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Weekly Commentary – Some thoughts on REITs

A PDF version of this commentary can be downloaded here.

Special Announcement

Newfound will be hosting its next monthly strategy review session on Thursday, May 14th from 2:00- 2:30PM EDT.

We’re fortunate enough to have a guest panelist joining us: Brett Hammond from MSCI. He will be discussing factor-based investing and MSCI’s portfolio construction methodologies that underlie many of the ETFs Newfound utilizes. We’ll also be discussing how tactical strategies can be incorporated into an existing portfolio framework.

We hope you can join us! You can register by going to the following link: https://attendee.gotowebinar.com/register/8709604704067592450.

Market Thoughts

We received a request to discuss our view on U.S. REITs, so we thought we would dedicate this week’s commentary to that very topic.

Now, before we start, it should be said that as a rules-based, quantitative firm, our individual views as portfolio managers are trumped by what our models dictate. Our models are designed to react to changes in the market environment: how our portfolios are positioned in the future will ultimately be dictated by the changes in market currents that our models identify as significant, emerging trends.

Nevertheless, one of our roles as portfolio managers is to constantly be thinking about risks and considering conditions that are historically unprecedented to determine if there are latent risks lurking within our portfolios. What can go wrong? is the question we frequently ask ourselves.

Let’s start with the basics: what are REITs?

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"Lies, Damned Lies, and Statistics" ... and Incorrect Statistics

In keeping up with my research reading, I came across a white paper from J.P. Morgan titled Defining Absolute Return Investing in Fixed Income.

A graph on one of the last pages caught my eye:

JPMorgan - Defining Absolute Return Investing in Fixed Income

The stunning non-normality of the Barclay's Aggregate Bond index struck me.  "It must be that yield is significantly swamping price return," I thought.

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Can you avoid rising rates with high carry assets?

First: the takeaways

  • Expected return for an asset class is a combination of carry and price appreciation
  • If carry is high enough, it can potentially dwarf price depreciation due to rising rates
  • Higher carry assets (e.g. high yield bonds, MLPs, REITs, bank loans, EM debt, et cetera) have historically had low-to-negative estimated duration profiles
  • High carry assets have a variety of associated risk factors, representing an ability to generate income and diversify away from interest rate risk

So what is carry?

In their paper "Carry," Koijen, Moskowitz, Pedersen and Vrugt define carry to be and asset's "expected return assuming that market conditions, including its price, stays the same."

Using this definition, we can decompose an asset's return into three categories: carry, price appreciation (or depreciation), and unexpected shocks.  The first two – carry and price appreciation – define the expected return.  Unexpected shocks are volatility.

Carry me away

For rate sensitive instruments – like bonds – a rising rate environment can present a very real risk to price return.  In fact, expecting a rising rate environment can lead to a negative expected return profile.

That is, of course, if carry is not sufficiently large to outweigh the impact of the rising rates.

In a prior post, I touched upon a simple formula to determine how rising rates might affect the returns of a constant maturity fixed-income portfolio.  The underlying tug-of-war was between carry and price appreciation: when rates rise, carry increases, but price decreases.  At a certain point, the increased carry outweighs the losses.

With Treasury rates near all-time lows, it is unlikely that carry will make up for price losses in the near future – but what happens if we start with high carry asset classes?

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Weekly Commentary – A Curated Charcuterie of Links

A PDF version of this commentary can be downloaded here.

Special Announcement

Newfound will be hosting its next monthly strategy review session on Thursday, May 14th from 2:00- 2:30PM EST.

We’re fortunate enough to have a guest panelist joining us: Brett Hammond from MSCI. He will be discussing factor-based investing and MSCI’s portfolio construction methodologies that underlying many of the ETFs Newfound utilizes.

We’ll also be discussing how tactical strategies can be incorporated into an existing portfolio framework.

We hope you can join us! You can register by going to the following link: https://attendee.gotowebinar.com/register/8709604704067592450.

Market Thoughts

We thought we would do things a little differently this week. As a research driven firm, we spend a lot of time reading, from books to research papers to blogs. This week, we thought we’d focus on some of the great content we’ve read in the last few weeks.

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New Research Paper: Minimizing Timing Luck with Portfolio Tranching

Frequent readers of this blog know that I am somewhat obsessed with the concept of timing luck and portfolio tranching, with the ultimate goal of reducing the variance of active returns.  For those less familiar with the topic, you can read our introductory white paper here.

I recently wrote a more in-depth research paper on the topic, covering how timing luck affects tactical portfolios, smart beta portfolios, and strategic portfolios alike.

Here the abstract: