CAIA L2 - 7.3 - Access to Real Estate and Commodities Flashcards
List and Describe
2 types of
unlisted real estate funds
+
2 examples
7.3 - Access to Real Estate and Commodities
Open-end real estate funds
* 30% of unlisted funds
* permit investment and redemption (after a specified lockup) with no notice period required
* Investments are usually in less risky assets
* Redemption price = quarterly => potential issue with stale pricing
* US: redemptions paid with generated income (not property sales)
* UK: property unit trust (PUT) to U.K. tax-exempt institutional investors (>better than>) Authorized PUTs (APUTs) to U.K retail. offshore PUTs provide some tax advantages for both taxable and tax-exempt investors. Property authorized investment funds (PAIFs) must be valued daily
Closed-end real estate funds
* 70% of unlisted funds
* no redemption provisions by the fund issuer
* Investments are usually in more risky assets
* US: matched-bargain system (buy offers directly matched with sell offers - no mkt maker)
Examples
Real Estate Funds of Funds
* +Diversification +professional management / - 2 fee layers
* US / US: formed as open-end funds (Europe = closed)
Non-Traded REITs
* registered with the SEC
* invest in equities, mortgages, or both
* invest in (1) multifamily properties (e.g., apartments); (2) office properties; (3) industrial properties; (4) retail centers; (5) hospitality properties; (6) health care facilities; or (7) self-storage units
* lifespan of 7 to 10 years
* up-front fee of 12% to 15%
* criticisms: 1) illiquidity <> low vol; 2) high fees come with conflict of interest; 3) borrow to pay dividends
7.3 - Access to Real Estate and Commodities
List and Describe
Potential
Advantages and Disadvantages
of Unlisted Real Estate Funds
7.3 - Access to Real Estate and Commodities
Potential Advantages of Unlisted Real Estate Funds
1. Diversify real estate specific risk Significant funds are needed to create a properly diversified real estate holding. Baum and Struempell find that at least £1 billion is needed for proper diversification.1
2. Access to skilled managers Skilled managers may wish to manage unlisted real estate due to high fees and return potential.
3. Targeted exposures Unlisted real estate funds may focus on niche regions or subsectors.
4. Tax-advantaged income. Unlisted REITs offer tax-advantaged income because they avoid taxation at the fund level as long as 90% of income (in the United States) is paid out to investors.
Potential Disadvantages of Unlisted Real Estate Funds
1. Cash drag. Investor commitments to an unlisted real estate fund will be drawn as the manager purchases properties. That can create a drag for investors as funds are not immediately invested in real estate and therefore, incur an opportunity cost while awaiting investment.
2. Higher fees. There are multiple levels of fees: (1) initial offering fees; (2) AUM-based fees of 50 to 200 basis points in the United States and 20 to 150 basis points in the United Kingdom; and (3) potential performance-based fees.
3. Leverage and the J-curve effect. The fees and costs of building an initial portfolio are often substantial, which creates a short-term performance lag. As a result, leverage is often used to bring performance up to expectations. That may magnify potential returns but it also increase risk, especially when illiquid assets are considered.
7.3 - Access to Real Estate and Commodities
List
Drivers of performance
of the closed-end
private equity real estate (PERE)
funds
(in Unlisted Closed end Real Estate funds)
7.3 - Access to Real Estate and Commodities
BETTER PERFORMANCE of private equity real estate (PERE) funds with:
1. + GDP in US. positive relationship between U.S. PERE performance and U.S. GDP growth. The relationship between international PERE fund performance and Global GDP growth was not deemed significant.
2. +Fund size internationally. Fund size is a statistically significant performance driver for international, but not domestic, PERE funds. A possible rationale is that large international funds have greater access, resources, and cost advantages.
3. -Vintage volume = ONLY NEGATIVE CORREL. There is an inverse relationship between vintage volume, which is the total capital raised in a particular year for a private market category, and PERE fund performance. Overinvestment may lead to poor performance.
4. +Default spread changes. A positive correlation exists, as PERE returns increase with a rising default spread. As exposure to default risk increases, investors will require a risk premium.
5. +Private market real estate returns. A positive correlation was found between PERE returns and returns on private market real estate.
6. +Inflation. PERE returns and inflation have a positive correlation.
7. +Performance persistence. Evidence showed performance persistence for both domestic and international PERE funds. For funds raised by the same manager, even minor increases in prior fund performance led to significant increases in current fund performance.
