The Potential for Effective Diversification Strategies Between the UK and Irish Property Markets European Real Estate Society Milan, Italy Terry V. Grissom Ph.D.* Jasmine L.C. Lim Ph.D.* Eriksson, C Ph.D.** *Built Environment Research Institute, University of Ulster, Northern Ireland **Jones Lang LaSalle, Ireland

This study investigates the potential for probable and potential diversification that can be achieved by limiting property portfolios to the geographical markets of the UK and Republic of Ireland. The literature has identified the need to diversify investment assets and the benefits that diversification offers. See Sharpe (1964), Fama (1972), Byrne and Lee (1997), Grissom et al., (1987a), Ibbotson et al (1984), Milevsky, (2003), McGreal et al., (2004), Tyrell and Jowett (2008).

Diversification focuses on the deduction of risk in association with a given level of return. Risk that are not systematically priced in the market is assumed to be manageable in that it can be diversified away. i.e. Combining it with the risk attributes of other assets. Active portfolio management - needs to additionally consider pricing issues that are concerned with market relationships and structure, cyclical phases and the potential for and operation of arbitrage equilibrium.

Why diversify? – Higher more consistent return – Lower risk Systematic and unsystematic risk – Systematic Risk (Market Risk) – inherent to the market that cannot be eliminated – Unsystematic (Asset Specific) - inherent to the specific asset that is diversifiable and can be eliminated through diversification

The total risk of any portfolio is therefore composed of systematic risk (the market) and unsystematic risk (the individual securities). Increasing the number of securities in the portfolio reduces the unsystematic risk component leaving the systematic risk component unchanged. Diversification by individual assets, or distinct asset classes; sector, geographical locations

The Research approach undertaken in this paper is based on three levels of diversification  Naive diversification based on the number of assets and portfolio sizes for the UK and Ireland as delineated by Evans and Archer (1968)  Allows for cross country comparison

 The alternative naïve diversification strategies are then compared to diversification benefits employing the construct of managed portfolios based on the use of correlation analysis.  Combining different weightings of property from across geographic markets (UK, Ireland, for property and equities, Global equities and the consideration of US properties as a comparative benchmark) and alternative risky equity assets.

 The managed portfolios as a function of correlation and portfolio structure are then considered as to the relation and impact of diversifiable risk to the structure and sensitivity of returns to market risk.  This is contingent on the degree of integration/segmentation operating within and between the two markets.

Market and Diversifiable Risk The degree of integration or segmentation address the pricing behaviour operating in the distinct markets and thus influence and the levels of market risk based on relative betas (potential of arbitrage potential operating in a given market).  The pricing associations defining the impact of market structure on diversification effects in addition to size affects and degrees of correlation.  Relationship of market risk to pure residual measures as identified by Klemkosky and Martin (1975) and Byrne and Lee (1999)  i.e relation of systematic risks operating within and between each country and the extent of these association on the impact for diversification

Market and Diversifiable Risk Klemkosky and Martins (1975) key findings was that assets or sectors with higher betas (market sensitivity) generate higher residual risk measures. This infers that more market sensitive asset portfolios require more diversification activity. Byrne and Lee (1999) shows this effect operating across the property sectors (IPD) in the UK. Chen and Keown (1980,1981) show that correcting the pricing equation to achieve a stationary beta measures corrects for this market impact on residual risk measure and hence diversification strategies. This measurement correction however is a manipulation of systematic impacts and not controllable

Data Sources, Data and Variables Development Property performance measures from IPD 852 property portfolios – UK (513), Ireland (339) National Statistical Offices, Bank of England, the National Bank of Ireland and EU Morgan Stanley Capital Index

Naïve Diversification E(  UK| Pi(n) ) =  UKi +  UKit (1/n)   UK it E(  ROI| Pi(n) ) =  ROIi +  ROIit (1/n)   ROI it

Figure 1

Table 1 – Correlation of Property and Equity Asset Performance as Potential Measure to Assist Diversification Effects ROI Property UK Property ROI EQUITY UK EQUITY World Wealth Portfolio - UK World Wealth Portfolio US Property ROI Property UK Property ROI EQUITY UK EQUITY WWP_UK WWP US Property

Efficeint Portfolio Construction and Correlation n V   it =  ROIi -  UKi  n/t Eq. 6 i =1 or its continuous form n V   it =   ROIi -  UKj dndt i =1

Figure 2

Figure 3

Market to Diversifiable Risk The impact of the market is considered in the context of Evans and Archer’s (1968) naive model is achieved using Fama’s (1971) market variable adjustment, he developed to estimate the components of total investment return. This adjustment is constructed to weight the effects of the total return by the beta measures. This allows a direct integration of the component adjustment into the construct developed by Klemkosky and Martin. This in turns is directly incorporated into the base Evans and Archer model.

Relationship of Market Risk to Diversification Analysis E(   | Pi(n) )|  pi|M = [   i -   it (1/n)    it ] - [  pi -  pi (  p  Rm )] Or E(   | Pi(n) )|  pi|M = [   i -   it (1/n)    it ] -  pi|M

Figure 4

Figure 5

Figure 6

Conclusions There are diversification benefits between the UK and Ireland property markets, despite moderate to high correlation. UK property market has a higher correlation with the Irish equity market performance than Irish properties, which offers mixes outside of Evans Archer range.

Conclusions Equity markets are highly correlated and potentially integrated across both markets. Higher integration across equity markets can benefit with combination of property in Ireland and the UK. Diversification potential is greater for Ireland than the UK – through active management of Irish portfolios.