1. 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

2. 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

3. 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

4. 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

5. 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: , ,
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

6. ERES Conference, Eindhoven, June 2011
ERES Conference, Eindhoven, June 2011

7. 1998-2007 Weights (percentage in each cluster)
HHLM weights
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

8. 1998-2007 Weights (percentage in each cluster)
Observed (CV)
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

9. ERES Conference, Eindhoven, June 2011
Temporal stability :
‘Medium’ variance :
‘High’ variance :
‘Low’ variance
ERES Conference, Eindhoven, June 2011

10. 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

11. 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

12. 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

13. 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

14. 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