Abstract
The volatility of a stock returns can be decomposed into market and firm-specific volatility, with the former commonly known as systematic risk and the later as idiosyncratic risk. This study examines the relevance of idiosyncratic risk in explaining the monthly cross-sectional returns of REIT stocks. Contrary to the CAPM theory, a significant positive relationship is found between idiosyncratic volatility and the cross-sectional returns. This suggests that firm-specific risk matters in REIT pricing. The regression results further show that once idiosyncratic risk is controlled for in the asset-pricing model, the size and book-to-market equity ratio factors ceased to be significant. The explanatory power of the momentum effect remains robust in the presence of idiosyncratic risk.
Similar content being viewed by others
Notes
In addition to incomplete information, there are a number of other factors that could also attribute to why investors hold undiversified portfolios. They include market segmentation and institutional restrictions including limitations on short sales, taxes, transaction costs, liquidity, imperfect divisibility of securities (Merton 1987; p. 488)
For example, to allow for variation in beta that is unrelated to firm size, FF (1992) subdivide each size decile into ten portfolios on the basis of pre-ranking betas for individual stocks. This results in 100 size-beta portfolios.
In another study, Chaudhry et al. (2004) observe that different firm characteristics impact idiosyncratic risk depending on the time period examined.
The rise in firm-specific risk of common stocks can be attributed to two interacting factors, namely a dramatic increase in the number of new listings and a simultaneous decline in the age of the firm at IPO. Fink et al. (2005), in particular, argue that since the equity of young firms typically represents a claim on cash flows that are further into the future, it is not surprising that the idiosyncratic risk of the typical public firm has increased. Xu and Malkiel (2003) further suggest that the rising idiosyncratic volatility is attributed to more institutional ownership and high growth.
Besides size, Chaudhry et al. (2004) also observe that efficiency, liquidity and earnings variability are important determinants of idiosyncratic risk of REITs.
In addition, to ensure that the observed patterns in the volatility series are not driven by outliers, we recompute the two series by omitting 5% observations at both ends of the distribution. The time trend for the reconstructed series is similar to that observed in Fig. 2 and hence, is not reported for brevity.
Goyal and Santa-Clara (2003) find that over the period 1926–1999, idiosyncratic volatility is on average 80% of total volatility of common stocks. In comparison, Anderson et al. (2005) observe that 62% of the monthly return volatility of the NAREIT index is unrelated to any of the capital market factors, namely large cap stock, small cap growth stock, small cap value stock, bond and real estate, in their asset pricing model.
Given that Figs. 2 and 3 show a countercyclical pattern, we further examine the payoff associated with adopting the idiosyncratic risk strategy in different market conditions using the portfolio sorting methodology. We sub-divide the sample period according to whether the market as represented by the NAREIT index is moving upwards or downwards. The corresponding risk-adjusted returns for the zero-cost idiosyncratic portfolio remain positive and statistically significant under both rising (0.46%) and declining market conditions (0.32%). This indicates that payoffs from the idiosyncratic risk strategy are robust to the overall performance of the market.
Although other studies have identified other factors that affect cross-sectional stock returns, such as leverage (Bhandari 1988) and earnings-price ratio (Basu 1983), FF (1992) test the joint role of market equity, book-to-market equity (BE/ME) ratio, leverage and earnings-price ratio (E/P), and conclude that the combination of market equity and book-to-market equity ratio seems to absorb the roles of leverage and E/P in average stock returns.
The intuition underlying the theory is best illustrated using the following thought experiment proposed by Berk (1995): Consider a one-period economy in which all investors trade off risk and return. Assume that all firms in this economy are exactly the same size; that is, assume that the expected value of every firm’s end-of-period cashflow is the same. Since the riskiness of each firm’s cashflow is different..., the market value of each firm must also differ. Given that all firms have the same expected cashflow, riskier firms will have lower market values and so, by definition, will have higher expected returns. Thus, even though all firms are the same size, if market value is used as the measure of size, then it will predict return (p.277).
