"The time to repair the roof is when the sun is shining."
– John F. Kennedy

Financial advisors have been preparing their roofs for rain, in the form of rising interest rates, ever since the end of the financial crisis. Many have put the rafters in place by shortening duration in their fixed income sleeves, but they’ve ignored the impact of rising rates in their equity and alternative sleeves and, in doing so, have left off the shingles and gutters.

Since March 2015, the Portfolio Consulting Group has performed comprehensive reviews of more than 500 models to help advisors plan for the possibility of adverse weather conditions. As part of these reviews, we have collected and analyzed data about how advisors construct models for their clients. Two key findings:

  1. Rising interest rates are the most often cited market concern.
  2. Real estate is the most commonly used dedicated equity sector or alternative asset.

These two observations have contradictory implications.

When seeking to protect models from rising rates, advisors often focus solely on fixed income while ignoring the equity and alternative sleeves of their portfolios. While 91% of models we reviewed use fixed income to hedge rising rates by being short duration,1 40% of advisor models allocate to a dedicated real estate strategy in either the equity or alternative sleeve. Given real estate’s potential underperformance during periods of rising interest rates, advisors may benefit from reconsidering the role of real estate in the equity and alternative sleeves to better address model objectives in this environment.

Real Estate as an Equity: Overexposed and Historically Underperforms in Rising Rate Environments

First, it is important to note that real estate is a GICS sector with a 2.7% weight in the S&P 500 Index,2 so a dedicated allocation to the sector can easily cause an unintentional overweight. The average advisor model we reviewed has a real estate sector weight of 5.9%, more than double the S&P 500’s exposure. Of the 40% of advisor models that include an explicit real estate strategy, the average real estate sector weight rises to 9.1%, more than triple the S&P 500’s exposure. We believe that advisors gravitate toward real estate because of its yield potential relative to more traditional fixed income and equity, causing an overweight to the sector.

Second, because it is a high-yielding equity sector, real estate carries sensitivity to interest rates and has the potential to underperform when rates rise. To prove this point, during three recent periods of rising rates, real estate underperformed both equities and fixed income. Exhibit 1. To align an equity portfolio with the expectation of rising rates, advisors should consider sectors that have historically benefitted when rates have risen, such as Financials and Industrials.

Real Estate May Underperform Equities and Fixed Income When Rates Rise

Source: Morningstar, as of 4/30/18. The indices are unmanaged, and cannot be purchased directly by investors. Index performance is shown for illustrative purposes only and does not predict or depict the performance any investment.

Real Estate as an Alternative: Boosting Volatility and Correlations

Advisors most frequently state that the objective of their alternative sleeve is to act as a volatility dampener and a diversifier. Real estate struggles on both fronts:

  1. Real estate has exhibited 50% higher volatility than equity benchmarks over the last 10 years.3 When 5% of a 60/40 model was reallocated from equities to real estate, the model’s volatility increased.4
  2. While, in our view, alternatives should diversify a model from equities, it is important to remember that they should diversify away fixed income risk as well. Real estate has had an average 5-year rolling correlation of 0.51 to equity markets,5 but what may surprise some advisors is that real estate’s correlation to bonds has been even higher over the last three years. Exhibit 2.

Correlations Between Real Estate and Fixed Income Have Increased in Recent Years

Sources: OppenheimerFunds and FactSet, as of 3/31/2018. The indices are unmanaged, and cannot be purchased directly by investors. Index performance is shown for illustrative purposes only and does not predict or depict the performance any investment.

As a solution, owning an alternative strategy, such as an absolute return fund with a flexible mandate and strong track record in choppy markets, may make sense. For a more traditional alternative, counter-cyclical assets, such as gold, may serve advisors well.

What About the Fixed Income Sleeve?

As discussed, advisors often ignore the equity and alternative sleeves when constructing models to protect against rising rates, and instead have looked to fixed income to address this concern. As a result, the average advisor model in our analysis is underweight duration by 1.8 years relative to the Barclays US Aggregate Bond Index duration of 5.9 years.

Ironically, fixed income is where advisors should consider taking interest rate risk because it can create ballast to mitigate volatility. Duration typically performs well when equity markets sell off as rates tend to fall in response.

Overall, advisors are justified in preparing for rising interest rates. Global economic growth is strong and the Fed has indicated that it will continue on a rate-tightening path. While we suggest caution, we also acknowledge that real estate can play an important role in a portfolio, and may fulfill yield and capital appreciation objectives. When addressing the potential for rising rates, we believe advisors should take a holistic approach with their model exposures and carefully consider the effects of real estate moving forward.

  1. ^Relative to the Bloomberg Barclays US Aggregate Bond Index.
  2. ^S&P 500 Real Estate GICS sector weight is as of 4/30/18.
  3. ^As of 4/30/18, the 10-year annualized standard deviations of the FTSE NAREIT Equity REITs Total Return Index, S&P 500 Total Return Index, and MSCI AC World Net Return Index are respectively 24.8%, 14.9%, and 16.6%.
  4. ^60/40 Benchmark refers to a blend of 60% S&P 500 Total Return Index and 40% Bloomberg Barclays US Aggregate Bond Index.
  5. ^Real estate is represented by proxy as the FTSE NAREIT Equity REITs Total Return Index.