The Return Due to Diversification of Real Estate to the U.S. Mixed-Asset Portfolio
Lee, Stephen L., Journal of Real Estate Portfolio Management
Executive Summary. Booth and Fama (1992) observe that the compound return of a portfolio is greater than the weighted average of the compound returns of the individual investments, a difference referred to as the return due to diversification (RDD). Thus, assets that offer high RDD to a portfolio should be particularly attractive investments for long-term investors. This paper shows that U.S. direct real estate is just such an asset; however, the results are dependent on the percentage allocation to direct real estate and the asset class replaced.
The argument for including real estate in the mixed-asset portfolio is typically made on its diversification benefits rather than on its contribution to the return of the portfolio. Indeed, in a recent paper Hudson-Wilson and Hopkins (2000) find that direct real estate in the United States offered investors such poor performance compared with either stocks or bonds that the authors can see little case for real estate in the mixed-asset portfolio. The argument of Hudson-Wilson and Hopkins can be criticized on at least three grounds. First, the data used only covers the period 1990 to 2000, a period of spectacular growth in the performance of shares on the back of the dot-com boom, which is unlikely to be representative of performance of stocks in the long run. The reversal in share prices since 2001 testifies to this. Yet it is the long-run returns that investors need to examine in deriving the strategic asset allocation (SAA) of the mixed-asset portfolio. Second, when an investor is contemplating the addition of an asset to the mixed-asset portfolio they need to consider the contribution the asset makes to the risk and return performance of the portfolio as a whole, rather than its individual risk and return characteristics. Third, institutional investors should be more concerned with the terminal wealth of their portfolio of investments rather than the individual asset's past performance, as it is from the terminal wealth of the fund that the institutional will meet its future contractual obligations (Radcliffe, 1994). Thus, for those institutionals with long-run holding periods, the terminal wealth or compound return should be seen as the primary measurement of performance. Assets that contribute most to the compound return, or terminal wealth, of the mixed-asset portfolio should present the greatest attraction to institutional investors. Hence, when deciding on the SAA of the mixed-asset portfolio investors should focus their attention on those assets that contribute most to the compound return of the mixed-asset portfolio.
This does not mean that investors should concentrate their allocations in assets with the highest expected returns. Booth and Fama (1992) show that although the compound return of an investment (asset or portfolio) is an increasing function of its expected return, it is also a decreasing function of its risk (variance). In other words, investments with higher expected returns and high risks do not necessarily provide higher compound returns to the portfolio than investments with lower expected returns and lower risks. Moreover, Booth and Fama show that the compound return of a portfolio is greater than the weighted average of the individual compound returns of the investments. Booth and Fama refer to this difference as the "return due to diversification" (RDD) of the investment within the portfolio. This counterintuitive result stems from the fact that although variance is an appropriate measure of risk of a portfolio it is not the relevant measure of the risk of the investment within a portfolio. The risk of an investment in a portfolio should be measured by its covariance with the portfolio. Thus, an asset with a low expected return but a low covariance may be more desirable, in terms of the compound returns of the portfolio, than an asset with a higher expected return but a high covariance.
Previous studies find that real estate is an asset that displays good returns and low covariance within the mixed-asset portfolio (see Seiler, Webb and Myer, 1999; and Hoesli, MacGregor, Adair and McGreal, 2001 for comprehensive reviews). …