Download Portfolio Optimisation - Hearthstone Investments

Residential Fact Sheet
Portfolio Optimisation
Adding Residential Property into a UK-based
Multi-Asset Portfolio
Contents
UK Residential as an Asset Class
UK Residential as an
Asset Class
Risk and Return Across the
UK’s Asset Classes
Asset Class Correlations and
Diversification
Portfolio Optimisation Adding Residential
Property into a UK-based
Multi-asset Portfolio
Conclusions
Technical Background
Important Information
Risk and Return Across the UK’s
Asset Classes
In recent decades, investors have focused
on equities, bonds (both corporate and
Government) and cash. These have been
the primary components of UK-based multiasset portfolios. This is clearly demonstrated
by a April 2012 survey by Reuters which
indicated that a typical (cautious) asset
allocation used by leading investment
houses was 53.5% in equities, 22.6% in
bonds, 15% to alternative investments and
6.5% in cash, leaving a meagre 2.4% for
commercial property.
The residential property market has shown
the best long-term performance of all of
the UK’s main asset classes (13.8% p.a.
over the 41 years to 2011). In comparison,
the equity market (FTSE All Share Index),
the next best performer, recorded a total
return of 12.3% p.a.. This is an additional
return of 1.5% p.a. compared with what is
traditionally deemed the most favoured
asset class.
Cash, the investment type associated with
the lowest risk, recorded only 7.2% p.a.
over the period, not far from half of the
residential market’s return. Indeed, using to
the latest available annual data (2011), the
residential market outperformed all
other asset classes over 10, 15, 20 and 41
years. And over the last 5 years, including
the financial crisis and the recent sovereign
debt worries, only Gilts performed better .
Although commercial property proved to
be one of the most attractive asset classes
of the early- to mid-noughties, the UK’s
residential property market has remained
a relative outsider in the investment world.
However, there are a number of compelling
reasons for adding residential property to a
multi-asset portfolio.
Figure 1: Risk vs. Return Across UK Asset Classes
16.0%
14.0%
Total Return
12.0%
10.0%
8.0%
6.0%
4.0%
2.0%
0.0%
0.00
0.05
0.10
0.15
0.20
0.25
0.30
Risk (Standard Deviation)
Residential Property
Commercial Property
UK Equities
Gilts
Source: Barclays Equity Gilt Study, IPD, Hearthstone Investments
T +44 (0) 203 301 1310
E [email protected]
W www.hearthstone.co.uk
|
Ref: August 2012
Cash
0.35
Residential Fact Sheet
Portfolio Optimisation
Over most time periods, therefore, residential property has
provided both a higher average total return and a lower level
of risk than most other asset types. This in itself is counter-intuitive
as it would be expected that in order to achieve a higher level
of return, an investor must take additional risk. As shown in
figure 1, however, this does not prove to be true in the case of
residential property. Although it does sit firmly in between cash
and equities in terms of the level of risk associated with the asset
class, it has produced a significantly higher return than either,
therefore suggesting that its inclusion in a multi-asset portfolio
could only be beneficial. This “outlier” effect could perhaps
be due to the asset’s foremost function as a home, rather than
purely as an investment type. The continued desire of the UK
population to own its own home acts to push prices upwards,
particularly given the shortage of supply, in a way that is
external to the investment market and, to some extent, the
state of the economy.
Combining both risk and return measures via a Sharpe ratio
calculation allows us to examine how investments perform
relative to the risk-free rate per additional unit of risk. The results
from this calculation are shown in Figure 2. It is clear from the
T +44 (0) 203 301 1310
E [email protected]
chart that the residential property market achieves the best
risk-adjusted return by a significant margin over all time periods
studied. Indeed, in the long run, its risk-adjusted return is almost
two times that of the next best performer (commercial property).
