Pagliari: Another take on real estate's role in mixed-asset portfolio allocations

Question 1

the use of annual returns often generates excessive allocations to private real estate:

Answer 1

1) the autocorrelation of price real estate return series understates a) the long-run volatility of such returns and b) its long-run correlation with other asset classes
2) the suggested allocations to real estate are substantially higher than the allocations generally found among large institutional investors

Question 2

preference for low-risk portfolios:

Answer 2

(unlevered) private real estate

Question 3

preference for high-risk portfolios:

Answer 3

public real estate (embedded leverage of 40-50%)

Question 4

potential explanations why investors’ allocation to real estate might be lower than 10-15%:

Answer 4

inclusion of investor’s liabilities, investment management fees and cost, liquidity, information costs, ownership involvement, conflict of interest

Question 5

the issue of high levels of serial correlation is often found with a variety of privately traded alternative assets

Answer 5

these securities often reflect very different serial correlation characteristics from their publicly traded counterparts

–> their long term portfolio enhancing characteristics may be very different from their short-term characteristics

Question 6

private real estate returns are proxied by

Answer 6

NCREIF

Question 7

public real estate returns are proxied by

Answer 7

NAREIT

Question 8

private real estate represents (largely to its unlevered nature) the

Answer 8

low-risk / low-return variant of public real estate (which is levered)

Question 9

three components in the standard portfolio optimization technique

Answer 9

1. average return
2. variance
3. correlation

Question 10

long-horizons would be the preferable prism when investors decide to

Answer 10

private market investments: illiquidity and transaction costs make frequent portfolio rebalancing impractical

Question 11

de-smoothing models often rely upon unknowable parameters and/or difficult-to-ascertain observations

Answer 11

long horizons allow the data to “speak for themselves”

Question 12

the longer holding period captures

Answer 12

serial correlation observed in t-bills and other private-market alternative investments

Question 13

the use of long run investment horizons provides investors with

Answer 13

another perspective by which they can make judgements about their ex ante portfolio allocations

Question 14

de-smoothing approaches attempt to

Answer 14

recover true market prices from the observed appraisal-based return series while reducing autocorrelation

Question 15

“constant liquidity value”

Answer 15

to reflect prices that would have been observed had the ease of selling been constant over time

Question 16

true returns are unobservable and reported returns represent a weighted average of current and previous true returns

Answer 16

reported returns are a smoothed byproduct of true returns

Question 17

publicly traded REITs are an imperfect substitute for

Answer 17

private real estate

–> these imperfections seem fairly small when viewed from a long run perspective

Question 18

NAREIT returns are reported ..

Answer 18

with leverage (40-50%)

Question 19

NCREIF returns are reported ..

Answer 19

on an unleveraged basis

–> increases the return and volatility of return

Question 20

NCREIF index returns are used as a proxy for the ..

Answer 20

returns available for non-core (value-added and opportunistic) funds

Question 21

institutional investors can create a risk/return continuum of real estate investment opportunities by

Answer 21

varying their leverage ratio

Question 22

what dominates the portfolio allocations at the low end of the efficient risk/return spectrum?

Answer 22

t-bills and private-market real estate

Question 23

what dominates the portfolio allocations at the middle of the efficient risk/return spectrum?

Answer 23

treasury bonds, small stocks, and real estate

Question 24

what dominates the portfolio allocations at the high end of the efficient risk/return spectrum?

Answer 24

small stocks

Question 25

real estate occupies an average portfolio allocation approaching 25%

Answer 25

real estate appears as a substantial portfolio weighting in all but the most extreme edges of the high-risk/high-return efficient frontier

Question 26

when the level of autocorrelation equals zero, the scaled long-term volatility equals the

Answer 26

periodic volatility: their ratio equals one and the volatility of long-run returns is said to be unitless

Question 27

assets which display significantly different single-period autocorrelation characteristics have a long-term (cross asset) correlation which is ..

Answer 27

more than twice as large as their single period (cross-asset) correlation

–> their beneficial diversification characteristics may be markedly diminished

Question 28

the Sharpe ratios represent the

Answer 28

interaction of changing means and volatilities as the holding period lengthens

Question 29

the general effect of using longer investment horizons was to

Answer 29

increase the average Sharpe ratio –> volatilities tend to drop faster than mean returns

Question 30

dramatic changes in the level of serial correlation in the observed one- and four-year returns

Answer 30

the two real estate return series saw their serial correlation fall by more than 50 percentage points while US equities saw their serial correlation rise by approximately 3ß percentage points

Question 31

potential downfall of strict application of portfolio optimization is that

Answer 31

small differences in risk/return characteristics may result in unjustifiably large differences in optimized portfolio weights

Question 32

“floors and ceilings” around the allocation of each asset class:

Answer 32

reduces the allocation to small stocks and increases the allocation to public market real estate

Question 33

because of the high serial correlation associated with t-bills and private real estate (NCREIF) returns, ..

Answer 33

their infinite-horizon volatilities explode as compared to their one-year volatilities

Question 34

the return series of private market assets generally display significant serial correlation

Answer 34

–> one-year returns as typically used in mixed-asset portfolio optimizations often fail to fully capture these effects

Question 35

using infinite time-horizons, the optimal real estate allocations are approx.

Answer 35

10-15% of the mixed asset portfolio (represents upper bound for most investors)

Question 36

for investors preferring a low-risk portfolio,

Answer 36

(unlevered) private real estate is the vehicle serving this allocation

Question 37

for investors preferring a high-risk portfolio,

Answer 37

public real estate (embedded leverage of 40-50%) is the vehicle serving this allocation

Question 38

whether investors prefer private or public real estate vehicles ought to depend on their ..

Answer 38

preference for liquidity, tolerance for short-term volatility, ability to exert control, etc.