Efficient market theory posits that alpha is just an anomaly and that efficient markets rule and there is no long-term prospect of managers achieving abnormal returns, obviating the possibility of active portfolio management. There are a number of variants of the theory, but the basic idea is this: the market effectively prices in all information that is realistically knowable to market participants.
Thus the market price is always the “right” price, and it is “impossible” to consistently beat the market. Investors who do so, are just lucky and eventually their luck will run out. Hence index funds are the most rational way to invest because they are simply a broad, representative swath of the entire market.
In fact, many empirical studies have borne out that the great majority of stock and bond mutual funds, over time, have only delivered average (beta) returns and, subtracting out fees and expenses, have actually under-performed the market. The stock and bond markets have seen increasing growth and popularity of index funds to the point that many pundits predict that they will be the dominant form of fund for most investors in a few short years. Is private equity real estate destined to become an index fund game eventually? I don’t think so and here’s why.
There are some limitations to the application of index portfolio management to real estate:
- Real estate is lumpy, chunky, location-bound and not easily divisible. Every asset is unique and possesses number of characteristics only found in that property. With skill and work, many properties can be improved through renovations, retenanting and increased rents, thus creating above-average returns. Geographic location also has a profound impact on the performance of real estate, both good and bad. Some of the effects of local economic performance and demographic trends can be anticipated or even predicted to a degree while some of these factors cannot. Few people could have predicted the massive back-to-the-cities movement 20 years ago and the positive impact it has had on global gateway markets returns
- There are high frictional costs with searching, buying, and selling real estate that are quite material. This means that property portfolios cannot easily be altered or optimized with a few key strokes of the computer. Properties will always be ineffient to some degree because of the inability to immediately change or rebalance portfolios.
- Paucity of publicly available, audited information. Private real estate can never fully be optimized in an index fund environment because there is so much information that can never be known or even if known, made widely available. Though data and information services such as Co-Star and Real Capital Analytics and others have made marvelous inroads into expanding our information base, there is still a long way to go and given the highly unique nature of real estate, the marginal utility of increased information may be insignificant. Many highly important facts about properties are not mandated to be made publicly known.
Index portfolio management assumes moderate to high market efficiency. In an efficient market, information is processed quickly and efficiently disseminated and asset prices adjust according to this new information. In efficient markets, there is little benefit to asset selection, research, or marketing-timing approaches. These factors inhibit the free, optimal portfolio construction and rebalancing that portfolio management entails. This makes real estate a highy inefficient asset class and the paucity of sufficient information, particularly for private real estate, makes indexation and even portfolio management difficult at times. However, as I have tried to highlight, it confers advantages (potentially apha out-peformance) to those participants who can develop positive informational asymmetries.
In active portfolio management, mispriced market segments and properties are worth seeking out. A passive, index portfolio approach assumes moderate to high market efficiency, and the costs of finding mispriced market segments and properties are insignficant. Until properties become uniform in size, shape, quality, independent of specific geographic location, consistent in terms of tenant type, credit quality, lease term and a host of other highly idyiosncratic factors, I’m not holding my breath on the advent of private equity real estate fund indexation. I can’t envision a time when a skilled and well-researched active portfolio management strategy cannot add value (alpha) to a private real estate investment strategy.
Part of this column are reprinted with permission from Summit Media and the ULI—“The Advisor’s Guide to Commercial Real Estate Investing,” Summit Media, 2014 and “The Investor’s Guide to Commercial Real Estate Investing,” The Urban Land Institute, 2014.
David Lynn, Ph.D., is CEO of Everest High Income Property in San Francisco.