US-listed Real Estate Funds: Chronic Underperformance

US-listed REITs account for nearly $1 trillion market cap out of the approximate $2 trillion global real estate estate sector. Not surprisingly, US-listed real estate funds, including active mutuals and exchange traded funds (ETFs), invest heavily in large cap domestic REITs. Listed funds manage roughly $170 billion of assets under management (AUM) across 190 products, however the vast majority of funds under performed the Morningstar Global Real Estate Index. Indeed, the Vanguard REIT ETF itself under performed not only the Morningstar Global Real Estate benchmark but also the S&P500 and displays higher volatility year-to-date, which suggests interest rate concerns are the over riding factor at play in the sector.

US-listed real estate funds are an interesting case study in both chronic under performance across the space and over concentration of AUM in popular products. The Vanguard REIT ETF holds 20% of all AUM and is nearly 7x larger than the next largest product. For the year-to-date period as of 10/14/2016, 72% of all listed products failed to match the returns of the Vanguard REIT ETF and a full 90% under performed the broad Morningstar Global Real Estate Index. We ran the same analysis over a five year period and the ratio of under performers mirrored the year-to-date results.


Our research suggests there a several factors at play here. First, US-listed funds tend to own the same basket of large cap REITs so other than cost, the typical real estate fund tracks the largest, most cost effective funds. Second, few US managers venture outside of large cap developed markets where non-correlated returns are available. Third, the concentration of AUM in a single product likely skews performance in the widely-held REITs, and fourth, US REITs are fully-valued and have been a drag on returns this year, as measured by higher volatility, beta and correlation versus the S&P500; that what worked well over the last few years, simply isn’t the case now. For example, the Vanguard REIT ETF alone shed $4 billion in market cap since the end of July (-11%) which likely impacted performance of other funds as well. And this shows up as well when we look at beta across the US-listed real estate fund space.

Few realize that US real estate funds are no longer non-correlated sources of alpha. In fact, over 80% of funds exhibit beta >1 versus the S&P500. The Vanguard REIT ETF showed a 1.1x beta versus the S&P500 year-to-date, realized volatility of 16.5% versus the S&P500’s volatility of 14%, and it under performed the S&P500 by approximately 200bps. It turns out that a 100bps in additional yield actually cost the investor 1000bps in alpha this year alone.


So what is going on here? Is this temporary or a harbinger of worse things to come? Real estate traditionally was a diversifying factor in a portfolio and that clearly is not the case for now. We believe, like fixed income, US REITs are already in a bear market but not the traditional bear market where losses occur over a relatively short period of time, asset prices reset and new capital re-enters. This bear is going to take a while, maybe two to three years, or longer. For the US REIT investor, it may end up feeling like a slow boil, marked by chronic under performance for the large cap, widely-held companies.

On the interest rate front, we think US REITs are trading in lockstep with fixed income. Large cap US REITs offer very limited appreciation potential as a result of oversupply and slow growth, trade at historically high valuations and have become quite crowded. In analyzing the real estate fund segment, the problem with US REITs becomes even clearer – extracting alpha from a crowded, highly correlated basket with above average volatility almost guarantees under performance. So, the question is: why aren’t managers diversifying into non-correlated, growth markets like Latin America?

By simply adding an allocation to properly diversified LatAm real estate this year, the average US manager could have improved performance substantially and reduced its risk profile at the same time. However, if the manager wants to move the needle, the allocation must be material. Some managers appear to have approached Latin America with a check-the-box mentality, wherein they add one or two names at a de minimis weight. Token allocations in the handful of widely-held Latin America names is not going to have an impact. To do so, the US manager will have to allocate at least five percent and ideally 10 percent but do so over a broad regional basket of real estate equities which presents a conundrum: many names are too small to be added individually. The solution? We believe a regionally diversified vehicle that offers exposure across the market cap structure without having to engage in single stock selection but offers compelling risk-adjusted exposure is a pretty good solution.


Petrobras Cuts Fuel Prices, Another Reason to Shun Popular EM ETFs

Today we get this news that Petrobras will cut fuel prices across the board. It is fiscal stimulus by another name and in our view, ensures that a rate cut is in the offing. On the other hand, it’s not so constructive for PBR investors who have paid a stiff price since the first whiff of Lava Jato hit the press and oil prices tumbled, but such is the land of single stock picking. The latest move doesn’t mean PBR isn’t a good stock to own for the long haul but overweighting it is another matter.

As we’ve said, diversification is key to investing in general but especially for emerging markets. One of the conundrums facing investors who are looking to make an EM allocation is the fact that the most widely-held EM products basically own the same equities (this also applies to many active products by they way). As evidence of this, look at the Top 10 EM ETFs which are 90%+ correlated to the MSCI Emerging Markets Index and have been 80% correlated to the S&P500 this year. A logical explanation for this: they own many of the same equities.

