ERES Conference, Eindhoven, June 2011 Diversification of Portfolio Risk: Reconciling Theory and Observed Weightings Cath Jackson   Department of Town and Regional Planning University of Sheffield ERES Conference, Eindhoven, June 2011

ERES Conference, Eindhoven, June 2011 Background Markowitz (1952) set out principles underlying portfolio theory Less than perfect positive correlation = diversification of risk MPT set out Mean Variance Criterion Efficient Frontier shows all possible (efficient) portfolios Asset classes provide practical structure for investors How define asset classes? “care must be used in using and interpreting relations among aggregates. We cannot deal here with the problems and pitfalls of aggregation.” (Markowitz, p. 91) ERES Conference, Eindhoven, June 2011

ERES Conference, Eindhoven, June 2011 Asset classes? US: consistently challenge NCREIF or Salomon Brothers areas Hartzell et al. (1987); Malizia and Simons (1991); Mueller and Ziering (1992); Mueller (1993); Eichholz et al. (1995); Goetzmann and Wachter (1995); Ziering and Hess (1995); Nelson and Nelson (2003) UK: consistently challenge Administrative Regions Eichholz et al. (1995); Hoesli et al. (1997); Lee and Byrne (1998); Hamelink et al. (2000); Jackson (2002); Jackson and White (2005a,b); Heydenreich (2010); Byrne and Lee (2011) Local area characteristics and property market fundamentals more important for optimal risk diversification ERES Conference, Eindhoven, June 2011

ERES Conference, Eindhoven, June 2011 Hindsight? Ten years have passed ... what would have happened if strategies had changed? Hamelink, Hoesli, Lizieri and MacGregor (2000) (HHLM) 157 markets, cluster analysis, estimated total returns, CB Hillier Parker Nine relatively homogeneous clusters, mixed sectors “conventional UK administrative and statistical regional classifications do not provide useful information in structuring a portfolio strategy” Jackson (2002) retail, Jackson and White (2005a) industrial, Jackson and White (2005) office (JJW) 322 markets, cluster analysis, rental growth rates, IPD Fifteen (sixteen) relatively homogeneous clusters, distinct sectors Regions largely not evident, market and occupier factors important ERES Conference, Eindhoven, June 2011

ERES Conference, Eindhoven, June 2011 Methods and Data HHLM and JJW classifications compared Original data to 1996/7; Now 1998+ Efficient frontiers developed Also compared to regional classes and sectoral classes Optimum weights compared to observed allocations (weighted by CV) Temporal performance/patterns: 1981-1985, 1986-1992, 1993-1997 IPD total returns data 73 markets common to HHLM, JJW and IPD (average fund holds 43) 23 retail, 18 industrial, 32 office markets No London retail Size of cluster membership affects variance ERES Conference, Eindhoven, June 2011

ERES Conference, Eindhoven, June 2011 1998-2007 ERES Conference, Eindhoven, June 2011

1998-2007 Weights (percentage in each cluster) HHLM weights   1998-2007 Weights (percentage in each cluster) Return Risk Northern Industrial and Office Peripheral Office and Industrial City Offices Scottish Retail Central London Offices London Fringe Mainly Offices London Fringe Mainly Industrial Retail I Retail II Low 16.2 6.4 9.5 21.0 0.0 46.9 31.4 7.1 13.8 23.6 24.1 65.3 1.8 13.2 17.7 2.0 51.9 44.5 3.6 18.5 81.5 High 100.0 3 Retail 4 Off / Indus No patterns Indus London Office ERES Conference, Eindhoven, June 2011

1998-2007 Weights (percentage in each cluster) Observed (CV) 1998-2007 Weights (percentage in each cluster) Northern Industrial and Office Peripheral Office and Industrial City Offices Scottish Retail Central London Offices London Fringe Mainly Offices London Fringe Mainly Industrial Retail I Retail II 1998 3.6 18.7 12.3 5.9 33.1 2.6 16.5 1999 3.4 18.0 12.0 5.8 33.7 4.1 3.7 2.5 16.9 2000 18.5 11.7 5.4 34.7 4.0 2.3 16.3 2001 12.5 4.7 35.5 3.5 2.2 15.3 2002 19.9 11.9 33.0 4.8 2.4 15.6 2003 4.5 21.1 10.1 5.3 30.3 5.1 2.7 16.8 2004 4.9 20.8 9.7 30.2 5.0 3.0 17.4 2005 5.5 10.6 3.3 2.8 16.7 2006 20.7 12.7 4.4 33.2 2.9 14.0 2007 20.0 13.3 4.3 2.1 12.9

ERES Conference, Eindhoven, June 2011 Temporal stability 1981-85: ‘Medium’ variance 1986-92: ‘High’ variance 1993-97: ‘Low’ variance ERES Conference, Eindhoven, June 2011

