Academic journal article Journal of Real Estate Portfolio Management

Persistent Mispricing in Mutual Funds: The Case of Real Estate

Academic journal article Journal of Real Estate Portfolio Management

Persistent Mispricing in Mutual Funds: The Case of Real Estate

Article excerpt

Executive Summary.

When mutual funds and related investment companies are unable to compute an accurate net asset value, unintended wealth transfers will occur among fund investors. Previous research has found this effect with international stock funds. Real estate fund managers face an even bigger challenge due to the lack of current price data. By focusing on an investment account involved with direct real estate ownership, the effects of inaccurate fund pricing can bee seen at monthly frequencies. The magnitudes of the asset mispricing and resulting wealth transfers can be estimated, thus pointing the way to a solution.

Open-end investment companies must compute a net asset value each business day. This serves as the basis for the price at which investors buy and sell shares. Since the counterparty for investor transactions in such a fund is the fund itself, inaccuracies in valuing the assets of the fund will result in unintended wealth transfers between trading fund investors and those investors who are more passively invested in the fund.

Much previous research on this issue has focused on funds located in the United States who are investing in international equities. Under those circumstances, the pricing problems result from the fact that funds commonly use the last trade price to value their assets. Since the fund asset value is calculated at the New York close, the most recent trade for foreign assets can be many hours old. Bhargava, Bose, and Dubofsky (1998), Goetzmann, Ivokvic, and Rouwenhorst (2001), and Boudoukh, Richardson, Subrahmanyam, and Whitelaw (2002) document the resulting profit opportunities for arbitrage investors. Greene and Hodges (2002) quantify the resulting losses for passive investors in those same funds.

The two main weapons for fund managers wishing to protect the long-term investors are restricting high-frequency trading and correcting the mispricing. However, the record here is mixed. Chalmers, Edelen, and Kadlec (2001) find that trading restrictions are not always enforced, and both Zitzewitz (2003) and Redding (2004) find that tools to correct mispricing are frequently not employed.

This research examines a longer-term mispricing phenomenon. A fund investing directly in real estate will not have the benefit of daily market prices to determine value. The values of individual properties must instead be established via formal and informal appraisals. Since these appraisals are costly, a good manager will limit the number of appraisals that are commissioned. Unless corrective measures are taken, however, use of outdated appraisals will lead to unintended wealth transfers between buyers, sellers, and long-term holders of fund shares.

This paper examines the case of the TIAA Real Estate Account, and develops a test to determine whether outdated appraisals are in fact generating predictable portfolio valuations. Given these results, the discussion then turns to estimating the magnitude of the wealth transfers and how managers can address this problem.

The TIAA Real Estate Account

The TIAA Real Estate Account is a variable annuity with assets of over $10 billion open primarily for the retirement savings of participants in TIAA-CREF. It was established in 1995 and has the majority of its funds directly invested in real estate. The Account is very similar to an open-end mutual fund in that it must establish a unit value each business day to enable participants to buy or sell accumulation units in the Account. Eligible participants are currently able to buy or sell at this unit value without paying fees to the Account or to TIAA. It therefore faces a severe challenge in terms of determining high-frequency prices for assets that trade very infrequently.

A primary difference between this type of investment and an open-end mutual fund is that this investment is a variable annuity open only to retirement accounts. Whereas a mutual fund pays distributions to its shareholders consisting largely of taxable income, the Real Estate Account pays no distributions. …

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