Diversification Issues in Real Estate Investment

Real estate asset management has been and will continue to be a topic of great interest. Specifically, does real estate warrant inclusion in an efficient portfolio? And if so, how much should be invested in real estate? This article reviews the extant literature in the area of real estate diversification and helps identify the reasons that there exists so much divergence in the answer to the question, “How much in real estate?” Moreover, diversification as it relates to real estate is discussed in reference to both mixed-asset portfolios and for diversification within the real estate asset class. Directions for future research are also discussed.     

Harmful diversification: Evidence from alternative investments

Alternative assets have become as important as equities and fixed income in the portfolios of major investors, and so their diversification properties are also important. However, adding five alternative assets (real estate, commodities, hedge funds, emerging markets and private equity) to equity and bond portfolios is shown to be harmful for US investors. We use 19 portfolio models, in conjunction with dummy variable regression, to demonstrate this harm over the 1997–2015 period. This finding is robust to different estimation periods, risk aversion levels, and the use of two regimes. Harmful diversification into alternatives is not primarily due to transactions costs or non-normality, but to estimation risk. This is larger for alternative assets, particularly during the credit crisis which accounts for the harmful diversification of real estate, private equity and emerging markets. Diversification into commodities, and to a lesser extent hedge funds, remains harmful even when the credit crisis is excluded.     

Realistic Portfolio Allocation Decision-Making For The Small U.S. Retail Investor

This study introduces new domestic mixed-asset and international equity securities that allow for exact portfolio replication even by small U.S. retail investors. Using these new series, various return characteristics are examined. Finally, three sets of mean-variance analyses are conducted: a domestic equity sector-only portfolio, a domestic mixed-asset portfolio, and an international mixed-asset portfolio. Real estate warrants inclusion to varying degrees in all three portfolios. International equity inclusion was also demonstrated.     

Equity Home‐Bias: A Suboptimal Choice for UK investors?

In spite of the popularity of international portfolio diversification theory, extant empirical literature shows that investors prefer domestic assets and as a result, many studies argue that investors' portfolios are largely suboptimal. This paper examines whether British investors need to diversify their portfolios internationally to gain performance benefits from international markets or can they obtain these benefits by mimicking the portfolios with domestically traded assets. The results confirm that it is possible to mimic the performance of foreign equity with domestic equity. Indeed, the pay‐offs from homemade portfolios outperform those from international portfolios regardless of the periodic variation in the overall performance of the UK market vis‐à‐vis foreign markets. The superiority of homemade portfolio is more prominent in recent years and is enhanced by the increased internationalisation of developed capital markets. Therefore, investors' home bias is not suboptimal.     

Diversification Benefits of Japanese Real Estate Over the Last Four Decades

This paper studies the benefits of diversifying into real estate and other assets that typify the wealth held by Japanese investors. We examine movements in mean variance frontiers by employing spanning tests to assess the statistical significance of frontier shifts. We also investigate the impact of shifts in mean variance frontiers before and after the precipitous decline in Japanese real estate and stock market values that began in 1990. Spanning tests show that real estate, short and long-term bonds, and Japanese equity provide significant diversification benefits. We find that mean variance frontiers shift after 1990. Statistically significant shifts are also economically important as measured by Sharpe ratio changes. Although significant, the portfolio weights on Japanese real estate are relatively small compared to their composition found in surveys of Japanese household wealth.     

Dynamic Interactions Between Private and Public Real Estate Markets: Some International Evidence

This study evaluates long-run relationships and short-run linkages between the private (unsecuritized) and the public (securitized) real estate markets of Australia, Netherlands, United Kingdom and the United States. Results indicate the existence of long-run relationships between the public and private real estate markets of each of the countries under consideration. This implies that for all countries, investors would not have realized long-term portfolio diversification benefits from allocating funds in both the private and public real estate markets since these assets are substitutable over the long run. Short-run analyses also reveal significant causal relationships between private and public markets of all countries under consideration. As expected, it was found that price discovery occurred in the public real estate market in that it leads but is not led by its private real estate market counterpart.     

International portfolio diversification benefits: Cross-country evidence from a local perspective

We investigate how the benefits of international portfolio diversification differ across countries from the perspective of a local investor. We find that the benefits of investing abroad are largest for investors in developing countries, including when controlling for currency effects. Most of the benefits are obtained from investing outside the region of the home country. These global diversification benefits remain large when controlling for short-sales constraints in developing stock markets. The gains from international portfolio diversification appear to be largest for countries with high country risk. In addition to this cross-sectional evidence, we also provide evidence that diversification benefits vary over time as country risk changes. We find that diversification benefits have decreased for most countries in our sample over the past two decades.     

International Real Estate Mutual Fund Performance: Diversification or Costly Information?

