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Paper eres2009_129:
Property Derivatives in the Strategic Asset Allocation

id eres2009_129
authors Steininger, Bertram
year 2009
title Property Derivatives in the Strategic Asset Allocation
source 16th Annual European Real Estate Society Conference in Stockholm, Sweden
summary Real estate investments have attracted attention as an asset class with high stability of their values, opportunity to hedge against inflation, specific risk-return characteristics, and low co-movements with traditional stock and bond markets. The integration of property investment vehicles to a stock and bond portfolio should ameliorate the performance of an until-then domestic oriented portfolio on the long run. Various studies ascertain that low comovements could also be observed among international stock, bond, and real estate markets. Consequently, international property investments would additionally improve the international diversification potential. Most studies arrive at the conclusion that 15 to 30 percent of a mixed-asset portfolio should be allocated to real estate due to the weak positive or negative significant correlation with stocks and bonds. Some studies analyze – using the co-integration method – the relationship among stocks, real estate, bonds, and T-bills and conclude that stocks have an inverse long-run relationship with real estate. Though, this procedure is also afflicted with some drawbacks. Direct investments in property assets are burdened with high transaction costs, large lot size, low liquidity, tying-up of management resources, and the need of a local market expertise. In addition, fluctuating exchange rates offer an additional exposure for private, commercial or institutional investors who want to diversify among different currency regions. Indirect property investments can solve some of the above-mentioned disadvantages of direct property investments. REITs, non-listed Real Estate Vehicles unlisted funds, either open-end or closed-end, and property derivatives are under consideration for indirect investment vehicles. At a first glance, derivatives would be the best choice from the indirect investment pool to avoid high transaction costs, large lot size, low liquidity, tying-up of management resources, and the need of property and local market expertises. Admittedly, it requires further empirical studies to confirm that by means of derivatives international diversified portfolios provide supplemental diversification benefits. Many studies present new results for diversifying internationally with real estate vehicles, but to a lower extent with derivatives or with limited focus on geographical or contractual application. This paper concentrates on property derivatives and their benefits for an international mixed-asset portfolio. This study approaches the investment vehicles of property derivatives through index certificates. Such financial instruments are basket products based on an index. Certificates give investors exposure to physical property market, real liquidity if continuously traded on a stock exchange, and the possibility of low initial investments. All factors are essential for an efficient market especially for the retail sector. In principle, there are three different index types available, appraisal-based, transaction-based, or indices of quoted property companies or REITs. By the end of 2008, certificates based on property companies or REIT are quite widespread through the easy access to such indices, but as these indices are highly correlated with the stock markets, it is highly questionable whether these underlyings can serve as real estate proxies. The underlying indices are fundamental for the derivative construction and performance. Unfortunately, real estate indices are complicated to calculate compared to other asset classes by virtue of the relative illiquidity and heterogeneity of the underlying assets. However, for an active worldwide real estate derivative market it is necessary to meet the needs of the investors with reliable indices and a bunch of sub-indices of sectors, region, capital, and income indices. There are mainly three dissimilar approaches for real estate index construction to fulfil the requirements of investors as aforementioned. When appraisal-based real estate indices are applied, the return-risk characteristics indicate a higher return and risk than bonds, and a lower return and risks than stocks. When transaction-based indices are applied, the return-risk characteristics generally indicate similar properties in comparison to the appraisal-based index. However, the positive effects decline. The results based on the third approach underestimate the role of direct property in a mixed-asset portfolio and behave in the short run more as stocks than as an alternative investment in order to diversify an investor’s portfolio. In order to overcome some of the problems of the traditional Mean-Variance Analysis, a Mean-Shortfall Analysis is adopted in this study. A few studies have applied this concept to real estate. While the theoretical aspects of the downside-risk are well documented in the literature, empirical evidence to which approach superior portfolios are produced has not been convincing. Few studies take similar approaches to