The risk-adjusted return further improves relative to other asset
classes if a Sortino ratio is used. Like the Sharpe ratio, this shows
the risk-adjusted return of an investment. However, it only
looks at the volatility of returns on the downside (i.e. when an
investment’s return falls below that of the risk-free investment),
rather than including situations where the investment sees
positive relative returns. This therefore shows the risk-adjusted
return per unit of downside risk and could therefore be deemed
a more realistic measure of risk given that investors are rarely
concerned with an investment’s upside volatility (i.e. high
returns). On this basis, the residential property market achieves
a risk-adjusted return of 1.1 over the 41-year period, compared
with commercial property, equities and gilts, which return 0.3, 0.3
and 0.5 respectively, per additional unit of risk.
Figure
2: Risk-adjusted
Total by
Returns
UK’s
Asset Classes
Risk-adjusted
Total Return
Assetacross
Classthe
Over
Time
1.2
1
Sharpe Ratio
However, the strong outperformance of the residential market
is only half of the story. The residential property market has
proven to be one of the most stable asset classes in return terms.
Over the full 41-year period (Figure 1), the standard deviation of
total returns, often used as a measure of risk, is significantly lower
than for UK equities and Gilts (0.11 vs. equities’ 0.30 and Gilts’
0.14). Although it could be expected that property would prove
less volatile than the equity market, it is perhaps surprising that it
appears to be less “risky” than the Gilts market. This, of course,
reflects the fact that if Gilts are not held to redemption, their
prices and yields can fluctuate wildly. Cash does, however,
prove to be markedly less volatile than all other asset classes,
as would be expected. Commercial property, meanwhile,
shows broadly the same volatility as the residential market
(0.10) over the longest time period. This is slightly unexpected
given the bond-like nature of the investment, whose higher
income component could be expected to cushion the asset
class’ cyclical capital growth movements and therefore
reduce its overall volatility relative to the capital growth-driven
residential property market. Moreover, over shorter time periods,
the volatility of residential property’s returns is actually markedly
lower than for commercial property (0.09 vs the latter’s 0.12
over 10 years).
0.8
0.6
0.4
0.2
0
-0.2
-0.4
5 Years
Residential Property
10 Years
Commercial Property*
20 Years
UK Equities
41 Years
Gilts
Source: Acadametrics, ARLA, IPD, Barclays Capital, Hearthstone. Data up to
December 2011 *IPD Monthly Index used for 1987 onwards
Asset Class Correlations and Diversification
Although the risk and return of an asset class is a fundamental
driver of whether or not to add an investment into a multi-asset
portfolio, it is also important to understand the relationships
between different asset classes. Correlations can be used to
examine how different assets move with each other, to see
whether, for example, losses in one asset classes could be
mitigated to a certain extent by gains in another (an inverse
correlation). In other words, having asset classes with negative
or weak correlations are beneficial to investors, whilst having
assets with strong, positive correlations in a portfolio can add
to the overall level of risk experienced by the investor.
W www.hearthstone.co.uk
|
Ref: August 2012
Residential Fact Sheet
Portfolio Optimisation
Figure 3: UK Asset Class Correlations (1971-2011)
Residential
Property
Residential
Property
1.0
Commercial
Property
0.7
Commercial
Property
Equities
Gilts
Cash
year series was available) and assumed a maximum possible
weighting of 30% for property. Starting from a portfolio with a
0% weighting, residential property was then added to the
portfolio in increasing amounts until the 30% maximum
weighting was reached.
Figure 4: Optimised Portfolio Weightings vs. Portfolio Returns
Cash
0.2
0.0
0.2
1.0
0.6
0.2
1.0
0.2
1.0
11.0%
90%
10.8%
80%
10.6%
70%
Portfolio Optimisation - Adding Residential
Property into a UK-based Multi-asset Portfolio
As already shown, adding residential property into a multiasset portfolio should lead to a reduction in overall risk, whilst
also boosting total returns. Portfolio optimisation, based on
Modern Portfolio Theory, can be used to demonstrate how
adding residential property into a portfolio can be beneficial to
investors. This attempts to create a portfolio that will provide the
highest risk-adjusted return, as indicated by the sharpe ratio. The
portfolio optimisation was run on the full 41-year data set for UK
assets (excluding corporate bonds, for which only a short-run 10
T +44 (0) 203 301 1310
E [email protected]
10.0%
40%
9.8%
30%
20%
9.6%
10%
9.4%
0%
5%
10%
Residential Property
Gilts
Portfolio Return
15%
20%
25%
Commercial Property
Cash
30%
9.2%
Equities
Corporate bonds*
Source: Barclays Equity Gilt Study, IPD, Hearthstone Investments
*Annualised returns over 2003 - 2011
As is clearly shown in Figure 4, adding residential property into a
multi-asset portfolio leads to an improved average total return.
