The Russell Fundamental Select Real Estate Index

Transcription

1 The Russell Fundamental Select Real Estate Index By: Xin Yan, Ph.D., Senior Research Analyst 1 EXECUTIVE SUMMARY: 1. Real estate as an asset class has attractive income characteristics and offers the potential for enhanced returns and diversification benefits to investors. 2. Fundamental weighting has helped the Russell Fundamental Select Real Estate (RFSRE) Index s performance relative to a cap-weighted real estate index, and the index is designed to target lower costs for implementation as an investment vehicle. 3. Diversification benefits are observed in a number of theoretical portfolios where a fixedpercentage exposure to the RFSRE index has been added to the Russell Global Index. To help investors gain exposure to the intrinsic economic value of the global listed real estate market, Russell has launched the Russell Fundamental Select Real Estate (RFSRE) Index, 2 a new equity index series. With the Russell Fundamental Index series as its parent, the RFSRE Index series seeks to achieve three primary objectives: a) to provide a relevant reflection of listed real estate managers opportunity set; b) to weight company exposure based on the economic importance of a company as opposed to its market capitalization, and c) to allow replication for investable product providers (i.e., mutual funds and ETFs) at a reasonable cost. As of June 2014, the following indexes are included in the Russell Fundamental Select Real Estate Index Series: Russell Fundamental Global Select Real Estate Index Russell Fundamental Global ex-u.s. Select Real Estate Index Russell Fundamental U.S. Select Real Estate Index 1 Author thanks our editors and reviewers: Mary Fjelstad, David Brunette, Mark Paris, Arun Singhal, Lori Richards and Rolf Agather. I d also gratefully acknowledge Pradeep Velvadapu and Nicole Bahr for their contributions to the creation of the RFSRE Index series. 2 For information on the indexes available, detailed calculations, and construction methodology, see Russell Fundamental Index Series Construction and Methodology, May 2014, available at or upon request. Russell Investments // The Russell Fundamental Select Real Estate Index JULY 2014

2 In this paper we first provide a brief overview of the characteristics of real estate, both private and listed, as an asset class. We then review the rationale for using fundamental or economic rather than market-cap-based weights in an index or investment portfolio. We describe the methodology of the RFSRE Index series, and report the performance characteristics of the RFSRE index compared to the FTSE EPRA/NAREIT 3 Index series and the broad market benchmarks. Finally, in historical simulations we examine the impact an allocation to the RFSRE would have had on an equity portfolio. Real estate as an asset class The real estate market is distinguished from almost all other asset classes in that real estate properties are permanently attached to the land. While not portable and local, the values of the properties are usually heavily influenced by the soundness of a nation s financial system and are sensitive to international capital flows. Historically, real estate performance has been cyclical: real estate has tended to produce the highest returns when investment was made in an economic recovery or early growth state and harvested during an expansionary phase. Investors have found real estate attractive due to income characteristics, return potential and observed diversification relative to other asset classes. 4 Why listed real estate? Given the non-portable nature of a property, direct real estate investment usually features a lump sum payment, a moderate buying/selling period, a price negotiation, a lengthy legal process to complete the ownership transfer, and a professional agent to service the deal. Alternatively, investors who are concerned about liquidity and transparency can choose to invest in equities of publicly listed real estate companies. Listed real estate companies can be classified into two major categories: 1) companies that directly participate in building, developing or servicing the properties and 2) real estate investment trusts (REITs). The first group of companies includes traditional homebuilders represented currently by companies such as the Toll Brothers Inc. and property management companies such as the CBRE group. The very first REIT was created in the early 1960s in the United States, but it was not until 1991, when Kimco Realty Corp. went public with its IPO, that the modern REIT era began. REITs have now become so widely accepted among global investors that more than 20 countries have REITs or similar structures. Listed real estate securities further de-localize the real estate market, making it a true global business. Capturing listed real estate with controlled implementation cost Russell has been researching the listed real estate market and active listed real estate portfolios for over 30 years. Investment portfolios in this space define an opportunity set that includes real estate management companies as well as specific classifications of REITs. While all REITs provide stable income and a tax-efficient structure, they are segmented by both property type and investment style. Traditional REITs are backed by properties, office, residential, lodging and resort, and so on. Mortgage REITs, however, do not buy buildings or malls but invest in real estate debt, mortgage-backed securities and commercial paper. Due to the lack of direct ownership of the real assets, the consensus among investment managers seems to be that mortgage REITs do not belong to their normal opportunity set. As a result, we exclude mortgage REITs from our RFSRE index universe, as our goal is to represent a true real estate investment exposure. Additionally, timber REITs are excluded because the underlying assets are timberlands. The value of timber properties moves up and down with 3 FTSE EPRA/NAREIT Index series is a well-accepted benchmark in the real estate investing community. FTSE EPRA/NAREIT indices are marketcap-weighted with a series of screening rules. For more details on the index, please refer to 4 With more than 40 years as a leader in real estate investing, Russell published a number of research papers in that express Russell s view on the real estate market and provided guidance to investors, See, for example, Structuring a Listed Real Estate Securities Portfolio, Dave Brunette and Leola Ross, Russell Research, November Russell Investments // The Russell Fundamental Select Real Estate Index 2

