REITS: Simple replication of active management with smart beta indices

In this note we aim to illustrate how Kania Global Real Estate Indices, CAI and CORE smart beta indices, can be used to replicate the performance of actively managed products. The simple approach presented here can help active managers to further isolate systematically replicable components of excess returns derived from their investment processes, construct better quantamental methods and focus their most costly resources, human capital, to pursue truly unique non-systematic alpha opportunities based on detailed knowledge of companies and predictive skills. Dedicating higher cost human resources to tasks related to processing of information that can relatively easily be structured and replicated in a systematic way creates both organisational inefficiencies and reduces competitiveness compared to alternative products. For investors, of course, eliminating excessive fees across allocations is important to improve investment outcomes. Being able to isolate all potential systematic sources of excess returns in actively managed products can bring significant benefits to design more cost efficient allocations without over-remunerating processes.

Simple replication with two smart beta indices

The approach presented here focuses on replication accounting for two main characteristics found across actively managed global real estate securities products namely, portfolio construction practices and alpha generating or stock picking profile.

With regards to portfolio construction practices, actively managed products are not truly active in large parts of the investable universe, i.e. benchmark. Active positions in approximately half of portfolios, predominantly in larger companies, are systematically closed-indexed with limited potential to generate alpha with any consistency (see here for detailed discussion). This part of actively managed portfolios can be considered a core beta exposure. The Kania Global Real Estate CORE Index (description) is a market-cap weighted index designed to capture this systematically low active share, low alpha generating portion of actively managed products.

On the other hand, the Kania Global Real Estate CAI Index, is a multi-factor index structured with full alpha generating capacity of the investable universe. It is based on factors specifically relevant to real estate and real estate securities markets rather than general equity market factors. Further, the CAI index has a fully and equally active profile throughout the opportunity set which optimizes alpha opportunities and eliminates flaws in portfolio construction found in actively managed products.

In practice this means that excess returns of actively managed products can potentially be replicated to a higher degree than previously. Managers can use these insights to construct better quantamental processes and improve the use and focus of their human resources, particularly their predictive skills. At the same time, the combination presents investors with straightforward tools to design more cost efficient allocations, only paying active fees for truly unique, non-systematic alpha returns and potentially improve investment outcomes.

Replication profile

In order to measure the effectiveness of using the combination of CORE (beta) and CAI (alpha) indices we evaluate the degree to which excess returns of actively managed products can be replicated with this simple two smart beta index combination. We measure replication in terms of R-sqr of a regression. The charts below illustrate results based on two approaches. Firstly, we look at a 10-year period as a fundamental long-term replication horizon. We expect stability in outcomes across funds as we account for both portfolio construction and alpha generation based on real estate specific factors. Secondly, we allow for a degree of cyclical changes as in practice active managers adjust the alpha/beta balance through portfolio construction; e.g. the degree of core beta exposure fluctuates and may increase during relatively uncertain market conditions i.e. portfolio holdings migrating closer to benchmark, and decrease otherwise. In order to capture this cyclical profile we regress excess returns in 5-year rolling periods; the period is largely arbitrary for illustration but aims to approximate the length of a business cycle. Results are based on monthly data.

Chart 1 illustrates the level of explanatory power of replicating excess returns with the two smart beta indices expressed as R-sqr for the full 10-year period. As the chart illustrates the combination produces consistently high outcomes, on average accounting for ca 84% of variation in excess returns across individual funds.

Chart 2 illustrates similar results of R-sqr for the rolling 5-year periods. Again, for majority of funds the combination produces high degree of fit, in most cases around or above 80% throughout the sample. It is also interesting to note that the R-sqr has been trending higher, reaching above 90% on average lately, implying that an increasingly higher proportion of excess returns across actively managed funds can be explained or replicated by the combination of CORE and CAI indices.

Generally, the results indicate that Kania Advisors’ factor methodology as expressed by the CAI index does capture real estate dynamics in a consistent way both fundamentally over long horizons as well as throughout cyclical fluctuations while the market-cap weighted CORE index accounts for portfolio construction practices. In addition, the results indicate that active managers may need to demonstrate higher degree of non-systematic alpha generation as some 85-90% of excess returns can be replicated in a relatively straightforward way using only two smart beta indices.

As factor based processes rely on actual past or known information flow, presumably active managers may need to focus their efforts on improving their predictive processes to provide better value, possibly by implementing quantamental methods that incorporate their predictive skill set. At the same time, the results indicate that investors may be able to implement more cost efficient allocations while taking comfort in that they are not compromising on real estate sector specific knowledge that they traditionally have relied on active managers to provide.

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 assets allocations and investment programmes. We provide advice and solutions to improve outcomes in real assets 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.