REIT investors can diversify through a fund or ETF tied to an index, such as the FTSE NAREIT Index. But new research shows that a factor-based approach has had superior risk-adjusted returns.
A large body of evidence demonstrates that a small number of factors provide a high level of explanatory power in the cross-section of stock returns around the globe. While there is competition to see which factor model will replace the Carhart four-factor (market beta, size, value and momentum) model as the new workhorse asset pricing model, it is narrowing down to the Q-factor (market beta, size, profitability and investment) model and the Fama-French five-factor (market beta, size, value, profitability and investment) model.
Massimo Guidolin and Manuela Pedio contribute to the asset pricing literature with their September 2019 study, How Smart is the Real Estate Smart Beta? Evidence from Optimal Style Factor Strategies for REITs. Guidolin and Pedio investigated the existence of a premium associated with the value, size, momentum, investment and profitability factors in REITs (real estate investment trusts). In other words, do other factors add explanatory power to the cross-section of REIT returns? Their study covered the period 1993 through 2018.
Following is a summary of their findings:
- There is support for the size, value and momentum factors and, to a lesser extent, the investment factor. REITs with a high book-to-market (BtM) are found to outperform those with a low BtM by 1.3% per month on average. REITs with high past returns outperform those with low past returns by 0.8% per month. Small REITs outperform large ones by 1.6% per month. The investment factor has a positive return of 0.4% per month.
- There is no evidence of a statistically significant premium associated with the profitability factor.
- From a risk-adjusted perspective, the size factor has the highest Sharpe ratio (0.23), followed by value (0.15), momentum (0.13), and investment (0.05). The excess mean return associated to the profitability factor is negative.
- With the exceptions of size and value, the factors typically display low or negative correlations among each other, providing diversification benefits that lead to higher risk-adjusted returns for factor-based strategies.
- Very rudimental portfolio rules, such as equal weighting, may prove as reliable and profitable as more complicated ones (such as risk parity and mean variance).
- There is large variability of the premia over time.
The authors concluded: “Factor-investing delivers better risk-adjusted performances than a direct investment in the FTSE NAREIT Index.” They added: “The exact allocation rule that is used to assign weights to the factors is much less important.”
Conclusion
The study by Guidolin and Pedio provides further support on the persistence and pervasiveness of the size, value, momentum and investment factors. Their findings on the low correlation of the factors also demonstrate the diversification benefits of factor-based strategies, leading to higher risk-adjusted returns.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.
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