3Q17 Factor Alpha Newsletter
“Are the fees that these funds1 are charging right now justifiable, given the outcomes and given that, in many cases, they are just simply ‘repackaging exposures’?
. . .
Absolutely. Because at the end of the day, “strategic beta is just a new form of active management.”
— Ben Johnson (Director, Global ETF Research Morningstar)2
While factor investing has experienced significant proliferation across the equity landscape, the approach has largely been ignored in the publicly-traded real estate securities market. There is an authentic set of REIT3 factors that have delivered absolute, risk-adjusted, and consistent portfolio returns. Critical to harvesting this opportunity is the liquidity inherent in publicly-traded REITs. In our most recent podcast, we highlight some of these factors and how they can be used to increase alpha and avoid pitfalls. We also discuss the prevalence of the agency problem among the REIT products currently available.4 The absence of other factor investors, and the prevalence of “closet-indexed” REIT portfolios, has led to the public real estate market to become a uniquely inefficient and fertile ground for active, factor-based investing.
Some background: To build conviction-weighted, high Active Share portfolios, we use various hybrids of several multi-factor Themes.7 Individual factors are chosen because they are driven by fundamentals and have proven their efficacy over full market cycles. Note: it’s important not to use any of these factors and/or themes in isolation.8
The charts below provide additional insight to help explain our strategy’s recent live-time performance.9 When paired with our Factor Attribution Tool, the result is an entirely unique, customized quarterly market commentary.10
To see what’s happened in the REIT market during the Summer months comprising 3Q17,11 first we’ll isolate the difference in performance associated with the FTSE NAREIT All Equity REITs benchmark’s methodology versus an equal-weighted selection universe:
Size: “Market Cap-Weighted” less “Equal-Weighted”
(Cumulative excess returns, 7/1/17–9/30/17)
Next, 3Q17’s cumulative excess returns for the top deciles12 of each Theme versus the entire universe of stocks in the benchmark:
Stocks trading at large discounts to current FFO,13 EBITDA, and Free Cash Flow.
Stocks with impressive and stable recent total returns.
OSAM Financial Strength
Stocks that use debt responsibly, and aren’t overly reliant on outside financing.
OSAM Earnings Growth
Stocks whose profitability is high and trending up.
OSAM Earnings Quality
Stocks with strong cash flows and conservative accounting.
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- Earlier in this interview, “Strategic-Beta 1.0” is how Mr. Johnson sardonically refers to “smart beta” ETFs — we would add: Do we really need a version 2.0? Based on recent results from that type of investing, the answer is a resounding “nope”.
- Transcript from “Strategic Beta Track Record ‘Awfully Similar’ to Active” — an interview with Ignites Senior Reporter Jackie Noblett at the 2017 Morningstar ETF Conference
- For the uninitiated: Real Estate Investment Trusts (REIT)
- The majority of REIT strategies have an Active Share lower than 60%. This equates to investors paying an average active fee of over 140bps for their allocation to REITs!
- Our systematic process is agnostic to headlines, Tweets, and other noise.
- FTSE NAREIT All Equity REITs is a free float-adjusted market capitalization-weighted index that contains all tax-qualified REITs with more than 50% of total assets in qualifying Real Estate assets (other than mortgages secured by real property) that also meet minimum size and liquidity criteria.
- We blend factors together to build proprietary multi-factor themes to help reduce the noise of any one factor, but even investment themes experience cyclical periods of underperformance. Themes are then woven together depending on the target market’s predicate.
- By “compositing” several factors together, investors are able to “diversify” their exposure to factors — similar to using an ensemble of equities, bonds, and capital as their suite of assets. In any given year one factor by itself can do well or poorly, creating noise in the long-term process.
- The O’Shaughnessy U.S. REIT strategy generally seeks to provide long-term appreciation by investing in undervalued REITs with strong balance sheets, high quality FFO, and good growth numbers relative to peers. Extensive research on what characteristics are rewarded in Equity REITs helps us build a concentrated, high active share portfolio that has consistent advantages on each of those characteristics versus the benchmark. Stock selection is a bottom-up, quantitative, model-driven approach. We first focus on active stock elimination, our research shows there are sets of factors best used to screen out REITs likely to underperform; Financial Strength, Earnings Growth and Earnings Quality. While owning strong performers is the most obvious source of excess returns, the stocks that are in an index but not in the portfolio often explain as much of the active portfolio’s returns. After removing the REITs most likely to underperform, the strategy then selects undervalued REITs with the highest recent performance relative to their peers.
- Financial Professionals: Email firstname.lastname@example.org for a copy of our 3Q17 REITs report.
- For these live-time factor snapshots, the multi-factor portfolios (Themes) are calculated using a compositing methodology: Monthly portfolios are created with a 12-month holding period, then the 12 monthly portfolios are combined to create the composite portfolio.
- As an example, Value’s top decile is “the cheapest 10% of stocks” within the universe.
- Funds from Operations