Investors’ Irrationality - The Determinants of the Performance Gap for Open-End Real Estate Funds

For investors, the time-weighted return only provides a partial picture considering their performance. The money-weighted return or internal rate of return calculation delivers a more precise measurement of how they performed for the time of being invested. The difference between those two types of return calculations is commonly referred to as the performance gap.Since the money-weighted return and therefore the performance gap is driven by the timing and magnitude of flows into and out of the asset, the behavior of investors plays an important role. Considering different asset classes, that behavior tends to change. Understanding what drives real estate fund flows is of importance for the size of the performance gap of these funds. It is said, that the return chasing behavior of investors is a source of bad timing skill. The convexity of the flow-performance relationship for open-end real estate funds suggests that the best-performing funds tend to be chased less as their risk of becoming illiquid increases. Furthermore, investors are more sensitive to poor performance when fund liquidity is low. Being more sensitive to fund-level underperformance, when there is increased liquidity risk, leads to investors being more likely to sell. Apart from commonly known drivers of the performance gap like volatility, all these vehicle-specific aspects also influence fund flows and therefore the gap between money-weighted and time-weighted returns.For a sample of German open-end real estate funds over the 1990-2016 period, we analyze the determinants of the performance gap, considering the special conditions of that investment vehicle. In contrast to the academic literature, mainly telling about the performance gap of mutual equity funds, the difference in the two return calculation methods for open-end real estate funds will deliver new implications for investors.