Schrodinger’s Portfolio

Erwin Schrodinger won the Nobel Prize in physics back in 1933 for his work on quantum theory.

Schrodinger is most widely known these days for a theoretical experiment he described about a cat in a box. The experiment went something like this: what if you placed a cat into a box with a hammer, a vial of poison, radioactive material, and a Geiger counter?

Eventually this mix of items would cause the cat to die because the Geiger counter would detect the radiation, triggering the hammer to open the vial of poison, thus killing the cat. But the problem is that it takes time for the radioactive material to decay so you wouldn’t know exactly when this process would occur.

Therefore, there’s no way to know if the cat is dead or alive unless you opened up the box. As long as the box is sealed, it can be inferred that the cat is both dead and alive. Apparently, this is the idea behind a well-known physics theory at the time. Schrodinger set out to prove how ridiculous the idea was that something could exist in two states simultaneously. Basically, it was impossible to judge the outcome of an event without observing that event.

Which brings me to Schrodinger’s portfolio…

Rising interest rates aren’t great for income-producing assets like real estate investment trusts. So far in 2018, the numbers bear this out. Through the end of this week, the Vanguard REIT ETF (VNQ) is down more than 7% in 2018. That compares to a return of around 0.30% on the year for the S&P 500, so REITs are obviously having a tough go at it a few months in the year.

The Wall Street Journal had a story this past week about the poor performance of REITs along with a  description of what many investors are doing about it:

The love-hate situation is driven by two main factors. Investors have sold REITs because of rising interest rates, which have left their yields less attractive. Meanwhile, investors also have been pouring cash into private equity, hedge funds and other alternative investments on the belief they will outperform public markets.

Yet REITs historically have outperformed similar private funds, according to Green Street. And when REITs are trading at big discounts, as they are today, they outperform by a lot.

The question is why investors would choose to invest in private funds when publicly traded REITs are on sale. The likely explanation is that investors believe private funds are less risky because their values don’t bounce around like stock prices do. Risk, though, isn’t volatility but rather the chance of a permanent loss of capital.

Setting aside the performance debate about public versus private investments, the biggest thing that sticks out here is the fact that some people actually believe investing in private markets are less risky because “their values don’t bounce around like stock prices do.”

To which I say, um…no.

The author of this article was right to point out risk isn’t volatility but even if it was, measuring the volatility of private investments is nearly impossible. You can’t possibly expect to compare the volatility of the stock market to the volatility of a private investment or fund.

Stocks are publicly traded with prices being set by market participants and shown in real-time. Private markets have no publicly available pricing data. You can’t just enter a ticker into Yahoo! Finance to see what the latest prices are to the nearest decimal point. If you’re an investor in a private fund you’ll be lucky to get quarterly pricing data that’s less than six months stale.

And those market values will likely be estimated by the fund company who owns the investment using their own valuation methods and models. So the volatility may not show up on the statement but it’s there. If the public markets are volatile then the private markets should be even more volatile because of the extra risks involved (illiquidity, lack of publicly available data, etc.).

It’s just that you don’t see the volatility because there aren’t tick-by-tick prices being set by the market.

Now, you could argue that this is a good thing from a behavioral perspective because volatility can cause investors to make mistakes. There’s something to be said for the out of sight, out of mind mentality when it comes to investing. But you can’t assume your private investments aren’t changing in value just because you don’t get an updated price on a daily basis.

During the financial crisis I saw firsthand how this impacted a number of private real estate funds in the endowments and foundations world. These funds waited a looooooong time to mark down their real estate holdings to reflect actual market value following the real estate bust. So on the surface the returns and market values seemed better than expected based on the statements they were generating.

But when the investors wanted to withdraw their capital a number of private real estate funds simply gated their funds and wouldn’t allow anyone to access their capital. The illiquidity in the commercial real estate markets turned into illiquidity for investors in these funds.

They knew if they had to sell anything it would force them to mark down the rest of their holdings, which would then be reflected in the investor statements and returns. These funds are leveraged so it wouldn’t have been pretty.

By locking up investors from exiting the fund they bought themselves some time. I saw one large fund that gated their investors for a few years and even after they opened things up they only allowed very small amounts to be withdrawn.

Eventually the write-downs came because there was no denying the damage done in the real estate sector but it was on a huge lag.

This was a case of Schrodinger’s portfolio.

It’s ridiculous to assume volatility doesn’t exist in private markets simply because it’s not being reported.

Real Estate Stocks Are On Sale But No One is Buying (WSJ)

Further Reading:
Why Investors in Alternatives Perform So Poorly


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