WHETHER YOU'RE MANAGING

Stocks are one asset class most people are familiar with. And as a result of the recent run-up, more investors are now getting into bonds as well. But there's another major asset class that's routinely overlooked even by most financial professionals. Hard assets not only increase diversification, but can boost returns as well.

According to a 1999 study by Ibbotson Associates, adding hard assets to a diversified portfolio has historically increased returns while reducing risk. That's largely because hard assets (more about just what these are in a moment) are noncorrelated with the stock market. In other words, when the Dow zigs, hard assets tend to zag. And although hard assets are traditionally seen as suitable only for high rollers, the research demonstrates they can benefit both low- and high-risk portfolios alike.

In the Ibbotson study, adding a 10% allocation of hard assets boosted the low-risk portfolio's expected return to 8.6% from 8.1%. More aggressive investors tend to do even better: A 25% allocation to hard assets boosted a high-risk portfolio's expected return to 14.1% from 13.3%. The most notable part is that returns were bettered even as risk was reduced. In all cases, adding hard assets to a portfolio bumps up its Sharpe ratio, which is a measure of a portfolio's return relative to its historical level of investment risk.

Hard assets encompass a wide range of investments. Loosely speaking, hard assets are nonfinancial assets. They're things you can touch, like real estate or gold, or use, like oil or copper. This week and next, I'll focus on two major categories. First, we'll tackle publicly traded real-estate investment trusts, known as REITs. In next week's column, we'll unpack commodities and commodity-related investments.

REITs were first created in 1960 as a way for small investors to own and invest in large-scale, income-producing real estate. Simply put, REITs are companies that are in the business of owning, and in many cases, operating, various forms of real estate. Some own apartments or warehouses. Others own hotels, timberland or even golf courses.

The idea makes sense. From their summer homes in Newport, R. I., to their exclusive private partnerships, wealthy individuals have benefited from owning property in more than one location for years.

Unfortunately, bought individually or through private partnerships, large parcels of real estate can be expensive, illiquid and difficult to manage. But just as mutual funds allow less sophisticated investors to get into stocks, REITs are one of the few ways where the little guy can effectively get in on the action in real estate.

Thanks to their recent outperformance and more widespread acceptance among individual and institutional investors alike, I am strongly of the belief that real estate will undergo the same democratization in this decade that stocks did in the 1990s or high-yield bonds did in the 1980s. The net result will be huge pools of new liquidity, higher prices and attractive returns.

Because REITs are legally required to pay virtually all of their taxable income out to shareholders, it's important to realize that a large part of their total return stems from the dividend yield, which is still on average well over 7%. From an asset-allocation perspective, this presents an attractive alternative to fixed-income investments, especially for the large population of aging baby boomers now looking for yield. REITs are the utility stocks of our generation.

Although they were all but forgotten in the late 1990s, dividends make a difference, as we've seen over the past few months. While many of us have grown accustomed to owning growth stocks that benefit from price appreciation alone, it was at one time routine for most stocks to pay dividends, offering yields even exceeding those of bonds. This was to compensate investors for the increased risk of having a subordinated claim on a company's assets. Indeed one of the elements the "long haulers" forget to mention is that over time, more than a third of a stock's historical return has come from its dividend yield.

REITs are a good idea in the abstract, but they are an especially good idea right now. As we always like to point out, the market moves in trends. Strong stocks tend to stay strong, and to say that REITs have been strong in recent months is an understatement. As measured by the National Association of Real Estate Investment Trusts', or NAREIT, composite index, REITs are now beating the S&P 500 on a one-, three-, five- and even 10-year compound annual basis. Equity REITs were up 26% in 2000 and have tacked on another 8% this year. And while refinancing your home may have saved you some dollars, you might have been better served by buying the companies that own the debt. Mortgage REITs, which we first pointed out last summer, are up 55% this year after rising 15% in 2000 and they still yield over 10%.

Sure, there are concerns about how real estate will fare in the recession we're almost certainly now experiencing. But all investing, even in so-called defensive sectors, involves taking a risk. The time to take that risk, especially in real estate, is now...when there is some element of uncertainty.

Consider the doubt that surrounded tech stocks in the early and mid-1990s. Skeptics questioned their exploding P/E ratios, their absent book values and, in many cases, their lack of a product altogether. None of that stopped the Nasdaq from gaining 39% in 1995, 22% in 1996, 21% in 1997, 39% in 1998 and 85% in 1999.

From a technical perspective, I see no indication that the run of the REITs may be ending. One of the most bullish signs is volume. Since the beginning of the year, the average daily dollar trading volume of the NAREIT composite has almost doubled, from $400 million to well over $700 million. Volume is often seen as a leading indicator for stocks and the major indexes. When accompanied by strong price action, a pattern of rising volume is a technically bullish sign.

And if $700 million worth of turnover seems steep (suggesting that it's likely to fall from here), consider that even at depressed prices, investors still regularly trade well over $1.5 billion worth of Cisco Systems each day. On a comparative basis, when it comes to daily turnover, I would suggest that REITS have room to grow.

The supply-and-demand picture is even more appealing. Standard & Poor's recent decision to include REITs in the S&P 500, S&P 400 and S&P 600 is a major move that not only legitimizes the asset class, but automatically directs billions of investment dollars its way. Despite over 40 years in existence and a very strong 24 months, there are still only 138 publicly traded REITs in the U.S. Fund managers who previously couldn't even consider REITs can now buy them without violating their mandates. Like a good Paul Simon song, they've got widespread appeal. REITs are for growth and value, large- and small-cap, speculative and safe investors alike.

And because more than 50% of the publicly traded REITs are clustered down in the smallest 20% quintile of market cap, a consolidation scenario is already beginning to unfold. In a free, competitive and peaceful marketplace, the big don't eat the small...they buy them. Just last February, industry giant Equity Office Properties bought Spieker Properties for $7.2 billion. Large investors will buy the big caps for liquidity purposes, but I suggest more money will be made by owning the small caps.

So has the REIT market topped out? Not in my book. Of the $6.5 trillion invested in mutual funds, just $10 billion is invested in REITS. As we pointed out a few weeks back, the message boards are still relatively quiet on the subject. There are no index options or futures currently traded on REIT indexes, and the exchange-traded funds that do track the sector remain among the most thinly traded. So with most people expecting the real-estate market to fall after its recent run-up, I'm of the mind it's just beginning to take off.

Next week: Commodities as an asset class.

Jonathan Hoenig is portfolio manager at Capitalistpig Asset Management, a Chicago-based hedge fund. At the time of writing, his fund was long shares of Equity Office Properties.