Applying fundamental indexation to listed real estate companies

Over recent years, alternative index weighting methodologies have attracted increasing interest amongst investors in passive funds. In this article, we present recent research on the application of a fundamental indexation methodology to an investment universe of global listed real estate companies.

Fundamental Indexation Explained

Fundamental indexation involves the allocation of different index weightings from those implied by the traditional method of weighting by market capitalisation. The underlying assumption of capitalisation-weighting is that stock markets are efficient. Equities with a larger market capitalisation are therefore allocated a larger weighting in the index than equities with a small market capitalisation.

One benefit of this approach is easy tradeability, as the greater part of the portfolio comprises the most liquid names. One disadvantage of the capitalisation-weighted index, assuming that markets are not always efficient, is that overvalued companies are automatically overweighted in the index and undervalued equities are automatically underweighted. The fundamental index methodology allocates index weightings to individual stocks, based upon other metrics that are designed to reflect index constituents’ economic weight.

Applying Fundamental Indexation To Real Estate

In the study described below, we compared the performance of the fundamental index with that of a capitalisation-weighted index on a risk-adjusted basis over a period from 1988 up to and including 2009. A back-test, which included the simulation of both a fundamental index and a market capitalisation-weighted index, was conducted over this period. The two indices comprise the same investment universe, but are weighted according to two different methods, providing a transparent return comparison.

The indices were constructed as follows:

• The first step was to select 150 real estate equities with the highest free-float market capitalisation from the investment universe. This guarantees the index’s liquidity and enables the index to be replicated in reality.
• The market capitalisation-weighted index then allocated weightings to these 150 real estate equities according to market capitalisation.
• The fundamental index allocated weightings to the same 150 real estate equities on the basis of fundamental factors. Before this could be done, the fundamental factors which were to serve as the basis for the index weighting had to be selected.

It was decided that the factors must be:

• A fair reflection of the economic size of a company.
• Price-independent, i.e. there must be no relation between a company’s index weight and its valuation.
• The information for each company must be published and calculated in the same way.

For equities, Arnott et al (2004)¹ use the following fundamental factors to create a fundamentally weighted index: revenue, gross dividend payments, cash flow and book value.

For listed real estate companies, some of these fundamental factors are less relevant. Revenue is not a relevant parameter for real estate companies as it does not represent the major source of such companies’ income, and therefore does not reflect true economic size. For listed real estate companies, as opposed to equities in general, book value is related to stock market price because real estate is valued at market value (in Europe).

Revenue and book value were therefore not used when putting together a fundamental index for real estate companies. For such companies, the following representative fundamental elements were used²:

• Total rental income.
• Earnings before interest, tax, depreciation and amortisation (EBITDA).
• Gross dividends.

By design, the factors should not have a direct link to share prices. However, they should have positive correlation to each other and should also provide an adequate representation of the economic size of a company. Total rental income is the most important source of income for real estate companies. EBITDA reflects earnings and dividends the distribution to shareholders.

The resulting fundamental index is an equally weighted composite of these three factors. An equal weighting prevents the index from having a structural bias towards specific companies; for instance, weighting on the basis of dividends would cause a bias towards REITs, which have to pay out almost all their earnings (80%-90%). This is explained in more detail in the ‘empirical results’ section, below.

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