by Lars Kroijer
In this chapter, I discuss other popular asset classes and their absence from the simple rational portfolio. We will see that appreciating that we are without an edge is even more important as we move away from the public equity and bond markets and into sectors that are typically closer to the local economies that we individually know and feel a part of. It may seem strange to have a whole chapter on things to leave out of your portfolio, but it is important to remember why: the portfolio in this book is for people who have no edge to outperform, and should be a simple and cheap portfolio as a result. The rational portfolio is certainly simple and cheap, and requires no edge in the three asset classes it suggests: the minimal risk asset, world equities and other government and corporate bonds. The asset classes discussed in this chapter will undoubtedly make many investors phenomenally rich in the future, but those will either be investors who have a great edge, charge others a lot of fees or are lucky. Since you don’t want to count on luck, can’t charge other people large fees and have no edge – and probably have a lot of exposures anyway – you should stay away. The eliminated asset classes are still important because you need to be sure that you know they have been considered and that there are good reasons for leaving them out.
A few recurring issues with these other asset classes make them unsuitable for the rational portfolio:
You don’t have an edge or special insight/knowledge to pick the outperforming sub-set of the asset class.
The whole asset class does not necessarily have return expectations in excess of the minimal risk asset in future.
You already have exposure to the asset class via companies represented both in your broad equity and potentially corporate bond exposures. Do you really need to increase them further?
The other asset classes can be very illiquid – do you get compensated with higher returns for this disadvantage?
Other asset class exposures can be very expensive in fees and expenses. Unless you have a great edge in picking the right products this can destroy any return advantage.
There is a good case for adding quoted property investments to the rational portfolio although only in limited size relative to the overall equity investment. But because it is small and you may already have this exposure indirectly elsewhere in your rational portfolio, and for the sake of simplicity, property investments have been excluded from the simple rational portfolio.
So, the excluded asset classes discussed in this chapter are:
property direct investments, private property funds
residential property
quoted property holdings
private equity, venture capital and hedge funds
commodities
private investments
collectibles.
Mortgage-backed, mortgage-related and asset-backed securities, other types of quasi-government debt and other debt instruments issued by financial institutions are also excluded. This is because some of them fall into the property category, and others are alternatives to the minimal risk investment, particularly in cases where the investments are quasi government and there are tax advantages. Also, a lot of the exposures those kinds of debts give you are captured indirectly elsewhere in the portfolio, but they are without easy products to gain access to – so in the interest of simplicity and ease of implementation these additional investment possibilities do not add enough additional value to be included. Financial institutions’ debt is a gigantic market (bigger than the corporate debt market), but less of a relevant product for the rational investor as a lot of it relates to the wholesale funding market for financial institutions and there are no easily accessible products available to most retail investors.
Property – don’t do it unless you have an edge
Rational investors would not expect to do any better than the general property market, less any cost disadvantage they may have, so the best expected return from property would be that of the whole sector in the relevant area. Someone investing in private/direct property projects or private funds that invest in property often invests in the same geographical area as their other assets and as we have seen this exposes them to a great concentration of risk in their overall portfolio as a result. There is a good chance that whatever may cause the local/regional property market to decline could affect other local assets, in addition to the value of investors’ private homes. Unless you get compensated for this concentration risk by getting higher expected investment returns, the concentration is a risk worth avoiding and as you are without an edge you would not predict this outperformance.
Likewise, consider the illiquid nature of private property investments. While even very large investors can liquidate world equity market investments in a short period of time, trying to sell a direct property investment or a stake in a private investment when you need the money is rarely a recipe for success. And while there have clearly been successful property booms, if you are selling at a tough time for property assets generally then others probably need to sell property at the same time. With liquidity drying up for those investors who are forced to sell their investments, this situation is terrible.
One of the reasons so many investors are fascinated by property investments has to do with physical proximity. People who are interested in investing often can’t help themselves spotting a great investment opportunity and where better to see it than right in front of you. You might see a decrepit building in a great location and wonder why nobody is fixing it up, and think that you might just be the best-positioned investor to do it. Or hear through a friend that planning permission is going through for an upscale development that would lift the value of an adjacent building, and so forth. Like a lot of people in London, I have been guilty of feeling like a property expert and thought I was an astute property investor until I realised that I had just been lucky and bought into a rising market.