“Dow Jones Brazil’s Petrobras Announces New Retail Fuel Pricing Plan

Brazil’s Petrobras Will Reduce Diesel Prices By 2.7% In Brazil

Brazil’s Petrobras Will Reduce Gasoline Prices By 3.2% In Brazil

Fri Oct 14 08:02:31 2016 EDT”

Higher Yields, Lower Correlations With This Real Estate ETF

Higher Yields, Lower Correlations With This Real Estate ETF

Higher Yields, Lower Correlations With This Real Estate ETF
Run, Don’t Walk To This Latin America ETF
Avoid Fed Shenanigans With This Real Estate ETF

In addition to the tidy dividends and often high-by-comparison yields, one of the primary selling points with real estate investment trusts (REITs) and the corresponding exchange-traded funds is the perception this asset class, often viewed as alternative, is not highly correlated to traditional equity indexes.

However, data suggest that many big-name U.S. REIT ETFs are highly correlated to the S&P 500 and, in many cases, have roughly the same beta as the benchmark U.S. equity index. Some major U.S. REIT are as much as 80 percent correlated to the S&P 500.

Almost A Year Old

Of course, elevated correlations to U.S. stocks are not a concern for Tierra XP Latin America Real Estate ETF NYSELARE, which allocates about 96 percent of its combined weight to Brazilian and Mexican real estate names.

LARE debuted in December and tracks the Solactive Latin America Real Estate Index.

“The Solactive Latin America Real Estate Index screens for all listed equities with primary listings in the Latin America region and which derive substantially most of their income from real estate and real estate services. The Index then uses dividend yield, market capitalization and liquidity in the underlying shares to determine weights. The Index is rebalanced quarterly,” according to Tierra Funds.

Not only is LARE not highly correlated to traditional equity benchmarks, but its holdings usually sport yields well in excess of those found on comparable U.S. REITs.

Setting Itself Apart

“Latin America real estate companies offer some of the highest dividend yields in the world with Brazil REITs paying around 10 percent and Mexican REITs offering yields of more than 6 percent,” according to LARE Index.

That at a time when yields of 3 percent to 4 percent are considered impressive for U.S. real estate strategies. For those that insist on labeling LARE as a Brazil ETF, notable are the facts that as of August 9, LARE is showing volatility that is about half that of the largest Brazil ETF and a dividend yield that is more than 340 basis points higher. Speaking of yield, LARE’s dividend yield is 5.58 percent, which is far superior to what investors will find on standard U.S. REIT ETFs.

LARE’s underlying index’s “low volatility and low correlation suggest it may be an attractive source of alpha for a broad Emerging Markets strategy and a risk mitigator for a Latin America allocation. For example, LAREPR’s realized volatility is less than half versus the MSCI Brazil Index and 20 percent lower volatility against the MSCI Mexico Index,” according to Tierra Funds.

On Brazil Valuations, A Reality Check

As long-mostly investors, we tend to be (a) optimistic about the future and (b) early at times. Full disclosure: we started to get really excited about EM last Fall which is why we decided to go live with the LARE Index and license it out to the first US-listed product offering access to the LatAm real estate asset class. Our 20+ years’ experience taught us that when EM valuations approach extremely oversold conditions, the first movers tend to be bond and real estate investors. That is exactly what we saw in the Fall: EM sovereign bonds rallied and FX correlations diverged. The USD negative correlation trade crossed an inflection point.

The late January swoon presented investors with a glaringly obvious entry point. Brazil REITs, for example, were trading at close to half of tangible book value. Brazil assets overall were trading at single digit P/E and the proverbial taxi driver was busy shorting everything EM. But old ideas die hard. After a massive rally in the 2nd quarter, we found ourselves, again, facing deep skepticism from even sophisticated institutional investors about Brazil’s prospects. The same crowd that doubted the oversold conditions a year ago simply swapped one wrong view for another, just because.

What we want to point out here is that despite an exceptional rally and continuation of the same rally into the Fall this year, Brazil remains quite attractive from a valuation standpoint. We estimate that about 60% of the Brazil rally YTD is attributable to FX, which suggests there is room to run.

Brazil becomes even more compelling when compared against the S&P500. By almost every metric, Brazil is attractive and offers a decent cushion should either macroeconomic or political conditions deteriorate. We believe Brazil is about halfway through the normalization process, however, this time is different for a couple reasons:

First, the current phase will be much longer than previous cycles. Given global slow growth and unknowns related to the post-commodity cycle, we just don’t know how Brazil will fare in its transition to a consumer-driven economy. Right now, it looks like the Temer government is steering policy successfully. That said, investors in broad equities need to accept the notion that alpha will become more elusive as Brazil volatility is unlikely to fall much and overall returns will come down. For this reason, we really like real estate which inherently is low volatility and low correlation. Real estate also pays the investor to wait. Note: historically high Brazil yields are gone for the time but not for real estate which offers unleveraged yields of around 10%.

