Diversification when it hurts? The joint distributions of real estate and equity markets

Much of the literature on the construction of mixed asset portfolios and the case for property as a risk diversifier rests on correlations measured over the whole of a given time series. Recent developments in finance, however, focuses on dependence in the tails of the distribution. Does property offer diversification from equity markets when it is most needed - when equity returns are poor. The paper uses an empirical copula approach to test tail dependence between property and equity for the UK and for a global portfolio. Results show strong tail dependence: in the UK, the dependence in the lower tail is stronger than in the upper tail, casting doubt on the defensive properties of real estate stocks.

The impact of real estate on the terminal wealth of the UK mixed-asset portfolio

The argument for the inclusion of real estate in the mixed-asset portfolio has concentrated on examining its effect in reducing the portfolio risk - the time series standard deviation (TSSD), mainly using ex-post time series data. However, the past as such is not really relevant to the long-term institutional investors, such as the insurance companies and pension funds, who are more concerned the terminal wealth (TW) of their investments and the variability of this wealth, the terminal wealth standard deviation (TWSD), since it is from the TW of their investment portfolio that policyholders and pensioners will derive their benefits. These kinds of investors with particular holding period requirements will be less concerned about the within period volatility of their portfolios and more by the possibility that their portfolio returns will fail to finance their liabilities. This variability in TW will be closely linked to the risk of shortfall in the quantity of assets needed to match the institution’s liabilities. The question remains therefore can real estate enhance the TW of the mixed-asset portfolio and/or reduce the variability of the TW. This paper uses annual data from the United Kingdom (UK) for the period 1972-2001 to test whether real estate is an asset class that not only reduces ex-post portfolio risk but also enhances portfolio TW and/or reduces the variability of TW.