One of the central tenants in the argument for passive / indexing style of investing is that you can’t beat the markets by actively selecting investments. As the overall economy grows an investor benefits from owning a basket of securities that represent that economy or sector. As long as the cost of that basket is low, the investor wins. Exchange traded funds (ETFs) have become the most widely used vehicle for this strategy.
Now we are seeing evidence that ETFs are influencing markets similar to active trading strategies. There was a lot of debate about the role of ETFs and other “speculators” in driving up commodity prices earlier this year. Even Congress got into the act with hearings on the matter for a while, but interest waned as commodity prices collapsed in the face of the credit crisis. Today’s WSJ story, REIT Moves Rub Executives Wrong Way, suggests that ETFs are creating artificial volatility in the REIT markets as well.
REITs have been unusually volatile lately, much more so than normal and more than the s&P 500, and in an asset class that traditionally is less volatile.
What’s driving REIT executives particularly crazy is that the volatility has upended notions that the asset class is less affected by the day-to-day vagaries of the public market.
“It’s just insane…with a business that generates much of its cash flow from leases that are not that volatile,” says Hamid Moghadam, the chief executive of AMB Property Corp., a warehouse developer whose stock has lost nearly half of its value in three months. “All I can tell you is that people are very confused.”
So why is this happening? Many REIT executives largely blame funds that pursue leveraged stock-trading strategies that let investors make quick, high-stakes bets on broad stock indexes or baskets of stocks in specific sectors.
Some market observers believe these funds — known as leveraged exchange-traded funds — increase the volatility of individual stocks in those baskets, particularly toward the end of the day, as fund managers buy or sell shares to square their books.
Leveraged ETFs are ones that are supposed to deliver 2x to 3x the movement of a particular index. So, for example, if the S&P 500 goes up 3%, the ETF goes up 6%, or down twice as much on a down day. Leveraged strategies can be especially detrimental when the ETFs invest in smaller sectors.
REITs are particularly susceptible to volatility because typical trading in them tends to be light.
Some executives are concerned that the volatility will scare off institutional investors that have traditionally invested in their sector to diversify their portfolio, with its long-term return and low volatility.
The evidence for this remains anecdotal, but this is another aspect of the active vs. passive debate that bears watching.
Executives at exchange-traded funds have argued that there is no proof that they are the cause of the volatility. But some market participants say there is evidence that day-to-day trading strategies have begun to drive the sector.
One REIT trader who asked to remain anonymous says dedicated real-estate investors, which in normal times made up about three-fourths of his flow, now account for less than half of it.
For now, I remain committed to keeping things simple and focusing on a smaller number of asset classes than I have in the past.