WASHINGTON, DC-In research commissioned by NAREIT, Morningstar has answered a nagging question since the crash and recession—whether or not REITs correlate with larger market equities and bonds. The answer, not surprisingly, is a complex one, but the primary finding is that they do not and that REIT dividends tend to smooth out the worst of the market turmoil.

Correlation, or more appropriately the lack thereof, is an essential part of a well-rounded, diversified, investment strategy. It means that REIT returns do not move in tandem with stock or bond returns. So when the equities and/ or bonds drop, REITs can be expected to increase or at least stay steady.

And the short-form answer is . . . that the study reinforced the importance of REITs in maintaining portfolio diversity, says Michael Grupe, executive vice president of Research and Investor Outreach at NAREIT. “They are important even, or rather especially, if you are trying to build a portfolio to provide added protection from extreme downside risk.”

This question of correlation is a key one for the industry; it is a truism on which countless investment managers have based their allocation advice and on which income-investors have relied. During the depth of the downturn, many investors and investment advisors concluded that REITs do correlate—as in they were sinking as much as the larger stock market was. It was widely believed that REITs would provide protection against larger market selloffs, Michael Grupe tells GlobeSt.com.

“However, investors didn’t experience that when the crash came, and it caused a fair amount of consternation,” he says. “It also raised in the minds of many investors and advisors the question of whether they were looking at allocation appropriately and effectively.”

Morningstar approached the question by developing alternative approaches for building diversified portfolios and identifying appropriate asset allocations using methodologies that were different than the standard ones. Those assumed so-called normal distribution of returns and used methodologies that were designed to take into account the occurrence of the significant sell offs.

One finding, Grupe says, is that very low returns or frequency of extreme market events on the downside happens more often than people expect. Between January 1926 to April 2009, the S&P 500 Index posted 10 monthly losses greater than 15.74%, or eight times more often than an investor would expect based on the normal distribution of returns assumed by many investment strategists and their models.

The role dividends play was also found to be important—indeed key to maintaining a stable portfolio return. The portfolio allocations suggested by the historical portfolio optimization run by Morningstar improved annualized long-term total returns by 60 basis points for a risk-averse investor portfolio (from 7.6% to 8.2%) and by 30 basis points for the moderate-risk investor portfolio (from 9.4% to 9.7%).