Read the full paper 'Diversification: friend or foe?' by Chris Urwin.
While the importance of diversification is well known, determining how much is appropriate for a real estate portfolio is not necessarily obvious. Similarly, the idea that concentration is a risk to portfolios is not as straightforward as some investors might assume.
The goal of diversification is to reduce or eliminate ‘specific risk’ from a portfolio. However, studies of both equity and real estate markets suggest this objective can be largely achieved in concentrated portfolios with relatively few holdings. Analysis also indicates that diversification can bring diminishing returns and rising costs.
Furthermore, there are considerable potential benefits to holding concentrated portfolios of well-understood assets. Increasingly, deviation from benchmarks is viewed as an opportunity for outperformance rather than a risk. Information asymmetry is a key characteristic of the real estate sector, and better-informed investors can exploit this to create value.
Not all risk can be eliminated
Although the idea that diversification should reduce risk is intuitive, it is nonetheless worth looking at the theory behind it to determine what diversification can and cannot achieve. By diversification, we mean the inclusion of additional assets in a portfolio in order to reduce risk, with risk typically measured by the volatility of returns.
The capital asset pricing model (CAPM), which applies to all risky asset classes, makes a key distinction between two sources of volatility: specific risk and market or systemic risk.
Specific risk is unique to an individual asset such as a particular equity or property, and independent from one asset to another. Specific risk can be diversified by combining assets, each with their own idiosyncratic risks, and effectively eliminated through portfolio management. As such, theory suggests that it shouldn’t justify a premium return.
Market or systematic risk, meanwhile, refers to the tendency of individual assets to move together in response to systematic factors that affect all properties to a greater or lesser degree. This is part and parcel of investing in the asset class and is inescapable. The model suggests that this type of risk does justify a premium return.
The key insight is that while specific risk can be eliminated through the creation of diversified portfolios, market risk will remain even in well-diversified portfolios. As only market risk justifies a premium return, the key concern for an investor in any risky asset class is to ensure a sufficient number of assets are held and those assets are sufficiently uncorrelated, to allow specific risk to be effectively eliminated and total portfolio volatility to approach the level of the overall market.
Diversification can be taken too far
The CAPM clarifies what investors can reasonably expect by diversifying their portfolio holdings. But how many holdings are needed in order to achieve the benefits of diversification? Studies of equities suggest the answer is relatively few. They indicate that although the initial benefit of adding more assets to a one-holding portfolio is significant in terms reducing portfolio volatility, the size of reductions tend to tail off quite quickly. In other words, there are diminishing marginal returns to diversification as a way to reduce risk. Most studies show that equity portfolios of about 15-20 assets will eliminate almost all specific risk and the addition of further assets has little impact in this respect. The chart below illustrates this.
For equities, at least, relatively concentrated portfolios can attain most of the benefits of diversification. Nonetheless, the above does suggest that continuing to add assets will have a beneficial impact on portfolio risk, even if the impact is small.
This being the case, why not add as many assets as possible? The answer lies in the potential for excessive diversification. Adding more and more assets to a portfolio leads to increased costs and potentially lower returns. At a certain point, the negative impact of these factors will outweigh any benefits from a reduction in risk. Increased costs are particularly likely in the form of higher transaction and management costs. The threat of reduced returns comes from this source as well as the potential for lower investment standards and the dilution of best ideas. In short, by overdiversifying investors risk acquiring more assets than can be effectively managed.
Concentrated portfolios can achieve the benefits of diversification
With regards to direct investments in real estate, can the major benefits of diversification be achieved in relatively concentrated real estate portfolios, as is the case with equities?
A major study of real estate risk by the Investment Property Forum, which looked at the volatility of returns on over 1,000 properties in the UK from 2002-2013, suggests so. For most properties, it found ‘the market’ is the major risk factor, with specific risk relatively low and, in general, truly idiosyncratic to the property. Because the specific risks are so different from property to property, this implies diversification can be achieved rapidly. The study found that portfolios of 15-20 assets would, on average, have recorded volatility of returns close to that of the overall market, a number that echoes the findings of the equity studies.
The chart below shows that diversification brings diminishing marginal returns and most of the benefits can be achieved in relatively concentrated real estate portfolios.
10-year standard deviations of simulated portfolio's, 2004-2013
Number of real estate assets
Concentrated portfolios and outperformance
We would also argue there are considerable advantages to concentrated real estate portfolios due to the nature of physical real estate as an asset class. Real estate differs in many ways from the other major asset classes, equities and bonds, with four key differences particularly relevant.
