way you slice the data, REIT Index has dominated Global ex-U.S. Real Estate Index.

only grew at a 2.6% pace. When we see that trend reverse, holding Global ex-U.S. Real Estate over REIT Index could look smart, though I’m doubtful that anyone is going to simply trade in all their REIT Index shares for an investment in the global fund. Vanguard never intended that you choose between the two. Their argument was that add- ing non-U.S. real estate holdings was a smart diversifier. Unfortunately, the past five years have mirrored the longer-running his- torical index returns I looked at before the foreign fund’s launch. Even then, I found that adding foreign real estate to a position in REIT Index reduced risk a bit. However, the reduced risk didn’t make up for the returns you had to sacrifice. Unless you are a diehard global diversifier, I wouldn’t rush to diversify away from REIT Index. I continue to rate the fund a Hold. n

The Independent Adviser for Vanguard Investors • November 2015 • 7

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