We investigate the net effect between diversification benefit and information cost of international real estate mutual funds from three dimensions: whether investors can benefit from investing in international real estate mutual funds, whether managers of international real estate mutual funds possess superior market knowledge and timing abilities, and whether investors are motivated by returns or diversification. Our findings are threefold. First, the results show that international real estate mutual funds perform better and are less risky than domestic real estate mutual funds before Jun 2007. That is, diversification benefits outweigh the information costs, and investors therefore gain from investing in international real estate mutual funds. However, the benefit is reduced because of the economic shock of sub-prime financial crisis. Second, on average, neither international mutual fund managers nor domestic mutual fund managers possess market timing abilities. Finally, we find that fund flows are driven by investors’ return-chasing behaviors and fund size, but not by diversification purpose.     

The Role of Real Estate in an Institutional Investor's Portfolio Revisited

Many papers have recently pointed out that institutional investors allocate only a very small fraction of their portfolio to real estate, much smaller than theory would dictate. This raises the question, are institutional investors underinvested in real estate equities? Or do we simply have the wrong priors? This paper is an attempt to provide some new insights into this asset allocation paradox. The key conclusions of the paper are several: First, unlike other assets, it would appear that real estate, and real estate diversification, pays off at the very time when the benefits are most needed, that is, when consumption growth opportunities are low. Second, real estate returns are predictable. In fact, the amount of predictability in real estate returns appears to be about the same as in stock returns. Third, real estate performs well in an asset-liability framework. Fourth, the chance of experiencing a large loss on real estate over a long horizon is quite small. We also report here that private sector commercial real estate investments represent between 6 and 12 percent of investable wealth in the United States. Thus, it follows (if one believes the capital asset pricing model) that if institutional investors were to invest more in real estate (up to 12 percent of their assets), they should be able to eliminate nonmarket or unique risk. All of this leaves us a bit dumbfounded as to why institutional investors hold only between 2 and 3 percent of their assets in real estate.     

Farmland Investment Under Conditions of Certainty and Uncertainty

This study investigates the potential for farmland to improve mixed-asset portfolio efficiency. Three major conclusions are drawn from the research. First, in a world with certainty, farmland can be shown to statistically improve mixed-asset portfolio efficiency. Second, with the introduction of uncertainty into the portfolio allocation model, investors can justify small or no allocations of farmland in a mixed-asset portfolio, although it appears that even with uncertainty prudent investors should evaluate the asset class. Third, with respect to farmland investment and geographic diversification, the results question the ability of an optimized mean–variance portfolio to provide substantial improvement in comparison to a naïve portfolio. The marginal improvement in portfolio efficiency of an optimized farmland portfolio versus a naïve farmland portfolio is not statistically significant.     

Risk Exposures and International Diversification: Evidence from iShares

Abstract:   We examine the newly developed international diversification instruments–iShares traded on the American Stock Exchange. Given the fact that iShares can be created and redeemed at will, the daily price of an iShare is expected to be equal to the daily portfolio value of the underlying assets in the home‐country market. Therefore, theoretically, iShare pricing should be influenced by the risk from the iShare's home‐country market and not the risk from the US market, per se . We evaluate the risk exposure of iShare prices to the US market (non‐fundamental effect) as well as the home‐country market (the fundamental effect). We find that most iShare returns are significantly influenced by and sensitive to the US market risk. Moreover, the US market appears to be the key permanent driving factor and the home‐country market is a pronounced transitory driving force for iShare prices. These findings indicate the presence of limits of international arbitrage for iShares. As a result, the international diversification benefits of iShares become questionable.     

Optimal portfolio choice in real terms: Measuring the benefits of TIPS

In this paper we solve an optimal portfolio choice problem to measure the benefits of Treasury Inflation Indexed Securities (TIPS) to investors concerned with maximizing real wealth. We show how the introduction of a real riskless asset completes the investor asset space, by contrasting optimal portfolio allocations with and without such assets. We use historical data to quantify gains from availability of TIPS in the presence of other asset classes such as equities, commodities, and real estate. We draw a distinction between buy-and-hold long-term investors for whom TIPS fully displace nominal risk-free assets and short-term investors for whom TIPS improve the investment opportunity set of real returns. Finally, we show how gains from TIPS are tempered by the availability of alternative assets that covary with inflation, such as gold and real estate.     

Do investors still benefit from culturally home-biased diversification? An empirical study of China, Hong Kong, and Taiwan

Due to the continual economic integration and the accumulation of wealth in China, Hong Kong, and Taiwan, understanding portfolio strategies and the benefits of diversification for these countries is an indispensible element in managing global assets. Using weekly industry-level data, we analyze culturally home-biased diversification strategies and find that local investors still benefit from regional investments. The time-varying benefits of diversification exist even as the economies of this region have become increasingly integrated. Our analysis suggests that stricter weighting bounds reduce the economic values of diversification but enhance the feasibility of the optimal portfolio allocations. The larger benefits gained by Chinese investors suggest that international diversification is more advantageous to investors in emerging economies than to those in richer, developed markets. The robustness tests generate similar findings when we evaluate the out-of-sample effectiveness and the benefits of diversification under various parameter estimation windows.     