I don’t doubt that many property investors are people with local connections or insight to do this well. Perhaps they have an edge, but unless you are one of those plugged in people, you probably do not have an edge in the property markets. And like the argument of picking active equity managers, picking property investment funds suggests an indirect edge if you claim to be able to pick a manager who has an edge.
So how do you know if you are one of these investors with an edge in property markets? As in the public equity markets it is not always easy to know if you have an edge. Those who perform poorly have a great excuse and those that perform well in the property market are unlikely to think it is luck and will always have other great reasons: they saw something others didn’t, knew something, understood something and heard something. Something. Just be honest with yourself as you consider your edge. It can be expensive to think you have it if you don’t.
Has residential property really been that great?
The best estimate of residential property performance is the Case-Shiller House Price index which represents the price changes in US residential homes. Professor Robert Shiller describes the housing index along with other interesting ideas in his excellent book Irrational Exuberance (Princeton University Press, 2005). To my knowledge there isn’t a property index that covers all forms of residential property investment across many countries that goes back many decades for us to analyse.
Using the Case-Shiller index as a proxy for residential property investments since 1890 we can compare the returns of the housing market to an investment over the same time period in short-term US government bonds (see Figure 9.1).
The first thing to note is that over the past century we would have done far better investing in US government bonds than in residential property. It is of course easy to criticise analysis like this for not correctly incorporating rental income (or the ownership benefit of not paying rent), maintenance and improvement costs, transaction costs, insurance costs, and transaction and on-going tax. Or not being international. I would agree that it is hard to claim that these things are an overly exact science, but this index questions the pr
emise that property investments are necessarily a huge profit centre.
Figure 9.1 Inflation adjusted Case-Shiller House Price index versus short-term US government debt
However, we can also see why property was such a hot investment in the years before the sub-prime crisis (see Figure 9.2).
Figure 9.2 Case-Shiller House Price index versus short-term US government debt and S&P 500, all inflation adjusted
As property markets outperformed debt and equity markets, many saw this as a sign of things to come and jumped on the bandwagon, even as longerterm data did not suggest that residential property markets outperform in the long run. Besides, it’s always easier to sell an investment in something that has recently done well, and property investments certainly did well until the bubble burst. Keep in mind that many countries have regulations or incentives that promote house purchase. As a good friend commented, ‘Where else can you get a subsidised 90% loan-to-value investment with no taxes?’ Of course, all those things should help house prices, but should already be reflected in the prices.
A home
A friend of mine and I were having a conversation a couple of years ago, soon after he had lost his job. He did not have much in the form of savings, about £20,000, but could probably support his family for a year without lowering their living standards. Almost as an aside, my friend said, ‘Thank God we have the house.’
Five years earlier he and his wife had put all their savings into the equity of their house, obtained a loan-to-value mortgage of 80% and bought the cottage of their dreams in South London for £200,000. They loved the house and financially it had been a huge success. An estate agent had told them that they would have no problems selling the house for £250,000 – a tax-free gain of £50,000.
In my view, their situation is fairly typical of a London couple; the vast majority of their wealth is tied up in London property (see Figure 9.3).
Figure 9.3 Net asset mix
Not only were my friends dependent on London property, but with their mortgage they were heavily geared. A decline in the London housing market could have a very significant impact on their net assets, the success of the house purchase not withstanding. Table 9.1 shows how this couple’s net assets of £110,000 (house of £250,000 less £160,000 mortgage plus £20,000 other savings) would be affected by different movements in London property prices, assuming their house moved with the market.
Table 9.1 London house price decline
In essence, my friends were taking an incredibly concentrated bet on the London property market. If the housing market in general, and their home specifically, sufferered a decline of 20% they would see their assets decline by 45%; a 40% decline in the value of the house and my friends would almost be bankrupt.
I thought I was stating the obvious, my friend saw no sense in my argument. He pointed out that if they had taken the £40,000 that they put down for the house and put it in the bank instead, their life savings would be £60,000 today instead of £110,000. Where was the sense in that? I mentioned that if you ignored that a lot of people thought there was a lot of additional quality of life from owning where you live instead of renting, they had essentially taken a geared bet on London property and been lucky. Again my friend thought I was wrong. He felt that they knew the local market and had been able to find an extra-attractive house and that when they bought the house the local property market was about to take off. Instead of luck, they had been astute house buyers. At this point I kept my mouth shut.
