The Ego, The Market, and The Mania

Since 2008, economic uncertainty and market volatility have tested the staying power of investors around the world. Many people fled equities during the worst months of the global financial crisis, while others waited for signs of a turnaround before investing more. Their emotional reactions may have exacted a large price on their wealth.

The graph below documents investor behavior during the stock market downturn in 2008 and subsequent market rebound. It offers a few key lessons about investing in turbulent markets.

Figure 1: Quarterly Equity Mutual Fund Flows

Industry vs. Dimensional Relative to S&P 500 Index Performance

January 2008–June 2011

For illustration purposes only. Industry net new cash flow data for US-domiciled equity funds provided by Investment Company Institute ©2011. Quarterly cash flows are estimates that are adjusted to represent industry totals, based on reporting covering 95% of industry assets. Dimensional’s figures are based on net new cash from financial advisors in US-domiciled funds. Industry and Dimensional data reflect investment in US and international equity markets and do not include funds of funds. S&P 500 Index performance is based on monthly returns data. The S&P data are provided by Standard & Poor’s Index Services Group. The S&P 500 includes 500 US stocks chosen for market size. Past performance is no guarantee of future results.

Reading the Graph

First, look at the shaded graph in the background, which plots the performance of the S&P 500 Index (measured by growth of a dollar) over this three-and-a-half-year period. The market began falling in late 2008 and hit bottom in early March 2009. It then reversed sharply and began a long climb through June 2011.

Now consider how mutual fund investors responded to the stock market’s downturn and recovery. The orange line plots quarterly net cash equity flows for the US mutual fund industry over the same period. (Net cash flow is the difference between redemptions and purchases of shares in a mutual fund. A net cash outflow occurs when redemptions exceed purchases.) Equity fund flows were cumulatively negative over the period. Investors were redeeming more shares than they were buying, and on a net basis, capital was leaving mutual funds.¹

Note that these fund industry outflows followed the stock market downturn, and net flows stayed negative even after the market rebound. Investors were reacting to the falling stock market by either redeeming their fund shares or delaying the purchase of additional shares.² When the stock market suddenly rebounded in March 2009, investors who had reduced their exposure to equities missed a good part of the recovery.

This apparent lack of discipline is well established over longer time periods too. Industry analyses and academic research suggest that investors tend to focus on recent performance and make decisions that compromise long-term returns in their portfolio.³

Recent history illustrates why the average fund investor may fail to earn returns comparable to those of the average fund or market index. Markets change quickly, and investors must be in their seats to capture returns. Unfortunately, many investors let their emotions get in the way of participating in long-term market performance.

Now consider the upward-sloping blue line, which plots quarterly net flows into equity strategies offered by Dimensional Fund Advisors. These flows were cumulatively positive throughout the entire period, suggesting that shareholders in Dimensional’s funds continued to purchase shares during the 2008–2009 market decline and after the March 2009 rebound.

As a group, these investors did not flee stocks en masse. In fact, they did the opposite by adding to their portfolios. Their discipline positioned them for the market rebound.

A mutual fund’s net cash flows also may reveal the collective discipline—or lack of discipline—among its shareholders. In fact, the direction of net flows can impact portfolio management and performance, especially for funds invested in less liquid markets. Large net redemptions typically increase the direct and indirect costs of a mutual fund, which compromise fund returns.⁴ The assorted costs are not borne by redeeming shareholders but by the shareholders who remain in the fund.⁵ Therefore, consistently positive net cash flows are helpful to a fund’s expenses, strategy, and performance.

Summary

The large net cash outflows from US-based mutual funds since 2008 document investor reaction to market volatility, while Dimensional’s stable and positive net fund flows suggest disciplined behavior. So why would shareholders in Dimensional’s funds behave differently? One reason might be the education, encouragement, and discipline offered by their financial advisor at that difficult time, underscoring the value of sound investment advice.

An advisor’s steady hand helps investors apply discipline in all types of markets, which can positively impact individual performance over time. Moreover, when advisors influence the collective decisions of shareholders in a fund, the greater cash flow stability can prove beneficial to the fund’s strategy, cost management, and returns.

Endnotes:

1. Mutual fund investors redeem their shares by selling them back to the mutual fund and receiving cash proceeds based on the net asset value (NAV) of the shares at day’s end. Redemption is a normal activity in a mutual fund, and liquidity is one benefit of owning fund shares. A fund manager may use inflowing cash to cover the redemptions or keep cash in a “liquidity reserve” for this purpose. When cash balances do not suffice, the manager may execute trades to raise the cash.

2. According to the Investment Company Institute, mutual fund flows do not offer a good measure of total demand for equities since funds hold only about 20% of the total US equities outstanding, with the balance held directly by individuals, institutions, and governments. Academic research offers some evidence that mutual fund flows do not drive market returns but reflect investor reaction to markets. (Roger M. Edelen and Jerold B. Warner, “Aggregate Price Effects of Institutional Trading: A Study of Mutual Fund Flow and Market Returns,” Journal of Financial Economics 59, no. 2 (2001): 195–220.)