The introduction of residential property into the portfolio comes
at the expense of the commercial property weighting.
Although it clearly has a positive impact on returns, does
introducing residential property into the portfolio provide
diversification potential as theory would suggest? Figure 5
indicates that this is likely to be the case.
Figure 5: Optimised Portfolio Weightings vs. Portfolio Risk
Portfolio Risk
100%
15.6%
90%
15.4%
80%
Portfolio Weighting
Despite correlating strongly with commercial property, the
residential property market shows little or no correlation with
other asset classes. Indeed, it is (mildly) negatively correlated
with Gilts and shows little or no relationship at all with the equity
market and cash. This therefore makes residential property
an ideal diversifier for a multi-asset portfolio as, by including it
alongside e.g. equities or Gilts, it should be possible to reduce
the weighted average risk in the portfolio.
10.2%
50%
0%
As a rule of thumb, correlations are deemed strongly significant
when they are greater than 0.6 and two assets are considered
perfectly correlated (either directly or inversely) when the
correlation is equal to 1. According to Figure 3 above, there
are strong positive correlations between residential and
commercial property, a relationship that would be expected,
and between equities and Gilts, a relationship that seems
counter-intuitive given that investors tend to flock to Gilts when
the equity market is falling. It must, however, be noted that
these relationships do vary over time, although the relationships
between residential property and other asset classes have
tended to remain relatively similar in most cases.
10.4%
60%
Total Return
-0.2
0.3
100%
70%
15.2%
60%
15.0%
50%
40%
14.8%
30%
20%
14.6%
10%
0%
0%
5%
10%
Residential Property
Gilts
Portfolio Return
15%
20%
25%
Commercial Property
Cash
Source: Barclays Equity Gilt Study, IPD, Hearthstone Investments
*Annualised returns over 2003 - 2011
W www.hearthstone.co.uk
|
Ref: August 2012
30%
14.4%
Equities
Corporate bonds*
Portfolio Risk (Standard Deviation)
Gilts
0.0
Portfolio Returns
Portfolio Weighting
Equities
1.0
Residential Fact Sheet
Portfolio Optimisation
Adding residential property into the portfolio leads to a clear
reduction in the weighted average level of risk, largely due to its
weak correlations with other asset classes and less volatile returns
in comparison with the equity market.
Figure 6: Optimised Portfolio Weightings vs. Risk-adjusted
Portfolio Return
Portfolio Sharpe Ratio
100%
0.30
90%
Portfolio Weighting
70%
0.20
60%
0.15
50%
40%
0.10
30%
20%
Sharpe Ratio
0.25
80%
0.05
10%
0%
0%
5%
10%
Residential Property
Gilts
Portfolio Return
15%
20%
25%
Commercial Property
Cash
30%
0.00
Equities
Corporate bonds*
Source: Barclays Equity Gilt Study, IPD, Hearthstone Investments
*Annualised returns over 2003 - 2011
Using the portfolio optimisation process has shown that adding
residential property into a multi-asset portfolio benefits the
investor in terms of both increasing his or her potential total
return as well as, via diversification, reducing the overall level
of risk that is inherent in the portfolio. As Figure 6 shows, the
inclusion of residential property in a multi-asset portfolio can act
to boost an investor’s risk-adjusted return over the long term. If
residential property is excluded from the “optimal portfolio”, the
risk-adjusted return only reaches 0.17. However, if included with
a weighting of up to 30%, it is possible for the risk-adjusted return
to rise to almost one and a half times this number. Although in
reality, it is unlikely that investors would choose to have such a
significant weighting to residential property in their portfolios, it is
nevertheless clear that even a small weighting to this “new” asset
class can pay dividends to the investor.