Firstly, while all ordinary shares in a company or bonds in an issue are identical, each property is unique. Properties vary by factors such as location, use, size, age, construction and tenant type. Secondly, each property’s location is fixed and local factors, such as infrastructure, can fundamentally affect its value.
Thirdly, in contrast to major equity and bond markets, property prices are not determined by the interaction of numerous sellers and buyers for a homogeneous investment. There is limited information available on transaction prices and the volume of transactions is relatively low. Judgment is required when interpreting the available transaction evidence and what it might imply for the pricing of other properties.
Finally, while the ownership of a share bestows rights, such as voting rights, it does not generally come with obligations. By contrast, ownership of physical real assets comes with significant management obligations, including rent collection, maintenance, rent reviews and lease negotiations.
While these features of real estate clearly give rise to management costs, they also create an asymmetry of information that is generally not found in other asset classes. Active real estate investors acquire information that is not readily publicly available and can use this to generate significant value.
We suggest this can be best achieved in concentrated portfolios by giving investors in-depth knowledge of their assets, with much of this knowledge unavailable to other parties. Real estate remains a local asset defined inherently by its location, and the more an investor understands local dynamics, the greater the potential to drive performance.
Concentration also allows more potential for asset management. In a relatively concentrated portfolio, resources can be focused where they have most potential to add value. It also provides managers with greater scope to spot and exploit mis-pricing and, crucially, the opportunity to focus on their best ideas.
Such advantages should be kept in mind when constructing real estate portfolios. While diversification is certainly advisable, investors should be wary of adding more assets than they can effectively manage and exploit.
Be wary of paying for passivity
The evidence suggests the potential for outperformance that comes from concentrated portfolios whose managers make well-studied, high-conviction calls. It also suggests such portfolios can be constructed without losing the benefits of diversification inherent in larger portfolios.
Investors are increasingly seeking managers willing and able to make conviction calls. In the wake of the financial crisis, investors are more focused on managers’ ability to provide active management. Investors in all asset classes, including real estate, have become increasingly wary of paying higher fees for active management while receiving passive ‘index-hugging’ or low-conviction products in return.
As a corollary of this, investors are increasingly willing to view a portfolio’s deviation from its benchmark as an opportunity for outperformance rather than just a risk. One indication of this is the growing focus on active share, which measures how much an equity portfolio’s holdings differ from the benchmark index constituents.
There are three sources of portfolio active share: including stocks that are not in the benchmark; excluding stocks that are in the benchmark; and holding benchmark stocks at different weights to the benchmark.
Many institutional clients and consultants use active share as a tool to determine if an equity strategy justifies active management fees. For example, if a portfolio claims to be actively managed but has a low active share, an investor may decide to shift to a cheap passive index fund instead.
The courage of your convictions
With real estate portfolios and benchmarks made up of collections of unique assets, active share as defined above cannot be calculated for real estate portfolios. Nonetheless, analogous measures can be calculated based on a portfolio’s sector or segment’s calls in order to get an idea of a fund manager’s conviction.
In a recent academic study, the deviation of active managers’ portfolios from the segment breakdown of their benchmark was calculated for over 250 UK real estate funds for 2002 to 2011, a measure that is comparable to active share. The results were telling.
The authors found that the most active commercial real estate portfolios – those with segment weights least like the index – have, on average, significantly outperformed. This performance has not been achieved by taking more risk: more active portfolios were as well-diversified as typical funds, with slightly less total volatility on average. The study also noted that although the more active, better performing funds tended to be smaller, outperformance cannot be explained by fund size alone.
These findings suggest that real estate fund managers whose portfolios look least like the benchmark index create most value for their investors. This could be due to managers’ ability to identify which segments offer better value, or their ability to build an informational advantage in certain segments, or a combination of both. The smaller number of holdings in these portfolios suggests they are run by managers who are willing to act with conviction, without benchmarks acting as a constraint on their investment decisions.
 Modern Portfolio Theory and Investment Analysis, Elton & Gruber.
 Individual Property Risk, Investment Property Forum, July 2015.
 How Active is Your Real Estate Fund Manager? – Cremers & Lizieri, December 2013.
Unless stated otherwise, any sources and opinions expressed are those of Aviva Investors Global Services Limited (Aviva Investors) as at 3rd January 2017. This commentary is not an investment recommendation and should not be viewed as such. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Past performance is not a guide to future returns. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested.