Alternative investment reallocation: sacrifice on returns

[johntavv]

Reading 25 Practice problem 3B says:
We should reallocate 10% from the 50% S&P allocation to REITS.
Annualized return for NAREIT index = 12.71%
Annualized return for S&P 500 = 10.94%
Annualised return for NAREIT index hedged = 8.96%
The answer says:
Return of unhedged REITS is almost 2% greater than return on S&P 500, whereas hedged is about 2% less than S&P. Therefore taking into account the equity return componenent of the NAREIT index, this reallocation could represent a slight sacrifice in return.
Why is reallocating from S&P (10.94% return) to the NAREIT index (12.71% return) considered a sacrifice, isn’t it better?

 

[myriam2222]

thanks for posting it here. Looking forward to reading what everyone says but it looks like a typo to me

 

[zulu007]

You are reallocating from S&P (10.94% return) to the NAREIT hedged index (8.96% return) which is ~2% sacrifice.
The key word here is “taking into account the equity return component”, which indirectly means using hedged index.
Unhedged NAREIT index is a combination of equity like featues (liquidity / tradeability) and pure real estate exposure. If you hedge the equity like features through S&P Index, you are left with just the pure real estate exposure.
So in this question - using NAREIT Index hedged would reduce your return by about 2%.
Hope it helps

 

[myriam2222]

Thanks a lot Zulu007! Sorry, I realized we missed your first post on this.
So you need to take hedged NAREIT to answer the question, not unhedged NAREIT. This is what I got wrong. How do we know from the question that we need to take the one with no equity return component though? I guess the answer is in your mention “if you hedge the equity like features through S&P Index”. Could you further explain what you mean through this please?

 

[zulu007]

I would expect them to indicate something like “taking into account the equity return component” in the question. In this particular question, they are asking for critique on both types.
Simply, if unheged NAREIT = Equity + Real estate
and you hedge the equity part through S&P (or any other index as per question) you are left with pure real estate exposure
Also look at the correlations:
Hedged NAREITs with S&P = 0
Unhedged NAREIT with S&P = 0.35
CFAI text confirms that the hedged NAREIT Index is a more realistic representation of the underlying real estate market (section 3.2.2)

 

[zulu007]

You are welcome - no problem.
“if you hedge the equity like features through S&P Index” = we are trying to establish purely the real estate part

 

[myriam2222]

Ok thanks a lot!
Your tip on correlation is for sure a good way to remember which one has equity exposure if we have the info in the question and we forgot.
Perfect!