Conclusions
To date, residential property has rarely been considered for
inclusion in most investors’ UK-based portfolios. However,
there are clear reasons why holding a nationally diversified
UK residential property fund should in fact provide significant
benefits for investors.
T +44 (0) 203 301 1310
E [email protected]
Historically, residential property has been the best-performing
asset class, providing average total returns that have been
higher than even the equity market, usually considered the
asset class that has most potential for buoyant returns. Equally,
residential property, despite its cyclical nature, has proven to
be less volatile than other assets such as equities and Gilts,
suggesting that by including this in a portfolio, it would be
possible to boost overall returns, whilst reducing average risk.
In addition, residential property could prove to have valuable
diversification potential due to its weak, and even negative,
correlations with the other main asset classes.
Applying Modern Portfolio Theory via a portfolio optimiser can
show how residential property would interact with other asset
classes once introduced into a multi-asset portfolio. The analysis
clearly suggests that including residential property in a portfolio
of equities, Gilts etc. can be highly beneficial, reducing the
average weighted risk, whilst increasing the overall total return.
As such, the argument for residential property as an asset class
is highly persuasive and means that investors should consider it
an important part of any multi-asset portfolio alongside the more
traditional main asset classes in the future.
Technical Background
Residential property is in emergence as an investment asset class.
Consequently, there is limited total return data available, and in
order to provide a realistic and informative long-term data series,
it has been necessary to combine different sources of data. Our
residential property total return is comprised of a capital return
taken from the LSL Acad house price index (formerly the FT HPI)
and an assumed constant gross income return of 5.5 per cent
(4.13 per cent net) until 2008. The gross figure has been sourced
from a GLA report, produced by Savills, and reflects a 20-year
average. The net figure has been calculated by applying a 25
per cent discount to the gross return, reflecting the approximate
costs of property management and maintenance in a largescale residential fund able to benefit from economies of scale.
By using a 20-year, rather than the higher 30-year average of
6.2 per cent, we are in fact presenting a relatively cautious view
on historic total returns. From 2008, ARLA buy-to-let rent figures
(gross) have been used and discounted by 25 per cent. The total
return data for commercial property has been sourced from IPD,
while equity and gilts data is from the 2012 Barclays Equity Gilt
study. Performance has been calculated on a per annum basis,
with 2011 (the latest available annual data) as the end-point.
W www.hearthstone.co.uk
|
Ref: August 2012
Residential Fact Sheet
Portfolio Optimisation
Important Information
Residential property prices can go down. Information on past
performance is not necessarily a guide to future performance.
The value of investments in a fund can go down, and there
can be no assurance that any appreciation in the value of
investments will occur.
Residential property values are affected by factors such as
interest rates, economic growth, fluctuations in property yields
and tenant default. Property investments are relatively illiquid
compared to bonds and equities, and can take a significant
amount of time to trade.
This information is intended for professional clients and investment professionals only and should not be relied upon by retail investors.
While all reasonable care has been taken in the compilation of this publication, Hearthstone Investments PLC will not be under any
legal liability in respect of any misstatement, error or omission contained therein or for the reliance any person may place thereon. This
report is published for general information only and while the report may be helpful in anticipating trends in the property market, no
warranty is given as to its accuracy, and no liability for negligence is accepted in relation to figures, forecasts, analyses or conclusions
in it. Under no circumstances must any of the content of this report be relied upon for investment purposes.
Hearthstone Investments PLC is the parent company of the Hearthstone Investments Group. Regulated business is carried out by
Hearthstone Asset Management Limited. Hearthstone Asset Management Limited is an appointed representative of Thesis Asset
Management PLC which is authorised and regulated by the Financial Services Authority (114354).
T +44 (0) 203 301 1310
E [email protected]
W www.hearthstone.co.uk
|
Ref: August 2012