I understand and appreciate the desire to own your house instead of renting, and also understand that we badly want to believe that we have made an astute purchase with what for many people is the largest investment of their lives. But buying a property may mean compromising the portfolio of our total assets, by increasing concentration risk and correlation risk in a leveraged way, and I would strongly suggest that any house owner takes a look at the fraction of total assets that local property constitutes.1 Then question what would happen if your local property market dropped in value by various double-digit percentages. Would it matter? Is this likely to happen at the same time as you lose your job or other savings? Would you risk the scenario of being unable to make payments on a mortgage or forced to refinance the mortgage, thereby risking having to realise the price change and being unable to ride out the stormy market?
A major part of good portfolio management is about not putting all your eggs in one basket and subjecting yourself to the risk of bad things happening all at once in an unpredictable fashion. For many who were hurt in the recent property bubble, this was what happened. But I do understand why individual investors put great intangible value to owning their own house on top of the large monetary value many have realised over the past decades. My parents have lived in the same house for about 40 years. Their house is not an integral part of their portfolio or an investment – it is a home. If that is somehow sub-optimal from a portfolio management perspective, so be it.
The case for commercial property
Despite the questionable history of great returns in residential property and its presence in many portfolios through home ownership, general property investing has been a thriving investment for some over the years and an integral part of many diversified portfolios. While there is good evidence that the return profile for commercial property has been attractive in the past, to my knowledge there hasn’t been a global diversified investable property index like there is in the stock markets with the MSCI World index and others. As an example, the FTSE EPRA/NAREIT Global index was not launched until 2009 and even while there is global data going further back, it is less clear how a globally diversified property investment product would have fared.
Proponents of property investment suggest that it is a separate asset class with limited correlation with equity and other markets. (Although only tracking residential property, the correlation between the Dow Jones Industrial Average and the Case-Shiller index since 1900 is only 0.19.) Limited correlation with other asset classes is obviously a good thing and if this low correlation is replicated in future then commercial property investment could provide a good diversifier (although virtually all publicly traded property investments suffered in 2008 along with the rest of the market, suggesting low correlation is not universally the case). With low correlation you don’t need that high a return expectation for a property investment to make sense and investing in a diversified global portfolio of property investments would also add geographic diversification.
But despite the promisingly low correlation and apparent good historical performance of commercial property generally, the FTSE NAREIT index mentioned above represents quoted underlying property investment companies with a market capitalisation that represents only 2–3% of the global equity market’s total market capitalisation.2 At the time of writing the largest constituent in the index has a market value of around $25 billion and the entire index of around 400 constituents spread around the world has a value of about $650 billion, or not much above the market value of a couple of leading individual companies. So while the global index provides the kind of good and well-diversified property exposure an investor should want, if you allocate far more to property than the sub-5% of the world market values, you run the risk of over-allocating to property, particularly considering the other ways you already have direct and indirect exposure to the sector.
Investors in equities are already directly and indirectly significantly exposed to the property sector on top of home ownership. A major constituent of equity markets everywhere is financial institutions, including banks. Those banks obviously serve many functions, but a key one is the provision or facilitation of capital for the property markets. The banks do this both in the form of residential property markets, but also by financing and investing in commercial property. Even in the cases where the banks only act as a facilitator and pass on the principal risks to other investors (as opposed to other cases where banks hold on to a property investment), they still have a huge intere
st in a positive property market.
The bursting of the US sub-prime market bubble in 2007–08 and the subsequent default of many geared products connected to it was one of the primary drivers of the financial crisis. So even if the direct representation of property investment companies represents a fairly small portion of the overall stock market, we have indirect exposure to property through many other sectors of the stock markets. In addition to the banks, the listing of many large infrastructure and construction-related companies further adds to our indirect exposure to the property market because corporations in a wide variety of industries already are the largest holders of commercial property.3
Some might disagree that I’m leaving out property investments and I can appreciate why. For those investors who wish to add an investment in property, I would recommend you invest in low-fee and geographically-diversified property investment companies. A good option is publicly traded REITs (Real Estate Investment Trusts). REITs have a favourable tax treatment, particularly for US investors, and distribute most of the income from their diverse set of underlying property holdings (often mainly commercial, like offices and retail, but also warehouses, apartment buildings, hospitals, etc.).