3 the price of timber, making it a segregated group from other REITs and not representative of real estate. When constructing the Russell Fundamental Select Real Estate Index series, we select companies that are classified by the Russell Global Sector Scheme (RGS) in the following two subsectors Real Estate (1050) and Real Estate Investment Trusts (1060) 5 but exclude mortgage REITs and timber REITs for the reasons given above. Consistent with Russell s global-relative design, the RFSRE Index series does not predefine a list of countries. Russell believes a company should be included as a qualified index member as long as it meets all the index requirements, no matter where it is located. However, when it comes to ETF replication, countries with few stocks and insignificant weights might generate unreasonable cost to investment product providers. As a result, any countries whose weights are less than 30bp in the index are removed. A buffer is given to countries that are already present in the RFSRE Index. More specifically, existing member countries won t be removed from the index unless their weights are less than 10bp at the annual index reconstitution. The buffer provided to current index constituent countries effectively reduces turnover, thus avoiding unnecessary investment product operational costs and trading fees due to short-term market movements. Profiling Global Fundamental Real Estate as of 6/30/2014 As of 06/30/2014, the Russell Fundamental Global Select Real Estate (RFGSRE) Index consists of 226 stocks from 21 countries. Roughly 44% of the index is comprised of U.S. listed real estate companies, which are almost exclusively REITs. Outside the United States, REITs are less of the overall market opportunity set, but they still play significant roles, particularly in Australia, the United Kingdom and France. Indexes focusing on real estate companies, especially those with large allocations to REITs, have historically provided higher dividend yields than a broad market benchmark provides. As illustrated in Table 1, dividend yields on both the U.S. and the Global Real Estate indexes are above 3.4%, as compared to 1.8% on the Russell 3000 Index and 2.3% on the Russell Global Index for the same time period. Table 1: Basic characteristics of Russell Fundamental Select Real Estate indexes, data as of June 30, 2014 # of constituents # of countries REITs as % of total weight Dividend yield Russell Fundamental Global Select Real Estate % 3.56% Russell Fundamental U.S. Select Real Estate % 3.40% Source: Russell Indexes, FactSet 5 The Real Estate subsector (1050) is further broken down into three industries, and the REITs subsector (1060) is further broken down into 14 industries. For a full list of Russell sector, subsector and industry classification schemes related to real estate, please see Russell Investments // The Russell Fundamental Select Real Estate Index 3

4 United States Japan Australia Hong Kong United Kingdom China France Singapore Brazil Canada Netherlands Sweden United Arab Emirates Taiwan Switzerland South Africa Austria Germany Belgium India Italy Percentage (%) Figure 1 shows the country breakdown of the RFGSRE Index. The United States and Japan account for more than half of the global real estate market as represented by the RFGSRE Index; country distribution is similar to that of its parent index, the Russell Fundamental Global Index. At the same time, real-estate-rich countries like Australia and Hong Kong get considerable lifts, each receiving approximately 8% additional weight. Among emerging markets countries, China, Brazil and UAE stand out. Real estate comprises a substantial portion of these countries economies, bumping up their presence in the RFGSRE Index. Figure 1: Country breakdown of Russell Fundamental Global Select Real Estate Index, June 30, Source: Russell Indexes Fundamental weighting has helped performance relative to cap-weight The starting universe for the Russell Fundamental Select Real Estate Index series is the Russell Fundamental Index series. What is fundamental-weighted indexing, and why are fundamental weights important? While recognizing that capitalization-weighted indexes are benchmarks or proxies for the market, Russell views fundamental weighting as an investment strategy. 6 In collaboration with Research Affiliates, Russell selects and weights stocks in the Russell Fundamental Global Index by a composite of three measures of economic size: five-year average adjusted sales, five-year average retained operating cash flow, and five-year average dividend plus five-year average buybacks. Companies are ranked according to economic size, irrespective of price. As a result, stocks that are overvalued by current market prices will likely get a lower weight in a Fundamental Index strategy than they would get in a cap-weighted index. Likewise, undervalued stocks are expected to have a bigger representation in a Fundamental Index portfolio than its cap-weighted counterpart. Being a pioneer in fundamental indexing, the team at Research Affiliates has published a series of articles offering empirical evidence that the Fundamental Index methodology has historically produced outperformance relative to cap-weighted portfolios. Back-tested returns show fundamental real estate indexes generated positive excess returns in both U.S. and ex- U.S. listed real estate markets over the sample period of 1984 through April More importantly, the authors argue that the fundamental weighting scheme added substantially 6 The Russell Fundamental Index Series: An investment strategy, Tom Goodwin, Russell Research, September Russell Investments // The Russell Fundamental Select Real Estate Index 4

