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Tuesday, May 3, 2016

Changes Are Coming to the Way Real Estate Investment Trusts (REITS) Will Be Treated in the Major Indexes....And it Could Have Some Interesting Consequences

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.

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 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
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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