Modern Portfolio Theory & Modern Real Estate Investing

EquityMultiple’s Real Estate Team works tirelessly to evaluate individual real estate investments, assessing return potential versus risk factors. But what of the broader picture of an investment portfolio? Experienced investors will seek to maximize return potential relative to risk at the portfolio level, whether that portfolio is comprised of a traditional allocation to stocks and bonds, or is more diversified. As we will show, there is analytic and historical evidence to support allocating a greater share to private real estate: a greater proportion than is reflected in the portfolios of most individual investors. Modern portfolio theory supports this thesis, and can provide a useful guiding framework for asset allocation, not just for large institutional investors but for individuals as well.

Modern portfolio theory refers to the quantitative practice of asset allocation that maximizes projected (ex-ante) return for a portfolio while holding constant its overall exposure to risk. Or, inversely, minimizing overall risk for a given target portfolio return. The theory, first put forth by Harry Markowitz in his paper “Portfolio Selection” in the 1952 Journal of Finance, prescribed diversifying across uncorrelated assets to reduce the overall risk exposure of the portfolio.

The theory uses a mathematical process called “mean variance optimization,” thereby considering the covariance of constituent assets or asset classes within a portfolio, and the impact of an asset allocation change on the overall expected risk/return profile of the portfolio.  

Modern Portfolio Theory and Investment Analysis

Consider a hypothetical fictional investor (let’s call him Steve, a lawyer in his early thirties). Steve currently holds a large amount of Apple stock, just received his holiday bonus, and is looking to grow his portfolio wisely. He does not want to put more money into Apple (though the stock is performing well) because he understands intuitively that he should diversify his portfolio as it grows. Steve is deciding between putting his money in Facebook, and devoting his bonus to passive real estate investments. Which investment choice is preferable with respect to the risk-adjusted return potential of Steve’s portfolio?

In order to employ modern portfolio theory to inform his allocation choices, he’ll need to gather a set of estimated asset performance figures: the expected return of each asset within his potential portfolio; the volatility of each asset class (as represented by their standard deviation from their expected mean return); the correlation between these asset classes; and their covariance with one another (as defined by the product of their volatilities and correlation with one another).

Steve arrives at the following regarding the expected return, volatility, and correlations of his portfolio’s constituent asset classes:

From here, Steve can then calculate the covariance of these assets using the covariance formula COVij=SiSjCij where S is the time-series standard deviation of periodic total returns (volatility), and C is the covariance between the two assets i and j. As such, Steve arrives at the following covariances for the constituent asset classes of his portfolio:

Hypothetical Cross-Asset Allocations

To capture the true impact of Modern Portfolio Theory is it important to examine what the expected return and standard deviations of portfolios with these potential allocations would be. Below are the expected return and standard deviations of Steve’s two portfolio options. Portfolio A consists of 70% Apple stock and 30% Facebook. Portfolio B consists of 70% Apple Stock and 30% real estate.

Hypothetical Asset Allocation Options

Note also that many investors may have little confidence in an expected return for a publicly traded stock. Facebook and Apple are used here for illustrative purposes, but ETFs or indexes may be more appropriate for such an analysis.

Despite the fact that Facebook stock and Steve’s real estate holdings have the exact same expected return and risk profile, the portfolio containing real estate has a significantly lower overall risk profile than the portfolio containing Facebook, an asset that is similar in nature and highly correlated to Steve’s main holding of Apple. True diversification considers not just the risk/return profiles of asset classes and assets within the portfolio, but also the correlation of the individual assets within the portfolio.

The figures above, albeit simplified, make clear the impact that modern portfolio theory practice can have. As you can imagine, the larger and more varied the portfolio, the more complex the calculations and the more powerful the output can be. Excel and other specialized software can assist with more complex mean variance optimizations.

Like David Ricardo’s theory of comparative advantage in trade, modern portfolio theory is a simple, elegant concept with profound real-world implications. While it may not be practical or feasible to employ sophisticated formulas to rebalance your portfolio, the take-home principals of Modern Portfolio Theory are worth keeping in mind when any new asset or allocation mix is considered: for any level of expected aggregate return, the degree of correlation between assets and asset classes within a portfolio should be minimized.

Correlation to Global Public Equities, 2009-2019

Sources: IDP Global Property Fund Index, MSCI, Bloomberg, Barclays, Cambridge Associates Global Private Equity Index

The basic premise is worth keeping in mind as you are adding individual private real estate assets to your portfolio. While all real estate asset classes are subject to macroeconomic factors to some degree, individual properties and local real estate markets are also subject to microeconomic factors and sectoral economic trends. If, for example, you are considering two private real estate assets with very similar risk/return profiles, modern portfolio theory would prescribe that you select the one that bears lower correlation with other assets in your portfolio – either the real estate portion or your portfolio as a whole. This may mean diversifying away from a geographic market where you already have exposure, or allocating to an asset whose investment thesis is supported by economic trends contrary to your existing holdings — for example, self-storage vs. ground-up luxury condos. 