7.3 - Access to Real Estate and Commodities
Contrast
REITs
vs
REOCs
(in Listed Real Estate investments)
7.3 - Access to Real Estate and Commodities
Both: managed pool of real estate that can be bought and sold on the stock market
REIT
- 90% of its income (in the United States) as dividends.
- Tax-advantaged treatment such that income is not taxed at the REIT-level but is passed onto investors as long as the REIT pays out
REOC
- Income is reinvested to acquire more real estate assets (goal = capital appreciation) => Has much greater investment choice
- NOT tax-advantaged
7.3 - Access to Real Estate and Commodities
List and Describe
Potential
Advantages and Disadvantages
of Listed Real Estate Funds
7.3 - Access to Real Estate and Commodities
Tip: ETFs are listed.
ETFs: (Basket = diversified, liquid (because they’re listed), already invested (cte exposure), lots of info); ETF tb (can trade outside NAV and correlate with equities)
Potential Advantages of Listed Real Estate Funds
1. Diversification. They offer instant diversification with relatively little cash outflow that would otherwise be very difficult to achieve through direct investment.
2. Liquidity. They are highly liquid in established secondary markets. Because they essentially trade as shares, investors can invest exactly how much they want.
3. Constant exposure. They have full real estate exposure immediately so there is no cash drag.
4. High information flow. They are regulated and therefore provide copious amounts of relevant and timely information for investors to consider.
Potential Disadvantages of Listed Real Estate Funds
1. NAV-relative volatility. They usually trade at a discount or premium to their NAV, which increases risk. For example, a 20-year study of U.S. REITs showed fluctuations between a 40% discount and a 20% premium. There are two possible reasons: (1) the smoothing effect with appraisals, (2) swings in short-term market sentiment.
2. High correlation with equities. They have been shown to have very high correlations with equity indices, especially for mid-cap and small-cap stock indices. That is not surprising given the many equity-like features of REITs.
7.3 - Access to Real Estate and Commodities
List and Describe
ETF categories of
- iShares FTSE NAREIT Residential Index
- iShares FTS NAREIT Industrial/Office Index
- SPDR DJ Global Real Estate ETF
- First Trust S&P REIT Index
- ProShares Ultra Real Estate ETF
7.3 - Access to Real Estate and Commodities
- iShares FTSE NAREIT Residential Index - U.S. sectors
- iShares FTS NAREIT Industrial/Office Index - U.S. sectors
- SPDR DJ Global Real Estate ETF - global real estate
- First Trust S&P REIT Index - broad U.S. exposure
- ProShares Ultra Real Estate ETF - leveraged long-bias
7.3 - Access to Real Estate and Commodities
List and Describe
Ways to have
ownership of
commodities
7.3 - Access to Real Estate and Commodities
Direct Physical Ownership of Commodities
‘+ Higherst correlation
‘- Costly to store (and difficult)
Indirect Ownership of Commodities - List:
- Commodity Index Swaps
‘swap buyer (i.e., receiver) = pay fixed receive variable
‘+ Customizable
‘- Counterparty risk / illiquid secondary market - Public Commodity-Based Equities
‘- Low correlation with commodities - Ownership of Commodities Through Bonds
‘- Low correlation with commodities (higher quality bonds) - Commodity-Based Mutual Funds
‘can be actively or passively managed -
Exchange-Traded Products
‘can trade <> from NAV value. (Liquid ETFs trade near NAV)
‘ Tracking Error: Lowest to highest => full replication ETFs, futures-based ETFs, and swap-based ETFs. - Public and Private Commodity Partnerships
‘high correlation with commodities
“like non-traded REITs”
‘MLP: master limited partnership - US-Listed LP ; volatility and drawdowns similar to equity (specially in market stress) - Commodity-Linked Investments (Ex: commodity exchange-traded note (ETN))
‘commodity index-linked note: fixed-income obligation, return is tied to a commodity or a group of commodities, do not impose margin, can be easily sold
‘ Like ETF, but it’s not a share => bears default risk in that the repayment of the ETN is tied to the creditworthiness of the issuer
‘+minimal tracking error
‘+ might be taxed at the long-term capital gains rate (if held +1y) - Commodity-Based Hedge Funds
‘ correlation ~0 with commodity indices
‘Long-only physical commodity funds = directly competing with producers and users of commodities.
