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Diversification of Portfolio Risk: Reconciling Theory and Observed Weightings

Diversification of Portfolio Risk: Reconciling Theory and Observed Weightings. Cath Jackson Department of Town and Regional Planning University of Sheffield. Background. Markowitz (1952) set out principles underlying portfolio theory

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Diversification of Portfolio Risk: Reconciling Theory and Observed Weightings

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  1. Diversification of Portfolio Risk: Reconciling Theory and Observed Weightings Cath JacksonDepartment of Town and Regional PlanningUniversity of Sheffield ERES Conference, Eindhoven, June 2011

  2. 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. 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. 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. 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

  6. 1998-2007 ERES Conference, Eindhoven, June 2011

  7. HHLM weights 3 Retail 4 Off / Indus No patterns Indus London Office ERES Conference, Eindhoven, June 2011

  8. Observed (CV)

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

  10. Suggested weightings Medium High Low

  11. Observed weightings Medium High Low

  12. 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. Conclusions • Reconciling theory and observed weightings ...... • Data? Sample? • Benchmarking? • Do investors affect the market, so others ‘have to’ follow? • Gabaixet 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 • Dunseet 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. Diversification of Portfolio Risk: Reconciling Theory and Observed Weightings Cath JacksonDepartment of Town and Regional PlanningUniversity of Sheffield ERES Conference, Eindhoven, June 2011

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