Historically low correlations (see matrix below) among real estate investment trusts (REITs) and other asset classes would suggest that they have potential diversification benefits within a globally diversified portfolio. Although REITs have generally been more volatile than stocks in the past, including a separate allocation to them would have actually helped to reduce the risk of your overall portfolio.
Correlation Matrix: January 1998–December 2011
Sources: Dimensional Fund Advisors, Morningstar EnCorr
As with any discussion about asset allocation, the optimal amount of REITs to include in a portfolio is more art than science – there is no hard and fast rule. Here is what some industry experts have suggested in the past:
I would generally consider starting with 10% of your stock allocation; whatever your portfolio allocation to stocks, carve out 10% from that amount and allocate this portion to Canadian, U.S., and International REITs. In the example below, I’ve taken the historical returns of a typical balanced “Couch Potato” portfolio (Portfolio 1: 40% bonds, 60% stocks) and carved out 10% of the stock allocation (or 6%) and allocated it evenly between three REIT indices (Portfolio 2: 40% bonds, 6% REITs, 54% stocks).
With a modest addition of REITs to the portfolio, the overall return actually increased (5.4% versus 5.2%) while the standard deviation decreased (8.0% versus 8.2%).
If you decide to include REITs as a separate asset class in your overall portfolio, understand that there may be lengthy periods when REITs will underperform the broad stock market; it is at these times that you will need to avoid any knee-jerk reactions and stick to your original investment plan.
For Canadian investors, caution should be exercised when trading international ETFs. Asian and Australian markets are not open during our trading hours, which results in an incomplete price discovery mechanism for a significant portion of stocks held by the ETF.
So what is an investor to do?
The best option would be to trade during the open market hours where the majority of international stock exchanges overlap the U.S. stock exchange.
In the table below, I’ve illustrated the overlap in market hours for a number of global stock exchanges (shaded in dark grey). Using the Vanguard International Stock Market ETF (VXUS) and the Vanguard FTSE All-World ex-US ETF (VEU) as examples, you can see that approximately 55% of the country stock exchanges represented in the ETFs overlap the U.S. exchange between 9:30 am and 11:30 am (ET).
World Stock Market Trading Hours: 9:30 AM – 4:00 PM (ET)
Sources: World Federation of Exchanges, Vanguard Group as of March 31, 2012
Although not a perfect solution, the following “rules of thumb” could be considered for Canadian investors transacting in International ETFs:
Rules of Thumb