Limitations of Modern Portfolio Theory

In its original form, MPT uses standard deviation as a proxy for risk, which investors seek to mitigate within the framework. Using standard deviation as a measure of risk, however, implies that a better-than-average return is as undesirable as a worse-than-expected return of the same magnitude. Furthermore, using the normal distribution to model the pattern of potential investment returns makes investment results with more upside than downside appear more risky than they really are, with the opposite true as well. This can lead investors to misunderstand the potential ‘upside’ or ‘downside’ of a particular investment when considering only traditional modern portfolio theory methodology.

Some academics and portfolio managers have taken to incorporating a metric called ‘Downside Risk’, which incorporates an investor’s goal return and defines risk as those outcomes that do not achieve that goal. The statistic is calculated in a similar manner to standard deviation, however only accounts for results that lie below the investor’s desired return hurdle. The metric measures the volatility of results below the target return. This modified framework is sometimes referred to as “Post-Modern Portfolio Theory.” 

MPT and the Current Landscape of Alternative Investments

Diversification across uncorrelated assets is the cornerstone of Modern Portfolio Theory, so it’s no surprise that acolytes of MPT have taken an active interest in diversifying across a growing spectrum of alternative assets.

Alternative investments are broadly defined as securities transacted in private, inefficient markets. They are typically less liquid than public market assets (like publicly traded stocks). While public market vehicles like index funds can offer access to “beta” (an investment in the broad health of the economy or sector of the economy), private-market alternatives offer access to “alpha,” or return potential derived from skill in management and the exploitation of market inefficiencies.

Performance of a privately-held commercial real estate asset, for example, tends to depend on the soundness of location and business plan and the skill and resources of the Sponsor and/or developer, rather than market swings. By definition, then, alternative assets exhibit low correlations with traditional assets, making them attractive additions to a portfolio when evaluated through the lens of Modern Portfolio Theory.

Recent studies have supported this assertion, including a Blackstone report that analyzed performance of a portfolio with a 20% allocation to alternative investments (including private real estate) over a 20 year period:

Two aspects of the current traditional asset environment have also pushed many institutional and individual investors toward greater alternative asset allocations:

• A Low-Yield Environment Among Traditional Assets: In the past several years, yields on bonds have dwindled to close to zero. Even if and when bond yields pick up, gains may be tempered by a concomitant increase in inflation. Meanwhile, there has been a combination of high valuations (the price-earnings ratio of the S&P 500 was 550 basis points higher over the period of 2008-2016 than during the years between 1985 and 2007).

• Higher Correlations Among Traditional Assets: Between the years 2001 and 2011, cross-asset correlations roughly doubled among traditional assets due to more integrated global securities markets, and heightened global volatility.

These factors both point toward the growing appeal of alternative assets, like private real estate, when considered within the Modern Portfolio framework. Unfortunately, individual investors remain severely under-allocated vs. institutional investors like pensions and endowments.

EquityMultiple levels the playing field for individual investors by offering high-quality, private-market real estate assets at relatively low minimums. 

It should be noted that alternative investments still carry risk, including liquidity risk. Again, alternative assets tend to exhibit a greater Alpha, so it’s important for investors to understand the quality of management and the underlying asset, as well as all risk factors.

As Blackstone notes, “returns tend to be less correlated to the beta of traditional market investments and are more dependent on the individual manager’s skill.” For more on alpha, beta, and mitigating exposure to systematic risk through allocation to alternative assets, please refer to this article.

Post-Script: Modern Portfolio Theory Today

Current financial headlines have not changed anything about the fundamental utility of the MPT framework. The trends that should encourage individual inventors to pursue greater allocations of private-market alternatives still prevail: 

• Interest rates have risen as the Fed aims to combat inflation; impetus for investors to seek new sources of yield aside from the fixed-rate vehicles that could be relied on in decades past. 
• Volatility in public markets will likely persist as overheated news cycles and wider adoption of trading apps fuel large and frequent swings. 

60+ years since the advent of Modern Portfolio Theory, the paradigm remains as relevant as ever.

Sources:

https://www.blackstone.com/docs/default-source/black-papers/seeking-an-alternative.pdf?sfvrsn=12

https://www.cboe.com/Institutional/JPMCrossAssetCorrelations.pdf