I don't hate off-market investment activity, James: I hate only the fact that people are fooled into thinking that "volatility is clearly reduced" and "the return-risk ratio is much higher."
It's simply not true, and the mistake you've made--which is still very, very common--has resulted in the misinvestment of billions or trillions of dollars over the past few decades.
How frequently an asset trades has absolutely nothing to do with how the actual market value of that asset changes on a day-to-day basis. Liquidity affects only how often and how accurately the actual market value is measured. Take any traded corporation, now buy up all its stock so it stops trading but make no other changes: the factors that now affect the unobserved value of its non-trading stock are exactly the same as the factors that used to affect the observed value of its trading stock. How can you say that its actual volatility has been affected?
As a case study, take REITs (frequently traded interests in institutional-quality real estate) and NCREIF data (infrequently traded interests in institutional-quality real estate). But instead of using the NCREIF Property Index (NPI), which is based on "values" estimated (poorly) by appraisers, use NCREIF's Transaction Based Index (NTBI)--same properties, but actual market values rather than appraisals. And, since the NTBI is based on unlevered returns, use unlevered returns for REITs too (the FTSE NAREIT PureProperty Index Series). The volatilities are essentially identical: by property type (apartment, industrial, office, retail), by region (East, Midwest, South, West), and in aggregate. I've done it.
In other words, there is absolutely no ACTUAL difference in volatility between listed equity REITs and unlisted property assets. The only difference is that people like you get fooled by the fact that returns are not measured accurately in the unlisted market.
Now let's go two steps further. First, net total returns have been better for listed equity REITs than for unlisted institutional real estate investments, even after adjusting for differences in leverage, property type mix, and geographic location. I can point you to at least 12 independent studies showing better returns for REITs, and I don't think you can point me to a single study showing better returns for unlisted real estate.
Second, even the NTBI smooths actual returns, meaning that the volatility of unlisted real estate is not as low as the NTBI says it is. If you adjust the way REIT volatility is measured to make it more comparable to the way NTBI volatility is measured, you find that REITs are actually about two percentage points less volatile. That makes theoretical sense: volatility is a measure of uncertainty regarding asset values, and there is more uncertainty when the market is illiquid and inefficient.
The conclusion? Risk-adjusted returns are actually higher for listed equity REITs than for unlisted institutional real estate investments.
I don't want to be enemies, James. I can support everything I've said both theoretically and empirically. And I'm also happy to discuss the reasons why REITs have historically generated better returns, even on a risk-adjusted basis. Please let me know where you would like to take this conversation. Thanks,
--Brad