compare the mean-shortfall with the mean-variance analysis. However their comparison methods are logically flawed because the two approaches use different risk measures and are not directly comparable. Consequently, we only focus on the downside-risk approach. The optimization approach helps to identify the ex post and ex ante diversification potential of real estate investments in a mixed-asset portfolio and to order various strategies by dint of the stochastic dominance analysis. Currency risk represents a drawback for international diversified investments. Hedging the currency exposure could minimize this problem; indeed this approach is not free of charge and influences the diversification potential. Some authors investigate this issue for international bond and stock markets and conclude significant performance differences for hedged and unhedged portfolios. Furthermore, the diversification potential depends on the reference currency of the investor. Several empirical studies concern with the issue to what extent diversification arises from international investments for investors in different currency regions. Thus, the paper also surveys the diversification potential of a currency hedging strategy using forward contracts with optimal hedge ratios from a euro area investor's point of view. Besides, the typical short selling constraint is abandoned. A long-only portfolio limits investors in their ability to generate performance because they are constrained in their investment decisions to one side. By contrast, active-extension strategies, i.e.~1X0/X0 longshort portfolio, try to increase alpha opportunities by dint of an active portfolio management, while having the same beta net exposure to the market, as the traditional long-only strategy. The leveraged structure of an active-extension portfolio follows the properties of any leveraged portfolio. Admittedly, the gross and net exposure differ. Both exposures of a 1X0 percent leveraged long-only portfolio is 1X0 percent, whereas for a 1X0/X0 portfolio, the gross exposure is 1X0 percent and the net exposure is only 100. Several authors suggest that traditional long-only portfolios could ameliorate their performance with limited short selling strategies and show that the portfolio's efficiency, measured by the information ratio, increases when the long-only constraint is removed. They reasoned that a fully leveraged 200/100 portfolio achieves the highest information ratio and efficiency benefit compared to a long-only portfolio. In this context, more leverage is better. Contrariwise, an increase of X reduces the marginal utility, so that taking transaction costs into account the utility and costs must be traded-off against each other. As a result, the short-percentage typically ranges from 20 to 50 percent, whereas 30 percent seems to be the most widely used in practice. The historical time series for the stock, bond, and real estate derivative markets are collected for the USA, the UK, France, and Germany over the time period of Q1 1998 to Q2 2008. These countries are selected as representatives of the international financial world by virtue of their market capitalization and turnovers. Japan and China are not included in the market due to the lack of reliable historical data. We use the national MSCI for stocks and the Datastream Government Bond indices as proxies for a stock and bond market investment. As we take the perspective of a euro-based investor, the risk-free rate is represented by the 3- months Euro Interbank Offered Rate. For the period prior to the introduction of the Euribor, a weighted average of interbank rates in the member states of the European Monetary Union has been used. The property derivatives are modelled with the aid of IPD indices due to their market coverage. It seems congruously to use the IPD UK Annual Total Return All Property Index for the UK market. IPD also publishes a monthly index that acts as an anchor function for the market price, so that the quarterly adjustments are easy calculable. In the USA, the NCREIF Property Index Comparable serves as the basis of various derivatives. In France and Germany, the IPD French Property Index and the IPD German Property Index, also referred to as Deutscher Immobilien Index, are common underlyings for OTC derivatives. However, the French and German indices are only annually computed. Subsequently, a method of interpolation proves necessary. At a first test optimization, the ex post perspective shows significant diversification benefits through the consideration of real estate certificates in all three portfolio strategies – Equally-Weighted Portfolio, the Minimum-Risk Portfolio, and the Tangency Portfolio. The source of these diversification gains is mainly seen in a risk reduction. The additional application of the 130/30 structure and of the optimal currency hedging also brings improvements on an average, based in risk reduction. In the ex ante perspective, the integration of property certificates leads in almost all portfolio strategies to a risk reduction relative to the corresponding stock and bond strategies.
series ERES:conference
email bertram.steininger@irebs.de
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last changed 2009/09/16 16:22
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