‘Others: Long-only equity funds, short-biased, long/short approach, market timing
7.3 - Access to Real Estate and Commodities
List and Describe
2 Types of
Principal-Guaranteed Notes
7.3 - Access to Real Estate and Commodities
- A cash-and-call strategy or participation note involves a principal guarantee, using a zero-coupon bond coupled with a call option that is commodity-linked.
investor wants to commit $100,000 to a cash-and-call strategy. Buys a zero-coupon bond from an issuer with a $100,000 face value at a discount for $85,000. Issuer uses remaining $15,000 to buy call options on a commodity index. At the maturity of the bond, the investor receives the principal back and possibly a positive return on the commodity if the call option ends up in the money. - Constant proportion portfolio insurance (CPPI) adjusts the commodity exposure to the current price of the zero-coupon bond. In the preceding example, both cash-and-call and CPPI would look the same at inception, but if market interest rates rose and the zero-coupon bond changed value to $80,000, then the commodity exposure would adjust for the change. The protection is dynamic by only holding commodity investments if their value exceeds the cost of the zero-coupon bond; the latter essentially being the cost of providing portfolio protection.
7.3 - Access to Real Estate and Commodities
List and Describe
3 interrelated economic variables
that may impact commodity returns
7.3 - Access to Real Estate and Commodities
Energy => follow inflation
Agriculture => follow interest rates
- Interest rates
High real rates lead to higher opportunity costs of owning physical commodities and lower demand for storable commodities in three ways: (1) greater desire to extract now instead of later; (2) lower holdings of commodity inventories; and (3) moving away from commodity investing and moving toward fixed-income investing. - Central bank policy
As an economy expands and inflation accelerates, the central bank implements a contractionary monetary policy, which will raise short-term real rates. The reduced economic growth could lead to decreased consumption of commodities and ultimately, falling commodity prices. At some point, central bank policy will become expansionary and commodity prices should rebound. There is generally a negative correlation between the price of commodities and both the strength of the domestic currency and the level of interest rates. - Inflation
If the inflation rate effect is dominant (e.g., energy), then commodity prices are likely to rise and fall together with inflation and there is an inflation hedge. If the interest rate effect is dominant (e.g., agriculture), then commodity prices are likely to rise and fall together with interest rates, and that is more of a business cycle hedge.
7.3 - Access to Real Estate and Commodities
Discuss commodity financing and private instution’s role
Commodity financing has traditionally been provided by merchant banks, investment banks, and commodity firms. Recently, private investment funds have also begun to extend credit for the production, storage, and transportation of commodities.
Loans are often secured with the commodity as collateral and they involve higher interest rates to compensate for operational, credit, and political risk exposures.
Private institutions are needed is to fill a void left when more onerous regulations for risk-weighted assets caused financial institutions to step away for the market to a degree
LO 7.3.5
four main means of gaining exposure to commodities for commodity-based ETFs and mutual funds
- Commodity index funds or swaps
- Equities of commodity-based companies
- Physical commodities
- Commodity futures
LO 7.3.4
Since the mid-1860s, the number and duration of commodity supercycles has been closest to
Four cycles, each lasting between 30 and 40 years
LO 7.3.7
Contrast Global and US REITS management and leverage limits
Global REITs are likely to be managed externally and be subjected to leverage limits
US REITs are more likely to be managed internally and not be subjected to ** leverage limits**
LO 7.3.3
REAL ASSETS
Differentiate between Contango & Backwardation
Reading 3.2: Commodities
The term structure of futures prices (or simply, the forward curve) is the relationship between the futures price and the maturity of the contract:
- Contango. This refers to a price pattern where the futures price is above the spot price and converges to that price from above over time. Contango markets have an upward sloping forward curve.
- Backwardation. This refers to instances in which the futures price is less than the current spot price. In these cases, the forward curve will be downward sloping, indicating that the futures price is lower for longer-term contracts.
4 possible forward market return structures
- Backwardation. The current forward price is less than the current spot price.
- Normal backwardation. The current forward price is less than the expected future spot price.
- Contango. The current forward price is greater than the current spot price.
- Normal contango. The current forward price is greater than the expected future spot price.
REAL ASSETS
Provide the 2 differing descriptions for rolling a contract often found within financial literature
Reading 3.2: Commodities
- Rolling between contracts (i.e., closing out the existing futures position and buying a new futures contract with a longer maturity). As an investor rolls between contracts, unrealized gains and losses are realized. However, this is not a true roll yield. Roll yield is generated over time as the basis changes rather than at the moment one futures contract is exchanged for another.
- Describing how the price of a futures contract changes over time as it approaches maturity. Assuming spot prices, the cost of carry, and the term structure of forward prices are constant, a positive roll yield is earned in a backwardated market as the futures price rolls up the term structure of forward prices. Similarly, a negative roll yield is earned in a contango market as the futures price rolls down the term structure of forward prices.
