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Article Excerpt
This study considers the case of two overlapping categories in the context of recent category models. Specifically, we examine whether investor sentiment and market frictions specific to one category can affect the returns on assets belonging to the other category. With recent additions of several real estate investment trusts (REITs) into general stock market indices as a natural experiment, we find support for spillovers of such nonfundamental effects, as evidenced by the increased return correlation between REITs that remain outside the index and the index stocks. Further analysis reveals that market frictions play a greater role than investor sentiment.
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Over the past several years, a literature has developed suggesting that asset returns can comove more than their fundamentals alone would justify. Among others, Barberis and Shleifer (2003) and Barberis, Shleifer and Wurgler (2005) show that, when investors form asset categories and trade based on them, investor sentiment or market frictions associated with those categories can lead to excess return comovement among assets in the same category. In the context of their model, category-specific sentiment arises when investors focus on differences between categories but not on within-category distinctions; in the extreme, such sentiment can lead investors to focus on a single category. At the same time, category-specific market frictions can retard the diffusion of new information so that assets in different categories do not incorporate the new information at the same speed.
In this study, we consider the case of two overlapping categories. This case complements the original category model by shedding light on possible spillovers of nonfundamental effects (i.e., investor sentiment and/or market frictions) between categories. An understanding of such spillovers is crucial for analyzing markets in which asset categories are dynamic, and thus category overlaps are likely.
An overlap can arise when an asset (which we refer to as the common asset) joins a new category while maintaining its membership in its original category. In this formulation, investor sentiment and market frictions that are specific to one category can affect the returns on assets belonging to the other category. Specifically, investors in one category can expand their investment interest to the other category, resulting in greater comovement between the two categories. Investor sentiment can also trigger mispricing in one category and consequently invite pairs trading between the common asset and assets in the other category, effectively transmitting sentiment across categories and creating excess comovement. (1) From the market friction point of view, such weakening of distinctions between the two categories can make new information diffuse to both categories at more similar rates, again leading to greater comovement.
We test this spillover implication using the recent introduction of several real estate investment trusts (REITs) into the Standard and Poor's (S & P) general stock market indices (i.e., S & P500, S & P400 and S & P600 indices). This event has several features that allow for a clean test. First, both the REIT sector and the S & P market indices are well defined, so that it is straightforward to determine whether a certain stock is a member. As a result, an overlap between them and the scope of possible spillovers can be accurately identified. Second, because the S & P market indices are well diversified across industries and sectors, possible spillovers will be unidirectional, flowing from the index category to the REIT category. Third, the REIT sector and the S & P market indices each constitutes a category as defined in the original category models. In particular, the common investment classifications divide the investment universe into four broad asset categories consisting of cash, stocks, bonds and real estate. Thus, representing the most liquid vehicle for real estate investment, REITs are considered to be a single homogeneous investment class, even though the economic fundamentals of individual REITs differ somewhat (e.g., Chui, Titman and Wei 2003). (2) Finally, because the index additions are a recent event, we can utilize an uncontaminated pre-addition benchmark period during which no REITs were included in the index category, and thus no spillovers can possibly be present.
Our first set of results is easily summarized. We begin by confirming for REITs the prior general finding of an increase in the beta of stocks that are added to an index. (3) Interestingly, these index REITs show virtually no change in their beta with the portfolio of nonindex REITs (those that are never added to the index), suggesting that, after some REITs were introduced into the index, the nonindex REITs might have comoved more with the index category as well. It turns out that the beta of nonindex REITs with the S & P market indices indeed increases after some REITs were introduced. The magnitude of these beta increases is not trivial; the beta of nonindex REITs, as well as that of index REITs, almost doubles around the index addition event. (4,5)
At least two issues arise in interpreting the above results as evidence of the spillover hypothesis. One is that the beta increase may be driven by factors other than the index-related sentiment or friction. More specifically, given that the index category is highly correlated with the general stock market, the observed beta increase may be a result of the increased loading of nonindex REITs on marketwide shocks or due to an increase in the marketwide shocks themselves.
The other issue is endogeneity. Suppose that, in a general context, an overlap arises between two categories and subsequently all assets in one category comove more with the other category. Then, instead of interpreting this as evidence of the spillover effect, one could argue that the overlap coincides with, or is even caused by, the increasing similarity between the two categories (see Barberis, Shleifer and Wurgler 2005, p. 299). Hence, it could be argued that the observed increase in the beta of nonindex REITs (as well as the beta of index REITs) with the index category is a result of the ongoing increase in similarity between the two categories.
To address these issues, we conduct an array of robustness checks. First, we examine whether the sensitivity of the REIT sector to marketwide shocks has increased, which also can be viewed as increased integration of the REIT sector with the general stock market. To this end, we construct a portfolio with stocks that are neither in the REIT sector nor in the index category and then purge the index-related components from it. (6) Under this competing explanation, we should observe an increase in the beta of nonindex REITs with this resulting residual portfolio return, because it still contains the marketwide shocks. However, we find a decrease in the beta of nonindex REITs with this residual return. Conversely, when we purge the marketwide shocks from the index return, nonindex REITs still show an increase in their beta with this alternative residual index return. (7) It thus follows that possible increases in the sensitivity of the REIT sector to marketwide shocks cannot explain the increase in the beta of nonindex REITs with the index category.