5 larger value in deflationary environments. 7 The Fundamental Index methodology may provide an extra cushion to investors in the part of the economic cycle when the real estate market produces low returns, as the asset class is generally expected to perform well in inflationary environments. The performance of Russell s fundamental-weighted real estate index series confirms Research Affiliates previous findings with an extended sample period that includes the second half of 2013, after the Federal Reserve announced that it might consider tapering its massive bond-buying program. Investors interpreted this as a hint that interest rates could be rising in the short term and that the borrowing cost for REITs could increase significantly. Figure 2 examines the calendar-year returns of the RFGSRE Index and the FTSE EPRA/NAREIT Global Index against the broad Russell Global Index, and Figure 3 shows their equivalents in the United States. As shown in the exhibits, real estate companies benefited from the recovery of the property market since the 2008 mortgage meltdown, but their performances lagged in 2013 due to investors concerns over rising interest rates. In this recent challenging environment for real estate, the fundamental-weighted indexes outperformed the FTSE EPRA/NAREIT indices both globally and within the United States by notable margins. Our study adds additional empirical evidence to support the prior Research Affiliates conclusion that the fundamental-weighting strategy has created excess returns relative to market-cap-weighted real estate benchmarks when real estate companies are in challenging environments. Figure 2: Calendar year returns: Russell Fundamental Global Select Real Estate Index, FTSE EPRA/NAREIT Global Index 8 and Russell 3000 Index, December 2006 June 2014 (all returns in USD) YTD Russell Fundamental Global Select Real Estate FTSE EPRA/NAREIT Global Russell Global Source: Russell Indexes, Bloomberg 7 Does Valuation-Indifferent Indexing Work for the Real Estate Market? Jason Hsu et al. The Journal of Investing, Q3 2010, 19.3: Performance of the RFSRE Index series goes back to July However, historical performance on the FTSE EPRA/NAREIT Index series can only be obtained publicly or from a data vendor such as Bloomberg or FactSet beginning March Thus the author decided to use 2006 as the first full calendar year in Figure 2 and Figure 3. Russell Investments // The Russell Fundamental Select Real Estate Index 5

6 Figure 3: Calendar year returns: Russell Fundamental U.S. Select Real Estate Index, FTSE EPRA/NAREIT U.S. Index and Russell Global Index, December 2006 June 2014 (all returns in USD) YTD Russell Fundamental U.S. Select Real Estate FTSE EPRA/NAREIT USA Russell 3000 Source: Russell Indexes, Bloomberg A few basic performance characteristics are also provided in Table 2. With higher annualized returns and higher Sharpe ratios, 9 our observation with the recent rising interest rate environment in 2013 is consistent with what Research Affiliates discovered using back-tested data from January 1984 through April 2009, as reported in their paper. It is also interesting to point out that over our more recent sample period, March 2005-June 2014, both the Global and the U.S. RFSRE indexes produced positive alphas over the broad market while the FTSE EPRA/NAREIT did not. 9 The characteristics are generated by FactSet SPAR 2.0. Sharpe ratio is calculated using Citigroup 3M Treasury bill as the underlying risk-free rate. Russell Investments // The Russell Fundamental Select Real Estate Index 6