For brevity reason, the estimation results are not presented here.
Note that the two sub-periods, 1990–1999 and 1996–2005, include overlapping years from 1996 to 1999 to provide sufficient length of time for the sub-period tests. Due to the substantial month-to-month variability of the parameters of the risk-return regressions, FM (1973) recommend that a longer time-period of analysis to make the t-statistic value meaningful (page 624). Consequently, subsequent studies such as Chui et al. (2003) and Ang et al. (2006) have carried out sub-period tests using at least 10 years data.
References
Ali, A., Hwang, L.-S., & Trombley, M. A. (2003). Arbitrage risk and the book-to-market anomaly. Journal of Financial Economics, 69, 355–373.
Anderson, R., Clayton, J., MacKinnon, G., & Sharma, R. (2005). REIT returns and pricing: The small cap value factor. Journal of Property Research, 22(4), 267–286.
Ang, A., Hodrick, R. J., Xing, Y., & Zhang, X. (2006). The cross-section of volatility and expected returns. Journal of Finance, 61, 259–299.
Bali, T. G., & Cakici, N. (2007). Idiosyncratic volatility and the cross-section of expected returns. Journal of Financial and Quantitative Analysis (in press).
Banz, R. W. (1981). The relationship between return and market value of common stocks. Journal of Financial Economics, 9, 3–18.
Basu, S. (1983). The relationship between earnings yield, market value, and return for NYSE common stocks: Further evidence. Journal of Financial Economics, 12, 129–156.
Bennett, J. A., & Sias, R. W. (2005). Why does firm-specific risk change over time, Working paper, University of Southern Maine.
Berk, B. J. (1995). A critique of size-related anomalies. Review of Financial Studies, 8, 275–286.
Bhandari, L. C. (1988). Debt/Equity ratio and expected common stock returns: Empirical evidence. Journal of Finance, 43, 507–528.
Black, F. (1972). Capital market equilibrium with restricted borrowing. Journal of Business, 45, 444–455.
Boer, D., Brounen, D., & Veld, H. O. (2005). Corporate focus and stock performance: international evidence from listed property markets. Journal of Real Estate Finance and Economics, 31, 263–281.
Campbell, J. Y., Lettau, M., Malkiel, B. G., & Xu, Y. (2001). Have individual stocks become more volatile? An empirical exploration of idiosyncratic risk. Journal of Finance, 56, 1–43.
Campbell, R. D., Petrova, M. T., & Sirmans, C. F. (2003). Value creation in REIT property sell-offs. Real Estate Economics, 34(2), 329–342.
Capozza, D. R., & Schwann, G. M. (1990). The value of risk in real estate markets. Journal of Real Estate Finance and Economics, 3, 117–140.
Capozza, D. R., & Seguin, P. J. (1999). Focus, transparency and value: the Reit evidence. Real Estate Economics, 27, 587–619.
Capozza, D. R., & Seguin, P. J. (2003). Inside ownership, risk sharing and Tobin’s q-ratios: Evidence from REITs. Real Estate Economics, 31(4), 367–404.
Chaudhry, M. K., Maheshwari, S., & Webb, J. R. (2004). Reits and idiosyncratic risk. Journal of Real Estate Research, 26, 207–222.
Chiang, K. C. H., Lee, M.-L., & Wisen, C. H. (2005). On the time-series properties of real estate investment trust betas. Real Estate Economics, 33(2), 381–396.
Chui, A. E. W., Titman, S., & Wei, K. C. J. (2003). The cross section of expected Reit returns. Real Estate Economics, 31, 451–479.
Clayton, J., & Mackinnon, G. (2003). The relative importance of stock, bond and real estate factors in explaining Reit returns. Journal of Real Estate Finance and Economics, 27, 39–60.
Fama, E. F., & French, K. R. (1992). The cross-section of expected stock return. Journal of Finance, 47, 427–465.