3. A Morningstar study compared the dollar-weighted returns of the average investor in a fund with the fund’s published total return for the ten-year period ending Dec. 31, 2009. In US equities, the average investor in all funds earned 0.22% annualized, compared with 1.59% for the average fund. (Russel Kinnel, “Bad Timing Eats Away at Investor Returns,” Morningstar.com, February 15, 2010.) Lack of investment discipline also is documented among individual investors who hold common stocks directly. Those who trade frequently pay a tremendous performance penalty for their actions. (Brad M. Barber and Terrance Odean, “Trading is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors,” The Journal of Finance, April 2000.)

4. Direct transaction costs include commissions, bid-ask spreads, and price impact incurred when a fund makes trades in response to shareholder redemptions. Net outflows also may generate indirect costs on a fund by forcing its manager to alter the target asset allocation or make disadvantageous, uninformed trades to raise cash. See Qi Chen, Itay Goldstein, and Wei Jiang, “Payoff Complementarities and Financial Fragility: Evidence from Mutual Fund Outflows” (white paper, February, 2007).

5. Mutual funds typically meet a redemption based on the NAV at day’s end but may execute a trade to raise cash on the following day. The redeeming shareholder cashes out at an NAV that does not reflect the trade, and the resulting costs are borne by remaining shareholders. See: “On the Run: Examining Patterns in Mutual Fund Redemptions,” Knowledge at Wharton,http://knowledge.wharton.upenn.edu/article.cfm?articleid=2133, accessed September 27, 2011.

Disclaimer:

The information presented above was prepared by Dimensional Fund Advisors, a non-affiliated third party. Diversification neither assures a profit nor guarantees against loss in a declining market. Past performance is no guarantee of future results. All expressions of opinion are subject to change without notice in reaction to shifting market conditions. This article is distributed for informational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products or services.

Dimensional Fund Advisors LP is an investment advisor registered with the Securities and Exchange Commission. Consider the investment objectives, risks, and charges and expenses of the Dimensional funds carefully before investing. For this and other information about the Dimensional funds, please read the prospectus carefully before investing. Prospectuses are available by calling Dimensional Fund Advisors collect at (512) 306-7400 or at www.dimensional.com. Dimensional funds are distributed by DFA Securities LLC. 

Real estate as a wealth generator is hardly a new idea. People owned property long before the advent of stock exchanges and other capital markets. In more recent times, large corporations and institutions have held commercial real estate in their portfolios.

But individual investors have not traditionally had ready access to a professionally managed, diversified real estate portfolio. This has changed in the last few decades with the development and growth of real estate investment trusts, or REITs. Now individuals can add a real estate component to their portfolio to improve overall diversification.

What is a REIT?

A REIT is a company that owns, operates, and/or finances real estate property.¹ Most of this discussion will address equity REITs, which manage different types of income-producing properties, such as hotels, office buildings, industrial facilities, apartments, and shopping centers. As commercial landlords, equity REITs typically generate dividend income from the rent paid by tenants. Many REITs in the US are traded on the public stock exchanges.

Publicly traded REITs offer investors several potential benefits:

• Real estate exposure. While publicly traded REITs account for only a small portion of the real estate investment universe and the equity market, academic evidence suggests that REITs have similar returns to the overall real estate market .2

• Low correlations with financial assets. Over longer periods of time, historical correlations of REITs and stocks have been generally low. (Correlation refers to the co-movement of asset returns. When two assets are positively correlated, their returns tend to move together; when negatively correlated, their returns are dissimilar.)

• Diversification. A REIT holds a portfolio of properties, which may specialize by property type and industry, or be broadly diversified according to industry and region. With the more recent advent of real estate securities overseas, investors can further diversify their exposure among foreign developed markets.
• Higher yield, regular income, capital appreciation. Since REITs have to pay out a large fraction of earnings as dividends, they tend to offer higher-dividend income than equities, and this may benefit certain income-oriented investors. Total return of the shares is tied to income and change in market value.

• Distinct asset class. While REITs are considered equity vehicles and can have significant exposure to the size and value risk factors, they are generally considered to be a separate asset class, due to their low long-term correlations with stocks.
• Liquidity and transparency. Publicly traded REITs can be bought or sold whenever the stock market is open for business. The availability of market-determined share prices can reveal information about the market’s assessment of the company’s prospects, including the ability of the firm’s management team.

• Tax treatment. REITs operate as “pass-through” corporations in which most income goes directly to shareholders. They typically pay little or no taxes on corporate income.³

Investing in REITS

A REIT mutual fund that manages a portfolio of REITs typically offers more diversification than owning a single REIT. Most REIT funds are either actively managed or indexed. An active fund manager seeks to pick securities that appear undervalued—an approach that often results in over-concentration in a single category, which may raise risks and potential costs, including transaction costs and management fees. On the other hand, an index fund tries to replicate a benchmark, such as the FTSE NAREIT Equity REIT Index or the Dow Jones US Select REIT Index. Although index funds may have lower fees, securities held in the portfolios may experience buying and selling pressure when indexes are reconstituted.

