REITS: Active managers' dilemma lies in mathematical impossibilities and opportunity costs

In today's highly competitive markets every basis point of performance or cost reduction counts and investors are taking action to eliminate inefficiencies. For active managers it may be a critical time to address key issues which contribute to such inefficiencies. Otherwise, there is a real possibility that active management in the sector could become marginalized as a result of not delivering value. Some of the answers could lie in increased reliance on quantitative solutions to improve information flow, analytics, decision making and ultimately performance. 

(In)active management puts up to half of industry AUM at risk

One critical inefficiency important to understand is that despite improvements in active profile, as defined by active share, those improvements are only partial leaving important issues unresolved. Systematic closet-indexing of large parts of actively managed portfolios by definition results in the inclusion of negative expected alpha positions in a significant part of the opportunity set. This inactive part is composed of large-caps and up to approximately half of relevant benchmarks by market-cap.

Although this has been, and continues for now to be, the standard portfolio construction practice, it is unlikely that restricting alpha generation at active fees to investors will continue to be a permanent feature of active allocations going forward. This issue affects approximately half of industry AUM of actively managed global real estate securities. 

Revisiting investment processes

Typically, active managers in the sector highlight qualities such as their specialist knowledge of real estate markets and the link to equity market valuations of companies, their established presence in key global locations and their teams' significant time following the companies in their coverage as a source of alpha generation.

All these qualities, and many other, are clearly important but while some may, and other may not, form necessary conditions for alpha generation, clearly none are sufficient, as is the case with any investment process. However, what matters is if qualities and functions essential to the process that seeks alpha generation can be shown to contribute to increase the probability of achieving its aim, i.e. probability of making the correct investment decision, at least directionally, compared to a random outcome.

One obvious conclusion is that if the process is not able to produce, or contribute to, a probability different from random, then there is no reason to expect alpha generation to be possible based on that particular process other than in a random fashion, sometimes 'yes' and other times 'no' but without consistency. 

Mathematical impossibilities

One relatively straightforward way to identify possible answers to why active managers systematically tilt portfolios away from the more information efficient large-caps and into the more information inefficient small-caps, and why they systematically create inactive parts of portfolios instead of focusing on optimizing alpha generation throughout the opportunity set, is to evaluate the probability of making correct investment decisions. We estimate the probability of active managers in the sector to make correct decisions, directionally, in the inactive part of the opportunity set i.e. approximately the top half of benchmark constituents by market-cap, to be 51.8% over the past ten years and 51.2% over the past five years, in both cases not significantly different from random. 

The question then becomes, is a margin of ca 1.5% in correct stock picking in this part of the opportunity set enough to generate outcomes that improve overall performance in a somewhat consistent way. The short answer is 'no'. Even without including transaction costs and management fees, a margin of this magnitude is for all practical purposes not sufficient to generate alpha other than randomly. Once transaction costs and management fees are included, what is technically a mathematical improbability on a gross basis, in practice resembles very closely a mathematical impossibility on a net basis. Therefore, it seems as up to half of allocations could be subject to no real possibility of achieving somewhat consistent outperformance or possibly even covering the cost. 

Opportunity costs

In addition, the less obvious cost absorbed by investors that also originates directly from these inactive exposures is the opportunity cost related to returns that potentially could have been generated had managers constructed fully active portfolios throughout the opportunity set. Based on the average probability margin of the top half outcomes, ca 3%, we estimate the opportunity cost to be ca 30bps per annum. This is a meaningful amount to leave on the table when every basis point counts and considering the magnitude of outperformance delivered by active management, which over the past decade stands at approximately an average of 35bps per annum.  

Both investment processes and practices need to be improved

The issue is that the overall cost that investors pay through higher fees and implied opportunity cost in the inactive part of allocations may in fact be higher than what active management in the sector has been able to provide in returns. It would also appear that overall relative performance might originate from general small-cap tilt so perhaps the more information inefficient small-caps provide a more suitable opportunity set for active managers to generate alpha. For investors there will certainly be little reason to pay active fees for a general small-cap tilt and alpha opportunities which are available but are not being fully pursued.

This means that both investment processes and investment practices need to be improved to provide value going forward. Active managers should invest in processes that have the potential to increase the probability of making correct investment decisions, at least directionally, utilizing the entire opportunity set of their mandates or risk being allocated a much smaller opportunity set which, at least for now, seems to more closely reflect the true capability to generate alpha. Presumably those investments will have to be different from those made to date.

In addition, active managers need to rethink the practice of closet-indexing in significant parts of the opportunity set and knowingly forgo crucial returns, there is simply no room for that in a competitive market.

Both these issues are critical to address to demonstrate value for investors. If not addressed, there is a real possibility that as allocations to real estate increase, active management may not be a competitive or efficient option to consider at least for a large part of the opportunity set.

For information about our services, 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.