7 Table 2: Performance characteristics report, March 2005 June Description Annualized return (%) Annualized StdDev (%) Beta Alpha Sharpe ratio Russell Fundamental Global Select Real Estate FTSE EPRA/NAREIT Global Russell Global Description Annualized return (%) Annualized StdDev (%) Beta Alpha Sharpe ratio Russell Fundamental U.S. Select Real Estate FTSE EPRA/NAREIT USA Russell Source: Russell Indexes, FactSet Figure 4 illustrates the risk and return characteristics of the RFGSRE Index and the Russell Global Index with a number of theoretical portfolios: allocation of a fixed percentage 20%, 30%, and 40% rebalanced monthly of the RFGSRE Index to the Russell Global Index. Over the period between March 2005 and June 2014, on an annualized basis, the RFGSRE Index returned 10.09% with 23.43% volatility. This compares to the Russell Global Index, which returned 7.52% with 17.28% volatility. The higher return of the RFGSRE Index was accompanied by higher volatility, resulting in a Sharpe ratio of 37% compared to the Russell Global Index s 35%. On the other hand, the FTSE EPRA/NAREIT Global Index had a much lower Sharpe ratio of 26% over the same time period, suffering from underperformance despite slightly lower volatility than the RFGSRE Index. As the allocation to the RFGSRE Index increases, performance improvements are seen with moderate increases in volatility. Figure 4: Annualized risk vs. return of varying allocations to the Russell Global Index and the Russell Fundamental Global Select Real Estate Index, March 2005 June See footnote 7. Russell Investments // The Russell Fundamental Select Real Estate Index 7

8 Source: Russell Indexes, MPI Stylus Conclusion Real estate as a unique asset class has attracted investors from all over the world. The newly launched Russell Fundamental Select Real Estate Index series provides a convenient tool for investors to gain exposure to selected listed real estate companies. As a subset of the Russell Fundamental Global Index, the RFSRE series offers the benefits of the Fundamental Index methodology. Empirical outperformance of the fundamental weighting scheme, specifically in the real estate market, was found by Research Affiliates in their earlier publications and is again confirmed by the performance history of the RFSRE Indexes. In particular, we included the year 2013 when the real estate market was threatened by rising interest rates. Observed returns suggest that the fundamental-weighted index approach may add value for real estate investors in challenging cyclical periods. Russell Investments // The Russell Fundamental Select Real Estate Index 8

9 About Russell Indexes Russell s indexes business, which began in 1984, accurately measures U.S. market segments and tracks investment manager behavior for Russell s investment management and consulting businesses. Today, our series of U.S. and global equity indexes reflects distinct investment universes asset class, geographic region, capitalization and style with no gaps or overlaps. Russell Indexes offers more than three dozen product families and calculates more than 700,000 benchmarks daily, covering 98% of the investable market globally, 81 countries and more than 10,000 securities. As of December 31, 2013, approximately $5.2 trillion in assets are benchmarked to the Russell Indexes. For more information about Russell Indexes, call us or visit Americas: ; APAC: ; EMEA: Disclosures Russell Investments is a trade name and registered trademark of Frank Russell Company, a Washington USA corporation, which operates through subsidiaries worldwide and is part of London Stock Exchange Group. Russell Investments is the owner of the trademarks, service marks and copyrights related to its respective indexes. Russell Investments and Research Affiliates LLC have entered into a strategic alliance with respect to the Russell Fundamental Indexes. Subject to Research Affiliates' intellectual property rights in certain content, Russell Investments is the owner of all copyrights related to the Russell Fundamental Indexes. Russell Investments and Research Affiliates jointly own all trademark and service mark rights in and to the Russell Fundamental Indexes. Research Affiliates is the owner of the trademarks, service marks, patents and copyrights related to the Fundamental Index and the Fundamental Index methodology. Research Affiliates is the owner of the trademarks, service marks, patents and copyrights related to the Fundamental Index methodology. The trade names Fundamental Index, RAFI?, the RAFI logo, and the Research Affiliates corporate name and logo are registered trademarks and are the exclusive intellectual property of Research Affiliates, LLC. Any use of these trade names and logos without the prior written permission of Research Affiliates, LLC is expressly prohibited. Research Affiliates, LLC reserves the right to take any and all necessary action to preserve all of its rights, title and interest in and to these marks. Various features of the Fundamental Index methodology, including an accounting data-based noncapitalization data processing system and method for creating and weighting an index of securities, are protected by various patents, and patent-pending intellectual property of Research Affiliates, LLC. (See all applicable US Patents, Patent Publications, and Patent Pending intellectual property located at which are fully incorporated herein.) Indexes are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance and are not indicative of any specific investment. This material is proprietary and may not be reproduced, transferred or distributed in any form without prior written permission from Russell Investments. It is delivered on an as is basis without warranty. This is not an offer, solicitation or recommendation to purchase any security or the services of any organization. Copyright Russell Investments All rights reserved. First use: July Revised: February CORP E Russell Investments // The Russell Fundamental Select Real Estate Index 9