Index reconstitutions may sound like an esoteric subject. But they can
create market movements of interest, that might create profitable opportunities
and which challenge the logic of “efficient market” theory.
Such is the case with regard to changes in the
treatment of REITs in the major indices the S+P 500 and the MSCI total US stock
market index . The changes in the S+P 500 take effect at the close of business
Septermber 16, the MSCI changes around the same time
From the end of August,
real estate investment trusts (Reits) will no longer be classified as financial
stocks by the mighty index providers S&P and MSCI. Instead, real estate
will be designated as a sector of its own, ranking alongside financials,
information technology, telecoms, utilities and six others under the Global
Industry Classification Standard. The plan was announced last year and more
details are due in the coming weeks.
REITs currently count as
part of the financial sector so an active manager can own little or no REITs in
their fund but still “match” the industry breakdown of the index through
holdings in other financials. But once the change is made such a fund would be
well underweight the new sector: REITs.
We know that many
actively managed mutual funds are “closet indexers” sticking close to the
industry weightings in the index they are measured against and some active fund
managers have as part of their mandate restrictions on how much they can stray
from their benchmark. Managers keep an eye on both their “tracking error”
(deviation from the their benchmark index) in their holdings in addition to
their performance.
FT:
If this sounds like the
sort of category reshuffle that only librarians could get excited about, think
again. An additional $100bn or more could flow into the Reit sector from fund
managers who have to hew closely to the sector weightings of the major indices.
As these managers top up their holdings of Reit shares, investors who get in
early should see an uplift in share prices.
Several firms have
researched the issue and all have concluded that there is potential for
significant demand for REIT shares as a result of these index changes
A study at Jeffriesbrokerage found that the average mutual fund manager in the US is underweight
Reits by 3.3 percentage points relative to their market benchmarks, :
S&;P Dow Jones Indices
on Aug. 31 will begin tracking real estate investment trusts, or REITs,
separately from other financial stocks, increasing the number of sectors to 11
from 10. That could lead to purchases of REIT stocks by active mutual fund managers,
who are “substantially underweight the sector,” according to Jefferies analysts
Steven DeSanctis and Omotayo Okusanya.
“We estimate each increase
of 1% weighting in the group represents $46.7 billion. Given the buying
pressure by active managers along with retail investors’ thirst for yield, we
think the sector will outperform despite being expensive on an absolute and
relative basis,” DeSanctis and Okusanya said in a report on Monday.
Using data provided by
Morningstar, the Jefferies analysts concluded: “Managers would need to add
nearly $154 billion to REITs to move to an equal weight” for the new REIT
sector. They expect “buying pressure” for REITs as Aug. 31 approaches.
An analyst at TimbercreeekAsset Management interview on bloomberg estimates increased demand of $105
billion
Relative to
the overall US stock market $100 billion is not a particularly large number.
However the REIT sector is tiny the
total market capitalization of REIT stocks is $800 billion so the increased
demand definitely has the potential to drive prices higher.
If this
information is so readily accessible “efficient market theory” which argues
that prices reflect all publicly available information would argue that prices
already reflect this information and there is no possibility of “excess
returns” as a result of purchasing REITs prior to the index change. There are
reasons why this may not be the case with regards to changes in indices like
this one.
Efficient
market theory assumes that market prices reflect the choices of “profit
maximizers” who would always act to take advantage of an event such as this
anticipated increase in demand. But in fact many in the market are not strictly
speaking “pure profit maximizers”. An active fund manager who is measured
against an index and may even have a mandate limiting the extent to which he can
stray from the index has many incentives not to hold a portfolio that significantly differs far from the benchmark index. We
know that most active funds have a low “active share” and that most of their
holdings closely match their benchmark. "Tracking error'--the divergence between the portfolios holdings and the benchmark-- is a very important
input in the decision making of a portfolio manager.
In the case
of an index change this can lead to a: “non efficient outcome” Even though a manager might be aware that there will be a change in the index
that might create demand for REITs and might require him to buy REITs to get
close to benchmark, he still may wait till the reconstitution date or close to
it before making the purchase. Why would that be the case:? if he buys too soon
before the reconstitution he will be straying far from the index weigthing from
now to the reconstitution date.
Buying the
REITS well in advance of the reconstruction of the index increases his “tracking
error” thus violating one of the mandates/strategies of his portfolio
construction.
From the
above comes the market anomaly: even though it is clear there will be demand
due to the index reconstitution there is a significant incentive for those
active managers that benchmark to the index to wait till the date of reconstitution
to make the purchase. The "price pop" due to the index reconstitution may not occur until very close to the reconstrtuction date even though it is well known that there will be increased demand for the sector.
Does this create a “market
failure” an instance where the efficient market theory doesn’t hold ? the
proverbial $20 bill lying on the sidewalk which—according to the theory-- can’t
possibly be there because someone would have already picked it up ?
The FT writes:
The FT writes:
The old stock market
adage is that one should “sell in May and go away”, but there is one sector
where investors might want to turn the recommendation on its head this year.
When it comes to US property, investors who buy in the coming month could get a
one-off boost that they can cash in when they return from holiday in the
autumn.
Time will tell
For those
looking to take advantage of the move the most direct way to do this would be
through one of the broad REIT ETFs such as VNQ(tied to the MSCI index which is
being reconstituted) or RWR(tied to the S+P index).
Changes
in the REIT Market in the Age of ETFs
The growth
of interest in REITs and the growth of ETFs has had significant impact on the
REIT market once a relatively obscure sector dominated by a few players. As a
consequecene the opportunity for outperformance of active managers vs low cost
passive ETFs diminishes further.
In REIT Industry Shift, Veteran Investors Lose Clout
Longtime funds see net outflows while assets grow in
passive indexes
By
LIAM PLEVEN
April
26, 2016 3:4
Asset
managers who have shaped the world of real-estate investment trusts for years
are losing influence as passive index funds attract more money and a wider
array of investors pours money into the stocks, according to industry insiders.
Members
of a core group of REIT investors once could alter the path of initial public
offerings and affect decisions about how companies should be run, longtime
executives and investors say. Many longtime REIT-focused asset managers still
control large sums.
Meanwhile, index funds that own REITs held shares worth
about 20% of the firms’ market value as of last year, up from 6% in 2006. This
year, real-estate index funds have seen nearly $2 billion in net inflows,
through March, according to investment-research firmMorningstar Inc., while actively
managed real-estate funds have seen net outflows of roughly $1 billion.
“The
growth of index funds and ETFs which now own a much larger share of the
capitalization of all companies—not only REITs—has reduced the role of any
investor whether that be an individual or a mutual fund,” Ken
Heebner, portfolio manager of the CGM Realty Fund, which invests in REITs,
said in a statement.
The shift means that longtime REIT investors
don’t act as gatekeepers to the same degree they did in the 1990s, when the
modern REIT era began
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