The debate about the relative merits of active and passive management of REIT funds continues. Greg MacKinnon examines the research

In creating REIT investment strategies, investors face an important choice: active or passive management. So what does the academic research say on the topic of REIT funds?

At the heart of active management is the idea that an active manager can create alpha for investors, ie, returns beyond what should be expected given the level of risk exposure. Those who favour passive management believe that the average manager cannot produce these excess returns, and that no manager can produce alpha consistently over time.

Simple passive indexing identifies a relevant benchmark index and invests in the constituent securities, or suitable proxy. Determining whether active managers create alpha is simply a matter of comparing manager returns to the returns on the index, on a risk-adjusted basis. However, passive investing could also involve the application of simple, naïve strategies based on factors affecting returns.

For instance, adopting a portfolio tilt towards value stocks may increase average returns over time but could easily be replicated passively - the same could be said of small caps or stocks that have performed well recently. Evaluating active managers, therefore, should really determine if they create alpha after controlling for style tilts towards these factors in their portfolios.

As the REIT fund industry took off in the late 1990s so did academic research on the active versus passive debate. A trio of studies, all published in 2000, examined the issue with varied results.(1)

One paper reported that REIT funds, net of expenses, exhibited positive alphas when compared with the Wilshire Real Estate or Wilshire REIT indices but not if compared with the NAREIT index, an index with greater weight on small REITs. It seems that managers were generating value by investing in small-cap and illiquid REITs and that "managers add more value in down markets than in up" since alphas were positive mostly when underlying property markets were doing poorly. A second study also showed that funds outperformed the Wilshire Real Estate Securities Index but ascribed the performance to good property-type allocation decisions by managers.

A third group of researchers in 2000 found no evidence "that, as a group, real estate funds deliver positive abnormal performance" when evaluated against a weighted portfolio of the Wilshire REIT, Russell 2000, MSCI World and S&P 500 indices. Similarly, a paper published in 2004 also reported no evidence of outperformance by real estate funds.(2)

These earlier academic studies covered a time period when the US real estate fund industry was still young; the REIT market of today may be much more efficient. Still, these studies highlight an important issue in evaluating active managers in the real estate securities space; one can observe diametrically opposed results with different benchmarks.

Two recent studies have emphasised the style tilts of active managers that could be replicated in a passive approach; the value/growth and large/small cap biases in fund portfolios, and especially momentum strategies based on the idea that stocks that have performed well recently tend to continue to perform well in the short run.

Research from Erasmus University reports momentum in REITs that is substantially stronger than that usually found in stocks in general and that accounting for this substantially reduces observed alphas.(3) This suggests that a lot of REIT-fund performance can be explained "by the funds chasing REIT momentum", and much of the value created by fund managers could be replicated with a passive strategy that follows REIT momentum.

A second recent study examines performance from 1994 to 2005 and, using a benchmark based on REIT-specific size, growth and momentum factors, finds little evidence of excess returns to funds.(4) In fact, if indices of non-REIT real estate companies (builders, REOCs) are included in the analysis alphas are typically negative on average. Real estate funds appear to generate some value relative to REIT indices by investing in non-REIT holdings; appropriate performance evaluation should account for this.

The paper also shows that if benchmarked against a single index it appears that a significant number of individual funds create value, but when appropriately benchmarked fewer funds exhibit significant alpha than would be expected simply by chance.

It can be argued that even if the average fund manager does not create value, certain above-average managers exist that can generate value consistently over time. To test this, researchers ask a simple question: do funds that are performing well keep on performing well? Little evidence exists to support the idea, with some researchers even finding a negative relationship; a positive alpha one month tends to be followed by a negative alpha the next, so that above-average managers become below-average and vice versa.

The weight of evidence seems to indicate that the average REIT fund manager may be able to create some alpha when benchmarked against a simple index, but much of what goes into that performance can likely be replicated using naïve, passive strategies that create exposure to value, small cap, and momentum factors within the REIT market, as well as some exposure to non-REIT real estate equities.

Given the current lack of style-based REIT ETFs investors must decide if it would be worthwhile to undertake the costs in terms of time and transaction costs of implementing such passive strategies themselves, or simply rely on outside active managers.

Notes:
(1) ‘The Value Added from Investment Managers: An Examination of Funds of REITs' by Jarl Karlberg, Crocker Liu and Charles Trzcinka. Journal of Financial and Quantitative Analysis, September 2000, Vol. 35, No. 3
‘Asset Allocation and the Performance of Real Estate Funds' by John Gallo, Larry Lockwood and Ronald Rutherford. Real Estate Economics, 2000, Vol. 28, No. 1.
‘Real Estate Mutual Funds: Abnormal Performance and Fund Characteristics' by Edward O'Neal and Daniel Page. Journal of Real Estate Portfolio Management, July-Sept 2000, Vol. 6, No. 3.
(2) ‘Real Estate Mutual Funds: Performance and Persistence' by Crystal Lin and Kenneth Yung. Journal of Real Estate Research, Jan-Mar 2004, Vol. 26, No. 1.
(3 )‘REIT Momentum and the Performance of Real Estate Mutual Funds' by Jeroen Derwall, Joop Huij, Dik Brounen and Wessel Marquering. Financial Analysts Journal, 2009, Vol. 65 No. 3
(4)"Alternative Benchmarks for Evaluating REIT Mutual Fund Performance" by Jay Hartzell, Tobias Mühlhofer and Sheridan Titman, 2008, forthcoming in Real Estate Economics
Article based on ‘Active vs Passive Management of Funds of Real Estate Securities: A Review of the Academic Evidence', produced by PREA