In one of the most famous episodes of Seinfeld, lovable loser George Costanza has an epiphany. "If every instinct I have is wrong, then the opposite would have to be right." For the entire episode, George does the opposite of what his instincts tell him.
This strategy works wonders for the serially unemployed character. At the coffee shop, George walks up to a blonde woman and says, "My name is George. I'm unemployed and I live with my parents." The woman smiles and George takes her on a date.
REIT investors would have enjoyed similar success over the past 20 years by "pulling a Costanza" and doing the opposite.
How To Outperform By Doing The Opposite
Using NAREIT sector data going back to 1994, we studied different sector rotation strategies. We wanted to find patterns that average investors could actually use.
To do this, we wanted to find strategies that are tax-friendly and fee-friendly, require infrequent rebalancing, and most importantly, do not require massive amounts of hedge-fund-style computing power.
To perform the study, we compiled the NAREIT total return data for the eight equity REIT sectors that the trade organization has been tracking since 1994. We should note that this does not include the newer sectors like data centers, manufactured housing, or single family rental.
Using this data, we studied what would happen if an investor were to rebalance every year by picking the most "beaten-down" sector of the prior year, and repeated the study by picking the bottom two, bottom three, and bottom four sectors of the prior year. Then we reversed the study, and picked the top performing sectors of the prior year.
Our findings were fascinating and our results are outlined below.
Picking the bottom two sectors from the prior year resulted in 2.27% of active return, but this came at a cost of a higher standard deviation of returns compared to the benchmark (active risk).
The ideal risk-adjusted return comes from picking the "Bottom Three" sectors of the prior year. By achieving active returns of 1.62% with an active risk of 6.43%, this strategy produced the highest information ratio, 0.25. This strategy did not work over the prior one-year period, but did work over a three and five year period.
Interestingly, going "all-in" on the most beaten-down sector produced returns that were not significantly different than the index and thus produced no alpha.
This result is a clear indication of outperforming by using a "value factor" REIT portfolio. How significant is 2.27% of active return (Bottom Two strategy) over 20 years? Before taxes and fees, using that strategy would result in a portfolio value over 50% higher than a passive investment in the All Equity REIT index.
Is Playing the Momentum Also A Good Strategy?
Investors who use a "jump on the bandwagon" approach to investing did not do as well as the contrarians, but we did find useful strategies within the results.
Going all-in on the best performing sector of the prior year did produce slightly positive active return, but it came with far higher risk. In all, the information ratio was a insignificant 0.07 before fees and taxes. Similar results were found with Top Two, Top Three, and Top Four strategies.
None of these strategies could be expected to reliably produce alpha after taxes and fees based on historical trends. In a tax-free and low-commission account, it is conceivable that the Top One and Top Four strategies could generate outperformance, but the margins would be far tighter under this momentum-factor portfolio than the contrarian value-factor.
Sector-ETFs May Be Required
Of course, this strategy requires buying "entire sectors" of REITs. If sector-ETFs in REITs currently existed, this would be relatively easy and require only a few trades per year.
Unfortunately, sector-ETFs for REITs do not yet exist, but we believe they are on the horizon as more generalist investors become interested in the oft-forgotten sector after the GICS sector split.
We plan to further analyze these results and try to minimize the total number of individual REIT holdings required to achieve these results. In other words, investors may not need to hold the "entire sector" but rather just 1-3 REITs in each sector to achieve similar risk and return results.
Bottom Line: Don't Believe the "Analyst Consensus"
Sell-side analysts have a long history of being on the "wrong-side" of price trends. Generally, consensus opinions tend to be excellent contrarian indicators. Behavioral biases and career risk issues tend to result in analysts making "Buy" recommendations after a period of strong performance and "Sell" recommendations after particularly weak performance.
While we did not incorporate consensus analyst opinions in this study (and it would be impossible to go back for 20 years on stock-by-stock recommendations), it can be reasonably inferred that the consensus was most likely incorrect.
Buying the most out-of-favor sector of the prior year is a winning strategy in the REIT universe.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.