Q: What is the history and goal of the fund?

The Guggenheim Risk Managed Real Estate Fund was launched in March 2014. Our portfolio combines Guggenheim’s traditional long-only domestic REIT strategy and its market neutral (long/short) REIT strategy.

The fund was designed to provide all the key benefits of REIT exposure including: high total return, attractive dividend yield, diversification, and inflation protection, while avoiding the downside of REIT exposure, which is volatility. We accomplish that by combining a long-only strategy with a long-short strategy and actively modulating the allocation between to two to manage the overall beta of the fund.  The targeted allocation levels are determined by a proprietary REIT risk allocation model.

The goal of the fund is to not only outperform the benchmark but to mitigate daily volatility and drawdown risk on a risk-adjusted basis.

Q: How can REITs add value and diversify an investor’s portfolio?

Real estate is an interesting asset class in that it falls somewhere in between traditional fixed income and equities. The stream of rental income is typically contractual and bond-like in nature, while the potential for increasing cash flow is more similar to equities. Because REITs are not perfectly correlated with either stocks or bonds, they can be used to enhance the risk-adjusted return of a diversified portfolio.

Q: How is this fund different from its peers?

In three ways. First, this is the only REIT fund that combines a traditional long-only strategy with a market neutral (long/short) strategy combined with active beta modulation. This results in three potential drivers of excess return. The long-only sleeve can outperform the long-only benchmark, the long/short sleeve can generate an absolute return, while proper beta modulation can also contribute to excess returns.

Second, the risk mitigation objective is to not only outperform the benchmark over a full cycle but to reduce daily volatility by at least 10%. At the same time, we want to reduce maximum drawdowns by at least 25%. 

Lastly, we have managed the underlying sleeves of this strategy since 2010 and have delivered consistent alpha and absolute returns.  In fact, our long/short strategy has never had a losing year. 

Over a full economic cycle, we would expect an average beta-to-index ratio of about 0.9.  Based on our back test under the most extreme conditions, that could range anywhere from roughly 0.5 to about a 1.1. 

Q: How do you manage volatility?

Historically, the volatility of the REIT sector was low relative to the S&P 500, but leading up to the financial crisis it was quite high. Today, it is not much different than the S&P 500 Index. 

What we try to do is take advantage of the volatility by capturing most of the upside over a full cycle, but, at the same time, reduce our beta significantly when faced with adverse market conditions. It is not so much that our competitors are more volatile than the index, or that the index itself is significantly more volatile than the S&P 500; it is simply that the index has gotten more volatile post-financial crisis, and we are trying to mitigate some of that volatility.

Q: What guidelines drive your investment philosophy?

We start with the basic assumption that the REIT market is inefficient. Commercial real estate trades simultaneously on two different markets: the private market and the listed REIT market. Since the underlying assets in both markets are the same, over the long run they are tied at the hip; however, in the short run there are often substantial divergences.

By comparing fundamental trends between the markets, we look for value opportunities. As a real estate specialist, we use net asset value as our primary metric for gauging the valuation, as opposed to earnings multiples or dividend yield.

Q: How would a potential rise in interest rates affect REITs? 

History has shown that there is no consistent correlation between REIT performance and interest rate tightening cycles. During the last cycle, REITs performed exceptionally well, while during the current tightening cycle, REITs have posted modestly positive gains. In some of the earlier cycles REITs underperformed. 

Normally, rising interest rates reflect improving economic fundamentals, which is accompanied by increasing economic activity, higher occupancy rates, and rising rents. There may be other times or situations, however, when interest rates are rising, but economic growth and rents aren’t rising commensurately. We make every effort to understanding what is happening at the macro level, but we are really focused on trends that impact our specific industry.

A current example would be what is happening in the retail REIT sector as online shopping has become more popular. We have been underweight retail REITs, particularly the big-box shopping center REITs, as well as lower quality regional mall REITs. At the same time, we have favored industrial and distribution real estate REITs that will benefit from the impacts of the online shopping. 

Q: What is your investment process?

We follow a top-down portfolio construction process with bottom-up stock selection. Using a specialized relative value framework specific to the REIT space, we estimate the net asset value of each REIT.

