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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