Suggested weightings Medium High Low Return Risk Low 0.0 76.1 8.8 15.1 Large/medium Retail 1: Southern, good employment Retail 2: Southern, mixed employment Retail 3: Southern, large, service centres Retail 4: Retail 5: Northern Retail 6: Northern, large, declining Retail 7: Regionally diverse Industrial 1: Regionally diverse / southern Industrial 2: South east and eastern I Industrial 4: South east and eastern II Industrial 5: London and south east Industrial 6: Southern and regional Office 1: Peripheral London and southern Office 2: Office 3: London Low 0.0 76.1 8.8 15.1 20.4 0.8 73.8 5.0 47.4 51.4 1.2 61.0 25.6 13.4 67.8 12.7 19.6 45.9 54.1 18.0 82.0 High 100.0 24.2 52.0 23.8 16.6 51.7 31.7 9.0 51.5 39.6 3.0 32.1 64.9 6.7 0.6 19.7 73.0 8.6 0.9 2.4 6.9 81.3 4.8 3.7 91.5 13.7 86.3 68.9 31.1 9.9 68.2 21.9 20.1 67.2 12.8 46.6 53.4 13.1 35.2 27.7 55.0 17.3 45.4 54.6 Medium Suggested weightings High Low

Observed weightings Medium High Low East EM London NE NW&M Scot SE SW Wales WM Y&H Retail Indus Office 1981 3.0 1.7 62.3 0.8 3.7 7.8 6.7 2.8 1.1 4.3 5.1 9.8 7.5 82.7 1982 3.3 61.5 3.8 8.0 6.6 3.2 1.2 4.9 10.4 7.3 82.4 1983 3.5 1.6 59.9 1.3 7.6 5.0 10.9 7.1 82.0 1984 3.6 2.0 59.8 7.7 3.4 1.0 4.8 12.1 6.5 81.3 1985 4.0 58.8 8.2 4.1 4.7 13.9 5.8 80.3 1986 1.9 60.8 14.1 80.9 1987 63.7 2.7 7.2 2.9 4.2 13.6 81.7 1988 2.1 65.5 0.9 2.6 0.7 12.6 1989 4.5 2.3 63.5 3.1 11.3 5.3 83.4 1990 2.5 11.8 5.6 82.6 1991 54.5 8.7 3.9 5.2 13.8 79.5 1992 48.8 10.2 5.9 5.4 15.0 76.9 1993 47.8 1.4 8.9 6.4 5.7 16.2 8.1 75.7 1994 45.6 11.0 9.1 16.6 74.7 1995 4.4 46.1 6.0 10.6 8.8 1.5 6.3 9.3 74.0 1996 46.5 11.2 17.2 73.7 1997 46.2 11.1 6.2 6.9 18.4 72.5 1998 47.4 10.7 19.4 9.0 71.6 1999 48.0 10.8 8.5 6.8 19.2 9.4 71.4 2000 48.5 8.6 17.6 9.5 72.8 2001 49.9 8.4 15.9 10.3 2002 47.0 6.1 16.7 11.7 71.7 2003 42.8 1.8 18.9 13.2 67.9 2004 42.1 20.0 66.4 2005 43.3 18.5 67.6 2006 48.2 7.9 12.7 72.3 2007 51.3 13.5 74.4 Medium High Observed weightings Low

ERES Conference, Eindhoven, June 2011 Conclusions Markowitz’s (1952) theory of portfolio selection helps guide optimal asset selection Grouping of assets into classes subject to ongoing debate Theory used to test HHLM and JJW classifications Recognising importance of asset performance at local level Efficient Frontiers (almost) always offer superior strategies Prudent to examine weightings underlying efficient frontiers Narrow allocations, heavy weights in few classes Marked contrast to observed (aggregate) allocations ERES Conference, Eindhoven, June 2011

ERES Conference, Eindhoven, June 2011 Conclusions Reconciling theory and observed weightings ...... Data? Sample? Benchmarking? Do investors affect the market, so others ‘have to’ follow? Gabaix et al. (2006) quantified endogenous effect of investor buy/sell decisions in thin equities markets Baum et al. (2000) suggest investors affect markets Henneberry and Roberts (2008) suggest they may be endogenous Dunse et al. (2007) empirical determine statistically significant effect of investor transactions on yields Fisher et al. (2004) explore the importance of “transaction cycles” to institutional investors Can theory and observed weightings be reconciled? ERES Conference, Eindhoven, June 2011

ERES Conference, Eindhoven, June 2011 Diversification of Portfolio Risk: Reconciling Theory and Observed Weightings Cath Jackson   Department of Town and Regional Planning University of Sheffield ERES Conference, Eindhoven, June 2011