Breaking the Market Cap Weight with an Index

When people talk about indexes, they are usually referring to market-cap-weighted indexes.

Market-cap weighting is based on price and an outstanding number of shares. One simply takes the number of shares outstanding and multiplies them by the share price to arrive at market cap. This calculation results in the biggest companies commanding the largest weights.

The first goal of the S&P Global QVM Multi-Factor Index is to “break the market-cap link” that many indices utilize.

Instead of weighting by market capitalization, the index – and a fund based on the index — holds all companies with a nearly equal weighting. This accomplishes a few objectives.

First, it provides broader diversification across the REIT sector by avoiding the index constituents being concentrated in only a handful of names. Second, it favors smaller companies relative to market-cap-weighted indexes by giving them the same weighting in the index as large-cap firms. Lastly, the index also may tilt towards value.

So, what’s the real benefit of these steps as manifested in risk-adjusted returns?

To answer that, below we compare three approaches to the REIT sector. First, we’ll examine market cap-weighted U.S. REITs; second, we’ll expand to include market cap-weighted global REITs; and third, we’ll look at global REITs with the aforementioned factors – in other words, S&P Global REIT Quality, Value & Momentum (QVM) Multi-Factor Index.

As you’ll see, for similar volatility levels using back-tested data with respect to the periods listed below, the S&P Global REIT Quality, Value & Momentum (QVM) Multi-Factor Index experienced a few percentage points of additional performance over the U.S. and global REITs, with similar or lower levels of volatility and drawdowns. Index performance does not equal fund performance because one cannot invest directly in an index, and index performance does not reflect management fees, trading costs, and other expenses.

How REITs Can Affect a Broader Investment Portfolio

Does a REIT allocation add any benefit to a traditional equity/fixed income portfolio?

Below is a sample hypothetical 60/40 portfolio composed of U.S. stocks as represented by the S&P 500 and U.S. 10-year government bonds, back-tested with monthly rebalances. In the second column, a hypothetical allocation of 20% of REITS as represented by the constituents of the S&P Global REIT Quality, Value & Momentum (QVM) Multi-Factor Index has been introduced.

The historical back-tested data results for this time period show an increase of over 1.3% in annual performance. The REIT allocation does increase volatility slightly, but the end result is a higher portfolio Sharpe Ratio.

To learn more about the S&P Global REIT Quality, Value & Momentum (QVM) Multi-Factor Index, it’s described in greater detail in Part I and Part II. See also the methodology.