New Morningstar Analysis Shows the Optimal Allocation to REITs
September 29, 2021 | John Worth
A new Morningstar Associates analysis, sponsored by Nareit, found that the optimal portfolio allocation to REITs ranges between 4% and 13%. The Morningstar analysis came on the heels of another Nareit-sponsored analysis by market research firm Chatham Partners demonstrating that financial advisors understand the importance of meaningful REIT allocations – irrespective of the client’s age – from early career through retirement.
Morningstar Analysis: The Role of REITs in Asset Allocations
As illustrated in Chart 1, the Morningstar analysis shows that the inclusion of REITs in a portfolio may increase the return for a given level of risk. The following table depicts five portfolios targeting different levels of risk. For example, a moderate portfolio targeting a 10% standard deviation and 4.4% return allocates 7.5% to REITs, and an aggressive portfolio targeting a 14% standard deviation and 5.8% return is estimated to have a 13% REIT allocation.
In this analysis, Morningstar used Black-Litterman methodology, a mean-optimization methodology well respected by the institutional investment community. Portfolio managers use this methodology as a tool to understand how to optimally allocate investments across different asset classes. The Black-Litterman model is an extension of mean-variance optimization, which asserts that an investment’s risk and return characteristics should not be viewed alone, but be considered based on how the investment impacts the overall portfolio’s risk and return. Black-Litterman seeks to avoid the often extreme unconstrained portfolio allocations that result from mean-variance optimization. The Black-Litterman approach produces stable, optimal portfolios based on an investor’s insights. Using the Black-Litterman mean-variance optimization, the table identifies efficient asset mixes that provide the greatest expected return for a given amount of expected risk. The inputs used are based on Morningstar Investment Management’s assumptions.
