After another tumultuous year for investors, the benefits of diversification and asset allocation have never been clearer. Last year was brutal for most investors. The U.S. equity markets fell for the third straight year, which has only happened twice since 1926, the last time in 1939-1941. There is still a great deal of uncertainty about when the market will recover. However, history has shown that by creating a diversified portfolio and allocating a portion of its assets to real estate investment trusts (REITs) and natural resources equities — companies that invest in so-called “hard assets” — an investor can increase long-term expected returns while decreasing the portfolio’s overall risk.
Investors who maintained an asset allocation with exposure to natural resources and real estate equities were able to cushion the blows dealt by the equity markets in 2002. The S&P 500 Index, a blue-chip stock index and market proxy, lost 22.2% last year. Energy and natural resources stocks outperformed the overall market, with the average natural resources mutual fund returning -0.7%. Real estate stocks also outperformed the overall market, with the average real estate mutual fund returning 4.2%.
Natural resources outperformed the market for a few reasons. Consumer demand for energy in the United States grew in 2002 by 0.8% despite rising prices caused by the possibility of war with Iraq and the general strike in Venezuela. Oil prices rose from $18 per barrel at the beginning of 2002 to $31 per barrel by the end of the year, and have moved as far as $40 per barrel in early 2003, yet demand has not subsided. Rises in energy prices were not enough to deter us from changing our spending habits on energy as we continued to keep our thermostats up during the winter and fill up our gas-guzzling SUVs.
Demand for energy is considered inelastic, meaning that as energy prices rise, consumer demand is not proportionately affected. Products with inelastic demand are products that consumers do not just want to have — these are products they need to have. Conversely, products with elastic demand, such as luxury items, did not fare as well in 2002 because consumers slowly reeled in discretionary spending. For example, 2002 was a good year for discounters such as Wal-Mart and Kohl’s, both of whom saw their revenues rise by double digits. However luxury goods businesses, such as Tiffany and Movado, saw both revenue and income decline.
Energy companies are able to reap benefits from inelasticity. Unfortunately, most energy suppliers ended 2001 with larger than normal inventory and were forced to reduce profit margins during the first nine months of 2002. As the overcapacity dried up, profits shot up. According to the Energy Information Administration, major energy companies saw their bottom lines rise by 296% in the fourth quarter of 2002 compared with the fourth quarter of 2001.
Many natural resources funds invested in precious metal stocks, whose values have increased this year. The value of gold has jumped from $278 per ounce in the beginning of 2001 to $343 per ounce by the end of 2002. Precious metals mutual funds were the top-performing mutual fund category of 2002, with the average fund returning more than 60%. In 2002 and in early 2003, investors moved money out of the stock market and purchased metals because of political concerns and confidence issues.
The real estate markets achieved positive returns in 2002, with the decrease in interest rates encouraging consumers to buy new and refinance existing homes. Also, as Americans continued their post-9/11 nesting in 2002, they spent more money on home improvements. Because of this spending, the value of single-family residential real estate increased accordingly.
While REITs do not invest in single-family homes, they outperformed the stock market in 2002 as investors sought less risk and higher yields. Retail and industrial properties outperformed the overall real estate market as a result of consumer spending. REITs specializing in retail real estate led their category, returning 21.1% in 2002, while industrial REITs returned 16.9%.
That Was Last Year; What About The Future?
At Palisades Hudson Asset Management, Inc., we typically allocate 10% of client equity portfolios to natural resources and real estate equities. The historic performance of natural resources and real estate equities has a low correlation to the broad equity market’s performance. The current geopolitical climate may have harmed the economy, but has had the opposite effect on natural resources. This is reminiscent of what occurred in the late 1970s and early 1980s, when oil prices hit $35 per barrel. For perspective, $35 in 1981 dollars is $69 in 2002 dollars but oil hasn’t reached that price because inflation is low. Still, the value of oil will increase during inflationary times.
As for real estate, Ibbotson Associates — an investment data research company — conducted a study demonstrating that not only is the statistical correlation between REIT returns and common stock returns low, it continues to decrease with time. Two items that move in the same direction will have a statistical correlation of 1, while two items whose movements are completely unrelated will have a correlation of 0. According to the study, the average REIT performance’s correlation to the domestic large-cap stock market declined from 0.64 during the 1970s to 0.45 during the 1990s.
While real estate prices may fluctuate, REITs pay income that typically meets or exceeds that of intermediate-term bonds. This high income helps stabilize the annual returns. The monthly rent collected by most REITS will tend to rise with inflation over time while the coupons of intermediate-term bonds tend to be fixed.
In an environment where interest rates increase due to a strengthening economy, real estate prices should not be adversely affected as more consumers seek to upgrade their current homes and more first-time homeowners emerge. But, if interest rates rise as the Fed fights inflation during a weak economy, real estate prices may fall. The current interest rate compared with the rate of inflation impacts the change in real estate prices. If interest rates are higher than inflation, investors will choose to invest their cash in bonds and worry less about inflation. But, if interest rates are lower than inflation in a weak economy like 2002, investors will seek the safety of hard assets to maintain purchasing power.
It is important to note that owning a house, even if it is your largest asset, is not a substitute for real estate stock. Owning a house is like owning an illiquid, single stock position. A house does not provide diversified exposure to the real estate market. On the other hand, REITs do. REITs tend to specialize in one or two types of properties such as shopping malls, apartment buildings or office buildings. They provide income to shareholders by distributing rental income received from the users of their real estate assets. At Palisades Hudson Asset Management, Inc., we invest a portion of our clients’ assets in real estate mutual funds, which are diversified portfolios of REITs.
Don’t Run To The Jeweler
While gold was a clear winner in 2002, we do not endorse loading up on the pretty metal. Unlike oil, gold is not consumable. The same exact bar of gold that existed 30 years ago still exists today, in one form or another. In fact, the global amount of the metal increases each year as more gold is mined, but not destroyed. Its commercial use is mostly limited to jewelry. It also is used in dentistry and some electronics fabrication, but these commercial uses are small and have limited growth potential.
Gold no longer has a role in commerce as a means of exchange the way dollars or euros do. As central banks moved away from the gold standard during the first 70 years of the 20th century, they did not dump all of their gold reserves onto the market. Thus, central banks still control approximately one-fourth of the world’s gold holdings. The central banks, often in cooperation with each other, sell portions of their holdings while being careful not to flood the market. Commodities with little consumption potential and a few owners with concentrated positions do not make good investments.
Over the last three years, we have heard sad stories about investors with concentrated portfolios who saw their assets vanish before their eyes. We also heard about undisciplined investors chasing recent-high-performance assets, such as gold. When the market recovers, gold-heavy investors will learn the same lesson that the Enron and WorldCom investors of 2002 learned. Disciplined investors didn’t panic in 2002 and maintained their asset allocations. They did not suffer losses similar to those with concentrated portfolios, and they are well positioned for a market recovery. It is possible that real estate and natural resources equities may decline as the market recovers and investors shift assets back to more growth-oriented stocks. But by maintaining a diversified asset allocation, including portions in real estate and natural resources, investors will see better long-term returns than investors who avoid them altogether or who over-allocate to last year’s hot commodity.