Fama, E. F., & French, K. R. (1993). Common risk factors in the returns on stocks and bonds. Journal of Financial Economics, 33, 3–56.
Fama, E. F., & MacBeth, J. D. (1973). Risk, return, and equilibrium: empirical tests. Journal of Political Economy, 81, 607–636.
Fink, J., Fink, K. E., Grullon, G., & Weston, J. P. (2005). Firm age and fluctuations in idiosyncratic risk, Working paper, James Madison University.
Fu, F. (2005). Idiosyncratic risk and the cross-section of expected stock returns, Working paper, University of Rochester.
Goyal, A., & Santa-Clara, P. (2003). Idiosyncratic risk matters! Journal of Finance, 58, 975–1007.
Jegadeesh, N., & Titman, S. (1993). Returns to buying winners and selling losers: implications for stock market efficiency. Journal of Finance, 48, 65–91.
Lintner, J. (1965). The valuation of risk assets and the selection of risky investments in stock portfolios and capital budgets. Review of Economics and Statistics, 47, 13–37.
Malkiel, B. G., & Xu, Y. (1997). Risk and return revisited. Journal of Portfolio Management, 24, 9–14.
Malkiel, B. G., & Xu, Y. (2006). Idiosyncratic risk and security returns, Working Paper, School of Management, The University of Texas at Dallas.
McIntosh, W., Liang, Y., & Tompkins, D. L. (1991). An examination of the small-firm effect within the REIT industry. Journal of Real Estate Research, 6, 9–17.
Merton, R. C. (1987). A simple model of capital market equilibrium with incomplete information. Journal of Finance, 42, 483–510.
Newey, W. K., & West, K. D. (1987). A simple, positive semi-definite, Heteroskedasticity and autocorrelation consistent convariance Matriz. Econometrica, 55(3), 703–708.
Ooi, J. T. L., Webb, J. R., & Zhou, D. (2007). Extrapolation theory and the pricing of REIT stocks. Journal of Real Estate Research, 29(1), 27–55.
Peterson, J., & Hsieh, C. (1997). Do common risk factors in the returns on stocks and bonds explain returns on REITs? Real Estate Economics, 25, 321–345.
Rosenberg, B., Reid, K., & Lanstein, R. (1985). Persuasive evidence of market inefficiency. Journal of Portfolio Management, 9, 18–28.
Sharp, W. F. (1964). Capital asset prices: a theory of market equilibrium under conditions of risk. Journal of Finance, 19, 425–442.
Shleifer, A., & Vishny, R. (1997). The limits of arbitrage. Journal of Finance, 52, 35–55.
Stattman, D. (1980). Book values and stock returns. The Chicago MBA: A Journal of Selected Papers, 4, 25–45.
Tan, Y. K. (2004). Is development goods for LPTs? Property Australia, 19(November issue), 50–52.
Tinic, S. M., & West, R. R. (1986). Risk, return and equilibrium: A revisit. Journal of Political Economy, 94, 126–147.
Wei, S. X., & Zhang, C. (2006). Why did individual stocks become more volatile? Journal of Business, 79, 259–292.
Xu, Y., & Malkiel, B. G. (2003). Investigating the behaviour of idiosyncratic volatility. Journal of Business, 76, 613–644.
Acknowledgement
We would like to thank the anonymous referee and editors, as well as seminar participants at the National University of Singapore and the 2007 American Real Estate Society Annual Meeting for helpful comments and suggestions.
Author information
Authors and Affiliations
Corresponding author
Rights and permissions
About this article
Cite this article
Ooi, J.T.L., Wang, J. & Webb, J.R. Idiosyncratic Risk and REIT Returns. J Real Estate Finan Econ 38, 420–442 (2009). https://doi.org/10.1007/s11146-007-9091-1
Received:
Accepted:
Published:
Issue Date:
DOI: https://doi.org/10.1007/s11146-007-9091-1