REITS: How fundamental management can benefit from factors
We have previously published notes on various aspects of active management in the sector and highlighted portfolio inefficiencies which systematically restrict alpha generation. In our view, investors are currently unable to realize full potential from listed real estate allocations. However, active managers are increasingly considering possible complementary options which would result in a better value proposition and improved outcomes, as long as on balance those options do not change their fundamental process.
In this note, we discuss how information derived from a factor based approach can be combined with fundamental investment process to potentially deliver better performance but without significantly altering it. As we have highlighted in previous notes, the most pressing issue is that active managers are still closet-indexing approximately half of their portfolios, the top half of benchmark constituents by market cap. Therefore, here we focus only on this 'inactive' part of actively managed portfolios and estimate the potential benefit of including information from Kania Advisors' factor based process to improve outcomes in fundamental portfolios. We base the analysis on actual actively managed portfolios over the past 10 years in order to capture important dynamics. Firstly, each portfolio reflects the actual fundamental view of that particular manager, expressed in stock selection and portfolio weights. Secondly, there is a range of differing fundamental views (although still close to benchmark). Thirdly, if a factor based process is to add value as a complementary discipline or unique source of information, then it should add value uniformly irrespective of the starting point i.e. irrespective of the initial fundamental portfolio composition.
In order to evaluate the contribution of factor based information, we adjust each portfolio holding's weight in the 'inactive' part, by our proprietary multi-factor methodology, Kania Factors (KFs), used to construct the Kania Global Real Estate CAI Index (KARECAITU Index, see previous notes for details and characteristics of the index). We measure the results based on a low contribution from KFs of 10%, a medium contribution of 25% and high contribution of 50% as beyond this level the impact of the KFs would dominate the fundamental process. In practice this means that an initial portfolio weight of e.g. 2.5% would be adjusted within a range of +/- 25bps, 62.5bps and 125bps respectively at the different levels of inclusion, similarly for an initial portfolio weight of 0.5%, the range of adjustment would be +/- 5bps, 12.5bps and 25bps respectively; if an initial weight is 0% then it remains at 0% to reflect the fundamental portfolio. The chart below presents average outcomes and max/min range across actively managed funds at each level of including KF information along with impact on portfolio returns, 'inactive' part, in basis points.
As shown, even nominal inclusion of KF information at levels of 10%-25% weight adjustments can potentially result in significant improvement in performance, of ca 35bps and 85bps per annum respectively, reaching ca 180bps at the 50% level. The results also highlight an important aspect that this can potentially be achieved consistently irrespective of the starting points, i.e. irrespective of the individual manager's fundamental view and portfolio construction which remain unique to each manager. Therefore, in our view, Kania Advisors' multi-factor methodology can provide valuable source of information also for fundamental managers that can be adopted in a flexible way and potentially can be one possible option to improve portfolio outcomes.
Kania Advisors methodology is developed based on factors specifically relevant to real estate markets and real estate securities markets.
For information about our indices or factor scores, please contact info@kaniaadvisors.com
About Kania Advisors
Kania Advisors is an independent research and advisory firm focused exclusively on institutional real estate allocations and investment programmes. We provide advice and solutions to improve outcomes in real estate investment programmes. We conduct detailed industry research and custom studies typically focused on quantitative analysis and provide insights which form a critical part of a client's decision process.