Applying the Advantages of Index Investing to Private Real Estate

Few could have predicted the extent to which Vanguard founder John Bogle would transform the investment industry when he launched the first retail index fund in August 1976. Dubbed Bogle’s Folly by many skeptical academics and industry practitioners, his Vanguard First Index Investment Trust was created on the premise that most mutual funds had a hard time beating the market. By passively owning the broad stock market, Bogle believed investors could get better returns at a lower cost than actively-managed funds.  

Today, Vanguard’s Total Stock Market Index Fund is the largest mutual fund in the world, with over $1.2 trillion in assets. Bogle’s novel concept of indexing has democratized the investment industry, and passive index funds have overtaken actively-managed mutual funds in U.S. stock ownership.¹

Benefits of Indexing

The advantages of owning index funds compared to actively-managed funds generally include:

• Lower management fees
• Broader diversification
• Better tax efficiency (lower turnover)
• Eliminates the cost of manager selection
• Eliminates performance dispersion relative to the index
• Delivers systematic exposures of asset allocation, a primary risk driver

Indexing Technology

New technological advancements allow managers to continue refining the indexing processes, as witnessed by the growth and popularity of more complex investments like synthetic ETFs. Of course, every indexing method has inherent limitations and potential risks to consider including variance in tracking error, uncertain performance in highly volatile markets and increased governance risk.² Three of the most common approaches to indexing are full replication, sampling, and synthetic replication.

Full Replication

This indexing strategy is generally used by fund managers who want to own every security in an index at the same weight as the index. Full replication is a common approach to replicating the performance of large, liquid markets such as the S&P 500 index. It is popular among investors who seek the same return as the index and who want to achieve broad diversification with lower turnover costs.

Sampling Optimization

This approach to indexing is often used when it’s difficult to own all the securities in the index. For example, it may be too challenging for an emerging market index fund to own all holdings at a low cost. A fund that uses sampling to track an index might own 80% of the holdings to gain exposure to various segments and to achieve an acceptable risk and return profile. Sampling can reduce the cost of replication and may provide the most representative sample of the index based on exposure, risk, and correlation.

Synthetic Replication

This is the newest indexing method made available by the latest technology. Instead of owning the stocks in an index, synthetic replication uses derivatives to track the underlying index. These are contracts with a counterparty (usually a financial institution) for the index's returns. ETFs are increasingly using this low-cost approach to indexing since there are lower transaction costs and an inherent arbitrage mechanism can exist.

Too Much of a Good Thing?

As tracking technologies have made it easier for index fund managers to offer new products, some funds hold only thin slices of an index or are actively constructed to exclude specific holdings or add securities unrelated to the index. The goal is typically to achieve greater performance than the index, but the trade-off often involves giving up many of the primary benefits of indexing.

Indexing in Real Estate

You may already own an index fund if you allocate to real estate for your clients. Publicly-traded REITs and real estate funds are available in index and ETF structures and offer many of the same advantages as equity index mutual funds. Also, public REIT stocks are easy to buy, highly liquid, and generally offer arbitrage opportunities. 

On the other hand, as publicly-traded securities, these investments are often subject to the same market influences that impact the performance of other asset classes. Subsequently, they may not provide the diversification you intended when making your allocations.

Private real estate historically has not been available to investors in index structures. While the industry does have index benchmarks that enable institutions to track the performance of different strategies, private real estate funds typically hold buildings rather than tradable securities.  And despite the investor diversification benefits of owning an asset class uncorrelated to stocks and bonds, owning hard assets may limit arbitrage, redemption and subscription windows and offers relatively limited transparency of underlying holdings.

A Private Index Fund Emerges

Overcoming the challenges of a lack of transparency into the underlying funds, limited subscription and redemption windows, and no market-based arbitrage mechanism, IDR Investment Management (IDR), a subsidiary of Accordant Investments and a registered investment advisor with $4.3 billion in AUM, has created an index fund that tracks the performance of the NCREIF NFI-ODCE index.

The NFI-ODCE index is an industry benchmark that institutional investors have used since 1978 to track the performance of a select group of premier investment management firms that own and manage diversified portfolios of institutional-quality core real estate throughout the United States. 

You cannot invest directly in an index. 

Creating a process that could effectively replicate and track the underlying investments of the NFI-ODCE index was a task few believed could be accomplished due to the size and complexity of the index.

But much like how technology accelerates ETF indexing, IDR leveraged its advanced technology to build a model that tracked the NFI ODCE Index. And after IDR filed for patent protection in 2014, the firm spent the next four years in research and development, refining its process. As a result, IDR’s institutional fund, the IDR Core Property Index Fund LLC, launched in 2018 has experienced impressive growth ever since.

As an index fund, IDR’s product provides many of the benefits of publicly-traded index funds and also overcomes many common objections to private real estate investing with a structure that offers:

• Lower cost than traditional private real estate investments
• Improved liquidity with quarterly redemption windows after year one
• Investment transparency as the Fund tracks the well-publicized NFI-ODCE index with low tracking error
• Simplified subscription process and no K1s

Discover how easy it can be to provide your clients with access to a broadly diversified portfolio of institutional-quality private real estate. Contact us at 833.768.0622 or by email at info@accordantinvestments.com

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Sources

¹ businessinsider.com 

² money.usnews.com

Important Disclosures:

The information contained in this Presentation is for informational purposes only and is not an offer to sell, or a solicitation of an offer to buy, an interest (“Interest”) in a fund or other investment vehicle (collectively as applicable, a "Fund") by IDR Investment Management, LLC,  (“IDR IM”) or their affiliates and subsidiaries. 

The information contained herein is subject to change, and may not be reproduced, used or disclosed, in whole or in part, without the prior written consent of IDR-IM.

Statements contained herein are not historical facts are based on current expectations, estimates, projections, opinions and beliefs of the Firm. Such statements involve known and unknown risks, uncertainties and other factors, and you should not place undue reliance on them. Additionally, “forward-looking statements” may be referenced. Actual events or results or the actual performance may differ materially from those reflected or contemplated in such forward-looking statements.

Certain economic and market information has been obtained from published sources prepared by third parties and in certain cases has not been updated through the date of the Presentation. Neither IDR-IM nor their respective affiliates nor any of their respective employees or agents assumes any responsibility for the accuracy or completeness of such information. The IDR Entities have not made any representation or warranty, express or implied, with respect to the fairness, correctness, accuracy, reasonableness or completeness of any of the information contained herein (including but not limited to information obtained from third parties), and they expressly disclaim any responsibility or liability for this information. IDR-IM and the IDR Entities do not have any responsibility to update or correct any of the information provided herein.