Second, while we know what Brazil growth looks like when you strip out China demand for commodities, we really don’t know what a consumer-driven long term growth rate will be? Will it look more like Mexico or better or worse? We don’t know.

Third, we know the central bank is very close to cutting rates and we also know they can cut rates a lot (we think 200bps to 300bps over the next 12 to 18 months). What we don’t know is the pace of cuts nor how the central bank would react if above average inflation remains sticky? Will they adopt the Yellen view of letting it run hotter for longer or will historical experience with hyperinflation cause the central bank to act hawkish should CPI remain high? We don’t know.

What we do know is developed markets assets are not cheap. Everywhere we look we see yields converging across the private-public spectrum, so while growth may still be a projection in Brazil, at least there is valuation on both an absolute and relative basis. You may not like it but it’s a clear reason to have at least some exposure.


No, Trump’s Poll Numbers Aren’t A Proxy For The Mexican Peso

Much fanfare is made about the impact on Mexico every time a new poll shows resilience for a Trump Presidency, and then the Mexican peso goes the other direction (and just because Bloomberg has a chart suggesting otherwise, doesn’t mean it’s real). It’s a classic case of media hype when the narrative suits but when the nanosecond correlation breaks down, we get silence. So, here it is: there is zero meaningful correlation between Trump and the Mexican peso (ok, fine, maybe not zero but de minmis). We are not saying there haven’t been and won’t be knee-jerk reactions. What we are saying is that the best way to understand long term impacts on the Mexican peso appears to be the JPYUSD. We look at a 5yr daily correlation (using a 252 period) and it’s pretty clear that when the JPY rallies against the USD, the peso gets a boost. Conversely, when JPYUSD destabilizes, the peso suffers. That’s it in a nutshell. The reasons why can be debated for sure but our view increasingly sees the rise of peso liquidity as the main causal factor than anything else. Free market capitalism cuts both ways and Mexico’s increased reliance on internal consumption, in large part, means that the central bank can manage periods of FX stress through smart monetary measures. Note: Mexico’s central bank in a surprise move this month, bumped the overnight rate 50bps. Second note: That Mexico can raise rates seems to have gotten little or no press.



Expectations for Rate Cuts in Brazil Pick Up Steam

Let’s recall that only a few months ago most viewed prospects for a Brazil rebound as somewhere between dead cat bounce and hopium. Most institutional investors missed the late Fall 2015 signs of a bottom being put in; then in February 2016 they sat waiting for the “floor” to drop out; finally, in June, they said that it wouldn’t last, that Brazil is doomed. We literally had pension investors telling us in July that Brazil was going to sell off hard, again. And this was well after the massive political upheaval and decided improvement in forward-looking macro data – especially trade, FDI and inflation. Well, how things change.

Our view towards Brazil shifted materially last Fall when it became apparent the correlation between EM FX and the USD started to break down. Following the January swoon, the time to buy was clearly staring right into our eyes. Fast forward, it’s pretty clear that when forward looking macro indicators started showing material improvement in Q2, combined with Dilma’s ouster, the inflection point had arrived.

Over the last several months, expectations for rate cuts have gained momentum and with YoY CPI now trending decidedly lower, most believe the central bank will cut as early as the end of October.

“DJ Brazil’s Central Bank Might Cut Aggressively — Dow Jones – Tue Oct 11 09:06:25 2016 EDT

The initial approval by Brazil’s lower house of a proposed constitutional amendment on taming government
spending paves the way for fast and aggressive interest-rate cuts, says Cristiano Oliveira, chief economist at Banco
Fibra. He expects the Selic to be slashed some 5 percentage points the next year from the current 14.25%. Central-bank
officials next meet next week.

While we don’t expect 500bps of cuts in 2017, it is certainly possible, but Brazil does have an inflation issue and it will be a while before we can really measure its progress in the post-commodity global paradigm. Our view is we’ll get a 25bps to 50bps cut either at the next meeting in a couple of weeks or next month and then it will be wait-and-see for inflation. The Fed’s lower for longer policy removes some of the Brazil central bank’s urgency to see growth rebound at the expense of moving too fast, too soon. For 2017, we continue to think a reasonable expectation would be for 200bps to 300bps in rate cuts.

CNNMoney – Jul 2016

‘Stampede’ of cash rushing into emerging markets