Our preferred approach is a structured strategy. Rather than trying to replicate an index, a manager may choose securities based on risk-return characteristics, diversification benefit, and favorable price negotiation. By keeping costs low and trading efficiently, a structured REIT strategy seeks to generate improved returns over time. Advantages of this approach include broader, more systematic exposure to the REIT universe at a lower cost.

Adding a real estate component to a portfolio may be a good diversification move. But strategy and implementation are crucial, and before investing, you should consider how a real estate strategy and the REIT you select may affect your portfolio. Some factors that may come into play:

• Asset coverage. Most actively managed stock funds and indexes include REITs in their equity holdings. This creates the potential for overlapping asset class exposure for investors who add a REIT component in their portfolio. Treating REITs as a separate and distinct strategy helps you achieve more precise risk exposure in the asset class weights. For example, investors with significant direct ownership in real estate may want to exclude REITs from the equity component in their portfolio to better control their overall exposure.

• REIT category. Equity REITs may operate property in a specific area of expertise, such as retail, office and industrial, hotels, or health care facilities. Residential REITs own and operate apartment buildings and multi-family commercial dwellings, rather than single-family homes. Mortgage REITs, which lend money directly to real estate owners or invest in existing mortgages or mortgage-backed securities, are generally excluded from the equity REIT universe because they perform more like fixed income instruments, with income based on interest payments. Hybrid REITs combine the strategies of equity and mortgage REITs.

• Diversification. As with financial assets, owning a broad mix of REITs can help reduce specific risk in a portfolio. This diversification eliminates exposure to a single REIT category, manager style, or geographic region. Also, adding international real estate can further enhance the potential diversification benefit.⁴ Correlations among international REITs are low across countries, regions, and equity markets, making them a useful complement to equities in developed and emerging markets.
  

Risk Considerations

REITs carry stock market risk, as well as risks specific to individual real estate properties, sectors, regional markets, and the operating firm. The securities are also subject to market pressures that may push share prices above or below the value of the underlying real estate. However, identifying a market premium or discount in a REIT is difficult since the underlying asset value reported by a REIT is based on an appraisal, which may be several months old. REIT returns also depend on the buying, selling, and operating decisions of management.

A manager may adopt risky strategies, such as heavy leveraging or lack of diversification. They may pay too much for properties, acquire poorly performing properties, change strategies regarding property mix, or make other business decisions that compromise performance. Investors holding foreign REITs or REIT funds are also exposed to risks specific to the country, such as legal structure, investment restrictions, ownership rules, tax treatment, and currency risk.

All of this underscores the importance of knowing your risk tolerance, carefully analyzing REIT fund managers, and diversifying to eliminate exposure to a single REIT manager or category.

Endnotes

1. Equity REITs make up about 91% of the REIT market. Mortgage REITs, which compose about 7% of the market, loan money to real estate owners or invest in existing mortgage-backed securities. Hybrid REITs combine the strategies of equity and mortgage REITs and make up about 1% of the market. Source: National Association of Real Estate Investment Trusts, Inc. (NAREIT).

2. Joseph Gyourko and Donald B. Keim, “Risk and Return in Real Estate: Evidence from a Real Estate Stock Index,” Financial Analysts Journal 49, no. 5 (September-October 1993): 39-46.

3. A US REIT must invest at least 75% of its assets in real estate and derive at least 75% of its income from real estate property or interest on real estate financing. It must also distribute at least 90% of its income to shareholders to maintain tax-advantaged status. This pass-through provision allows REIT investors to have access to the same cash flows as investors in private real estate equity. REIT shareholders, however, generally must pay taxes on income they receive from a REIT.

4. Over the 20-year period from 1990 to 2009, the annual return correlation between US REITs and the US stock market was 0.498 (1.0 denotes exact positive correlation in returns).

Disclosures

The information presented above was prepared by Dimensional Fund Advisors, a non-affiliated third party. Diversification neither assures a profit nor guarantees against loss in a declining market.

REITs vs. US Stocks
Annual Returns: 2000-2009

US Equity REITs are represented by the Dow Jones US Select REIT Index.
The US equity market is represented by the CRSP 1-10 Index.

Average Annualized Returns: 1990-2009

Returns in USD. Inception dates for Dow Jones US Select REIT Index is January 1978; CRSP Deciles 1-10
Index inception date is January 1926.

Indices are not available for direct investment, and performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is no guarantee of future results.

The Center for Research in Security Prices (CRSP), at the University of Chicago Booth School of Business (Chicago GSB), is a nonprofit center that also functions as a vendor of historical data. CRSP end-of-day historical data covers roughly 26,500 stocks—active and inactive—listed on the NYSE, Alternext, Amex (formerly AMEX), NASDAQ, and ARCA exchanges. OTC bulletin board stocks are not included.