Mind the Gap in REITs

Executive Summary. Portfolio diversification is a fundamental tenet of modern portfolio theory. Statman and Scheid (2008), however, argue that while correlation is the common indicator of diversification, correlation coefficients alone do not provide an intuitive indicator of diversification benefits. The authors demonstrate that portfolio diversification also depends on the standard deviation of asset returns and introduce the idea of return gap. Return gap is basically a gap between the returns of two assets. Statman and Scheid (2008) conclude that “the relative ranks of assets by benefits of diversification are quite different when measured by correlation and by return gap.” I investigate this claim in the U.S. real estate investment trust (REIT) industry using monthly data from January 1994 to December 2014. I find that, while correlation coefficients suggest little diversification benefits within the REIT sector, return gaps indicate that there still is scope for diversification across REITs, even during down markets and periods of financial crisis.