Hedging REIT Returns Using the Futures Markets

Executive Summary. Modern portfolio theory demonstrates that investors minimize risk by diversifying their holdings over asset classes containing different return patterns. Past research in real estate has compared returns on direct ownership in real estate assets with equity instruments for their portfolio diversification benefits and inflation hedging characteristics. Also, the literature has examined REIT returns for their co-movement with inflation, common stock returns, and returns generated from direct ownership in real estate. Specialty mutual funds that invest in a single industry attempt to diversify risk by purchasing equity interests across a broad range of companies within the industry. In addition, a manager may use the futures markets for hedging against industry risk.This study uses historical market data to investigate hedging a REIT portfolio with stock and Treasury future contracts. Johnson's (1960) minimum variance hedging strategy is used to reduce the systematic risk in a REIT portfolio. Stepwise multiple regression identifies futures contracts that contain significant (positive or negative) correlation with the returns from the REIT portfolio. The regression equation's betas represent the optimal hedging ratios for the number of futures contracts needed to minimize the variance of the REIT portfolio's returns. Results of the study show that futures contracts on Treasury debts provide the best cross-hedging during the period of study. This may be due to investors' yield expectations forcing REIT returns to perform similar to debt instruments. Problems associated with using historical return data to construct ex-ante hedging ratios compared to ex-post hedging ratios are also demonstrated. In addition, the Working's (1953) hedging strategy is discussed as an alternative to Johnson's minimum variance hedging strategy.