On the diversification benefits of commodities from the perspective of euro investors

This paper investigates the diversification contribution of several commodities to a portfolio of traditional assets from the perspective of a euro investor. The approach applied in our analysis has high informational content as it differentiates between the sources of the diversification benefits in a statistically significant way. The results indicate that the diversification contribution varies greatly amongst the different commodities. Industrial metals, agriculturals and livestock contribute to the reduction of risk, while energy and precious metals contribute to both the reduction of the level of risk and to the improvement of return. The differentiation between bull and bear markets reveals that investors can enhance the portfolio performance by changing exposure into individual commodities. Investors can benefit from the diversification gains through financial instruments as the diversification gains hold both in the sample of physical commodity and commodity futures. Overall, the results confirm that commodities are valuable investments from the perspective of diversification.     

International diversification gains and home bias in banking

This paper studies international diversification in banking, exploiting a bank-level dataset that covers the operations of 38 global banks and their subsidiaries overseas during 1995–2004. The paper finds that banks with a larger share of assets allocated to subsidiaries in emerging market countries were able to attain higher risk-adjusted returns. These gains were somewhat reduced by the concentration of bank subsidiaries in specific geographical regions, which is typical of the observed international expansion strategies. The paper also finds a substantial home bias in the international allocation of bank assets relative to the results of a mean–variance portfolio optimization model.     

Dynamics of Private and Public Real Estate Markets

Using five assets (T-bills, bonds, stocks, and both public and private real estate), this study investigates how cointegration of capital markets affects the dynamics of public and private real estate markets. The results show that the price indices of the five assets are nonstationary and cointegrated. Some implications for the long-term equilibrium relationship for portfolio diversification, price discovery and prediction are discussed. In a Granger causality framework, error-correction augmented VAR models (VECM) and unrestricted VAR models are compared with respect to the conclusion regarding the interaction between public and private real estate returns. VECM is also shown to improve the prediction of private real estate returns relative to an unrestricted VAR model. These results raise questions about previous research studies regarding the dynamics between public and private real estate returns. It is shown that the long-term equilibrium relationship establishes a feedback between the two real estate markets, but the private market seems to informationally lead the public one. Possible explanations are also explored.     

Global Property Market Diversification

This paper examines global diversification benefits provided by developed property markets over 1992–2007. We employ a cointegration methodology, invariant to pair-wise correlational instability plaguing MPT approaches, to investigate regional and country property market diversification benefits for U.S. domiciled global real estate investors. We show, theoretically and empirically, the cointegration procedure aptly identifies markets integrated by common trends that mitigate diversification potential. We show global property markets are interregionally independent but find intraregional market cointegration. A portfolio of markets independent of cointegrating relationships performs best during the period but is insufficiently diversified relative to a cointegrated portfolio. Independent country markets do account for the bulk of global property diversification gains but cointegrated markets, particularly from the North American and Asia Pacific regions, retain some diversifying qualities. We also show cointegrated markets converge toward benchmark characteristics, reducing their attraction as portfolio candidates.     

How to quantify the influence of correlations on investment diversification

When assets are correlated, benefits of investment diversification are reduced. To measure the influence of correlations on investment performance, a new quantity—the effective portfolio size—is proposed and investigated in both artificial and real situations. We show that in most cases, the effective portfolio size is much smaller than the actual number of assets in the portfolio and that it lowers even further during financial crises.     

Long-Term Co-Memories and Short-Run Adjustment: Securitized Real Estate and Stock Markets

This study considers whether securitized real estate and stock markets have long-term co-memories and implications for short-term adjustment. Our results offer reasonable support for fractional cointegration (characteristic of a long memory process) between securitized real estate price, stock market price and key macroeconomic factors in some economies. The implication is that where fractional cointegration prevails, securitized real estate and common stocks are substitutable assets over the long run and these assets may not be held together in a portfolio for diversification purpose. Furthermore, short-run analysis indicates that the speed of adjustment towards the long-run equilibrium is faster for fractional integrated vector error correction model (FIVECM) than VECM as the former incorporates a long history of past cointegration residuals. Additional comparisons of the two models’ forecasting accuracy show that incorporating fractional cointegration in a VECM model improves the forecasting performance over conventional VECM models. Our results reinforce the notion that cointegration, fractional cointegration and short-run adjustment dynamics are important in understanding market integration/segmentation.