Another competing explanation is that the second half of the sample period had more marketwide shocks, and consequently the comovement among all stocks, including nonindex REITs and index stocks, increased. If this were the case, then such an increase in marketwide shocks would have caused greater commonalities among REITs and, more importantly, other stocks in the market must have experienced a similar magnitude of commonality increase. Indeed, the commonality of nonindex REITs, measured using the first five principal components of their return covariance matrix, has increased during our sample period. However, the commonality increase for stocks that are neither in the REIT sector nor in the index category is far smaller, suggesting that contemporaneous increases in the marketwide shocks alone cannot explain the increase in the beta of nonindex REITs with the index category.
Regarding the endogeneity issue, because the concern is about contemporaneous changes on the part of the index category in a particular way (i.e., additions of stocks that happen to be similar to REITs or the growing importance of such similar stocks that are already in the index category), we prescribe a simple fix. (8) By reconstructing the index return using only those stocks that have been in the index during the entire sample period and holding their weights at their initial values, we can prevent any changes on the part of the index category from affecting our results. With this reconstructed index return, we still observe an increase in the beta of nonindex REITs. Although the statistical significance weakens in some cases, we remain confident about our inference due to the magnitude of the beta change.
Another way of ensuring robustness of our results is to examine the pattern of the beta change. If our results are due to the increased similarity between the index and REIT categories, then the change in the beta of nonindex REITs with the index category should rather be gradual, and thus the beta change should be detectable even before the overlap between the REIT and the index categories arises (i.e., before the first index additions of REITs). Also, if our results are simply a transient phenomenon, then the increase in the beta will eventually be reversed over time. We find that the beta of nonindex REITs with the index category remains unchanged until after the first index addition event. Subsequently, their index beta increases, and this increase persists as more REITs join the index category, suggesting that the observed spillover effects are not temporary. The REIT sector in general appears to experience similar changes in other aspects of its trading environment. For example, changes in both the institutional holdings of REITs and REIT mutual fund flows exhibit similarities with those from S & P500 stocks until after the first index addition event. Subsequently, they increase substantially relative to S & P500 stocks, making these alternative explanations less of a concern.
In addition to stock returns, we examine the trading volume of REITs relative to the index category. Admittedly, it is difficult to make inferences from trading volume results, because we do not know the exact composition. However, the spillover hypothesis clearly implies that trading volume should become more highly correlated between the two categories, even if it does not increase generally. Indeed, we find that the trading volume of nonindex REITs becomes more highly correlated with the trading volume of the index category. However, changes in the REITs volume itself are inconclusive, because the results are not robust to using different measures of trading volume.
We then investigate the relative importance of the two possible components of the spillover effect: investor sentiment and market frictions. As in Barberis, Shleifer and Wurgler (2005, p. 309), we use the Dimson (1979) beta to quantify the contribution of market frictions to the observed beta increase. We find that the increase in the beta of nonindex REITs with the large-cap index is attributable primarily to mitigated market frictions, as is evidenced by no significant change in the Dimson beta. In contrast, the Dimson beta of nonindex REITs with the mid-cap or small-cap stock index categories continues to show a significant change. With the reconstructed index category returns (using only stocks that have been in the index during the entire sample period and holding their weights at their initial values), the Dimson beta does not increase, suggesting that nonindex REITs comove more with those incumbent stocks because they now incorporate new information at more similar rates. These results are consistent with the notion that large firms tend to incorporate new information faster than smaller firms (e.g., Lo and MacKinlay 1990, Chordia and Swaminathan 2000).
To put our results in perspective, we examine their implications for a mean-variance optimizer who uses REITs for diversification purposes. Specifically, we conduct the mean-variance spanning test of Huberman and Kandel (1987) to answer the question of whether an investor who already holds a well-diversified portfolio of non-REIT equities (i.e., the three S & P market indices omitting any REITs) can improve the mean-variance frontier by adding some REITs to the portfolio. Although REITs remain a useful diversification instrument throughout the study period, the results show that the diversification potential of REITs is weaker following the introduction of REITs into the S & P indices. The magnitude of the diversification reduction is equivalent to increasing the annualized portfolio return standard deviation by up to 2% for the same mean return.
This article proceeds as follows. The next section discusses the related literature. The third section discusses in more detail the REIT sector as our experimental setting. The next three sections present the empirical
results, and the last section concludes.
Related Literature
A substantial literature about nonfundamental determinants of asset price co-movements exists both at the aggregate and the individual asset levels and in both domestic and international settings. Although the initial research question on this issue was whether shocks in one country can affect other countries that are economically unrelated to the...
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