We then estimate the warranted premium or discount at which each REIT should trade at relative to its fair market value. The estimate combines a number of subjective as well as objective factors. Factors like balance sheet leverage, corporate governance, management track record and acumen all have an impact at where a REIT trades relative to its net asset value. 

We conduct fundamental research on major property markets, meet with local property brokers, and meet with management teams to formulate a view on the local economies and real estate conditions. Those assessments help us shape our top-down sector allocation. 

We then identify stocks that are consistent with our top-down views and appear attractive from a relative value basis. Since inception, roughly two-thirds of our alpha has been generated through stock selection and the balance through sector allocation. 

Q: Can you give a specific example to describe your investment process?

One recent trade that we put on was an investment in a prison REIT. There are two leading prison REITs, CoreCivic Inc. and GEO Group Inc. They both fell about 60% between July and October 2016. That was caused by panic due to the Federal Bureau of Prisons issuing a statement saying that they were planning to reduce private prison populations. 

The valuations of these REITs dropped from 13 times down to 7 times EBITDA in less than six months. But when we analyzed the impact of what was announced, the impact on earnings was likely to be about 10% spread over a number of years.

After looking more closely at their current contracts, we realized that, even if 10% of their cash flow were to be removed, they were way undervalued. With meeting with their management teams and sell-side analysts, we took a position that turned out to be our best trade last year. While that is an extreme example, it illustrates how doing fundamental due diligence and seeking attractive relative value, can pay off. 

Q: Do you set price targets for making sell decisions?

No, we don’t set price targets because we don’t focus on absolute valuations. We closely monitor relative values. It is only when the relative value gap closes sufficiently that we consider taking off a winning position.

Q: Do you only participate in the publicly-traded REITs?

We invest primarily in domestic publicly-traded REITs but also invest in real estate C-corporations and other real estate related areas. Mortgage REITs, for example, are also within our investable universe, though we are less active in that sector. The majority of capital is typically invested in the traditional commercial REITs: apartments, shopping malls, office buildings, etc.

Q: What is your portfolio construction process?

Our investable universe is broader than the REIT Index, but remains focused on real estate. Our benchmark index contains roughly 150 to 160 REITs which includes a broad cross section of property types. We also include companies that may not be REITs for tax purposes, likewise own, build, or manage real estate such as homebuilders, hotel operators, and real estate service providers that are not included in the benchmark.

Diversification is an important part of our process.  Our long-only strategy typically has 50 to 60 positions, while our long/short strategy has 55 to 75 positions. For each strategy, we have investment guidelines that allow us to generate alpha, but at the same time, limit the impact of a single mistaken position or from some other unforeseen event. 

The risk-managed fund is a combination of the two-individually managed, independent portfolios. The long-only portfolio has sector overweight or underweight limits of about 300 basis points and a maximum cash balance of about 5%. In addition, we limit any single position to 15%.

The largest REIT index constituent is roughly 10%, so that is roughly a 500-basis point overweight for an individual position. But we are typically targeting tracking error of about 200 basis points versus the index.

The long/short strategy uses a different methodology altogether. It is market neutral at all times with no directional bias. We normally target an annualized standard deviation between 3% and 5%, so it is a very low risk and low volatility strategy.

In that portfolio, we would typically have 30 to 40 long positions and 25 to 35 short positions. The maximum size of a position could represent 10% of the portfolio, although more commonly each position would be no more than 4%. No sector would represent more than 25% of the gross exposure. On a net basis, no one sector can be net long or net short greater than 10% of the portfolio. 

Q: How do you define and control risk?

From a broad perspective, we view risk in terms of our tracking error versus the benchmark.  We control risk by carefully monitoring our portfolios to be sure that they adhere to their respective portfolio construction guidelines. We also monitor for any outsized style or factor biases.

In addition to the real estate team’s risk management framework, the firm has broader risk management teams and frameworks monitoring our portfolios at a higher level.  Within the equity group, for instance, we hold monthly performance review meetings where risk and performance analyst look at the risk parameters for our strategies to verify that we are maintaining risk within our guidelines.