I'm writing this article on REITs today because of some great questions that have come from the participants of our Asset Allocation seminar. These folks are smart, interesting people, and they've been a lot of fun to interact with on the Asset Allocation discussion board. Through some of their questions, they've reinforced a thought that I discussed in my last article, which is that puny interest rates are forcing many to get a bit more creative in their search for income.

Of course, many of the seminar participants are also interested in REITs for their diversification benefits, ability to reduce volatility, and the market-trouncing returns they've produced over the past several years. So, all in all, I thought this would be a good time to discuss the REIT hopes and concerns of some members of our vibrant Fool Community.

Why REITs?
Like some of our seminar participants, you may be asking yourself, "Self, why should I be investing in REITs at all?" Well, first off, equity REITs have had an average annual return of about 12.6% over the past 30 years, which beats the S&P 500's 12.2% -- not bad. But that's an all-REIT portfolio vs. an all-stock portfolio, which really isn't what we're looking for.

That's where a study by Ibbotson Associates comes in handy. Ibbotson compared the 30-year return of a non-REIT portfolio (33% stocks, 52% bonds, 15% T-bills) with that of a portfolio including 10% REITs (35% stocks, 40% bonds, 15% T-bills, 10% REITs) and one including 20% REITs (37% stocks, 28% bonds, 15% T-bills, 20% REITs). The results are in the chart below:

      Total Annualized Return Per Level of Risk
    1      2     3      4       5      6
    No REITs  10.7%  11.7%  12.2%  12.7%  13.1%  13.5%10% REITs 11.2   11.9   12.4   12.9   13.4   13.820% REITs 11.5   12.1   12.6   13.1   13.6   14.0Risk*      9.0   10.0   11.0   12.0   13.0   14.0
*as measured by standard deviation
Source: Ibbotson Associates

As you can see, a diversified, average-risk portfolio including 10% REITs beats the non-REIT portfolio by 0.2% annually, whereas the portfolio containing 20% REITs beats the non-REIT portfolio by 0.4% annually. That may not sound like much, but over 30 years those little tenths of a point could mean thousands of dollars.

It gets better: Adding REITs to a portfolio not only increases returns, but it reduces volatility. This is possible because the correlation between most major REIT indexes and the S&P 500 is very low (approximately 0.16), meaning REITs tend to move fairly independently of stocks. The correlation between REITs and investment-grade bonds tends to be even lower (approximately -0.20). These attributes make REITs an excellent tool for diversification purposes.

Making it happen
For those investors who would like to make some headway in this sector but just can't seem to find that perfect office space renter, shopping mall developer, or apartment community owner, there are some solid investments that provide all the benefits of this asset class along with an adequate level of diversity.

There are quite a few REIT mutual funds that will help you achieve the diversification goal. However, like most mutual funds, their higher management fees tend to leave them underperforming the indexes. That's why I generally prefer REIT Exchange-Traded Funds (ETFs) to REIT mutual funds. Specifically, the average mutual fund expense ratio for the class is a little over 1.6% vs. a typical ETF ratio of about 0.32%.

Now, it's important to note that this argument for ETFs assumes you'll be making your investment in a single transaction (or at least in only a few), as opposed to building a position over time. This is due to the fact that ETFs trade throughout the day like stocks, which means you'll have to pay a commission for each purchase. Still, you'll almost certainly come out ahead with ETFs in the long run because of the significant fee savings and their superior total returns.

Two of my favorite REIT ETFs are the iShares Cohen & Steers Realty Majors Index Fund (AMEX:ICF), and the streetTRACKS Wilshire REIT Index Fund (AMEX:RWR). The iShares fund has a current yield of about 5.8%, and an expense ratio of just 0.35%. If you'd like to see what's under the hood, check out the fund's current holdings. The streetTRACKS ETF (.pdf file) has a current yield of about 5.1%, and a paltry expense ratio of 0.25%. Both of these ETFs are only a couple of years old, but the indexes that they track have been around for some time and have outperformed most REIT mutual funds.

The iSharesDow Jones U.S. Real Estate Index Fund (AMEX:IYR), which has a current yield of about 5.7%, is also worth a look. However, this fund's expense ratio tops out at 0.60%, which brings its total returns below those of the ETFs mentioned above.

If you just can't resist the lure of a mutual fund, or you need to invest smaller sums on a regular basis, stick with an index fund. In this category, check out the Vanguard Real Estate Index Fund (NASDAQ:VGSIX), which is currently yielding about 5.9% and has an expense ratio of just 0.28%. This indexer would make a solid addition to your portfolio, but, again, its total returns have been slightly below those of the ETFs mentioned above.

Tax REITlief
Unfortunately, because REITs avoid paying income taxes -- as long as they distribute at least 90% of their earnings to shareholders -- most of the recent tax breaks won't apply to them. However, with REIT yields at current levels, their after-tax returns still exceed many alternatives. And, though there may be some individual tax considerations, you can always take full advantage of the dividends by placing REITs in a tax-advantaged account.

Overall, REITS offer a great opportunity to further diversify your portfolio and produce current income -- two benefits that should appeal to just about everyone. Thanks again to our Asset Allocation seminar participants for all the great questions, and, of course, just for being such cool folks.

Be sure to tune in next week when I'll offer some unique REIT investments that are somewhat insulated from typical real estate woes.

Fool On!

Mathew Emmert thinks Fool editor Bob Bobala was lying when he said, "Nah, it doesn't rain that much here in D.C." If you're looking for him, he'll be loading animals on a large wooden boat, two by two. He doesn't own any of the investments mentioned in this article. The Motley Fool has a disclosure policy.