Real Estate and Timing the Rebalance

Since Real Estate is an important asset class in any serious allocation, we are providing this link to a very good article on when to fill one's allocation to Real Estate (specifically via REITs, for anyone whose home equity does not fulfill the allocation).

Historically, they key has been to look at REIT yields versus Treasuries, and buy when the yields are high. While this is naturally intuitive, the article does a nice job laying this out.

Finally, "Real" Asset Allocation For Individuals

The famously successful asset allocation strategies of top investors and university endowments such as Yale have been the envy and goal of many sophisticated individual investors for years. Yale's endowment, for example, is up an astonishing 16.1% per year for the past 22 years, with remarkably low volatility, since current head David Swensen took over. Look at the Yale annual report and our blog summary "Yale and You" here to see how Yale does it.

But individual investors haven't been able to participate directly in such diverse and exclusive funds, and instead have had to (1) try to construct their own sophisticated asset allocation from the bottom-up, (2) hire professionals for enormous fees and scant accountability, or (3) settle for the badly inferior "life-cycle" funds that offer a simplistic mix of stocks vs bonds as individuals age.

Happily, today Vanguard announced its Managed Payout Funds, which will help individuals gain access to more of the true diversification benefits that professional asset allocators achieve. Vanguard will offer three funds containing not only U.S. stocks & bonds (which are often highly correlated and therefore far from optimal), but also international stocks, REITs, Treasury Inflation Protection Securities (TIPS), commodity-linked investments, and market-neutral equity funds. These additional asset classes have different return and correlation characteristics in comparison to U.S. stocks & bonds; institutional investors have been exploiting them for years to obtain higher returns and lower variability of returns year-to-year.

Vanguard will construct its Managed Payout portfolios to achieve closer-to-optimal portfolios (in a Markowitz sense) than most investors can achieve for themselves. The new funds will pay out a percentage each year to investors needing retirement income and (probably) better risk-adjusted returns than are widely available to them otherwise. Vanguard will re-balance each asset class regularly to accord with long-run allocation targets, something individual investors also fail to do. Astonishingly (though perhaps not for Vanguard), annual fees will be only 0.57-0.58%.

Of course, the new funds' reward/risk tradeoffs won't come close to the characteristics of the best institutional asset allocators, who beat market-averages within traditional asset classes, and push into private investments and emerging asset classes that Vanguard's public funds will not be able to incorporate. But Vanguard's Managed Payout product will open a new efficiency frontier to many individual investors.

REITs and Commodities -- Key For Personal Investors (At Least, So Far)

The following interview with BYU professor Craig Israelsen makes it very easy to see why REITs and Commodities have been crucial to asset allocation strategies, at least historically. The interview keys off this article in the Journal of Indexes (Nov/Dec '07 issue).

• HardAssetsInvestor.com (HAI): What did your study on correlations show?

  Craig Israelsen (Israelsen): Basically that diversification really works. That's a real stunner, isn't it?

  HAI: Shocking. But seriously, how did it work?

  Israelsen: I built equal-weighted portfolios out of up to seven different asset classes: large-cap U.S. equities, small-cap U.S. equities, non-U.S. equities, U.S. intermediate-term bonds, cash, REITs and commodities.

  For commodities, I used the S&P GSCI commodities index going back to 1970. I'd note that before 2001 or 2000, the GSCI was not investable, so I'm making the assumption that there could have been an actual portfolio tracking that index back in 1970.

  In my original analysis, I started with an equally weighted two-asset class portfolio composed of large-cap and small-cap U.S. stocks, and I looked at the returns. Then I started adding more asset classes: non-U.S. stocks, bonds, cash, REITs and commodities. I found that as you added the additional asset classes, you improved the returns and limited the worst one-year drawdown of the total portfolio. But importantly, it was not a linear relationship.

  HAI: How so?

  Israelsen: There's a major change when you get to commodities and REITs.

  With the five-asset portfolio - large-cap U.S. stocks, small-cap U.S. stocks, non-U.S. stocks, bonds and cash - which is about what the typical target date portfolio held three years ago, you get a 10% internal rate of return while sustaining retirement withdrawals. The worst one-year drawdown since 1970 is 17%.

  When you add REITs and commodities, the internal rate of return rises to 11.3%, which is nice. But the worst one-year drawdown falls to 10%. That's a 40% reduction!

  Most people wouldn't immediately notice a 1.3% increase in the annual return. But they would notice a 40% reduction in the worst one-year drawdown. You can feel that.

  HAI: Why does that happen?

  Israelsen: Commodities and real estate have fairly low correlations to the core assets of large-cap U.S. stocks, small-cap U.S stocks and developed markets international equities.

  When people buy foreign stocks, they think they are diversified. But the three main equity asset classes have correlations of 0.7 to 0.9. You don't get a lot of correlation benefit from adding more equities to an equity portfolio.

  Cash is a good diversifier, and so are bonds. But they don't have a very attractive long-term return. The real benefit comes when you add REITs and commodities. They have equity-like returns, but low correlations ... and in one important way, they have lower risk than equities.

That's the crux of it. What follows is more detail. It's very helpful to finally have a researcher discuss volatility in terms of "the worst year you'll sustain" rather than standard deviation, because it's easier to understand "worst year" in terms of one's real-life financial needs and risk tolerance:

• HAI: Lower risk for commodities?

  Israelsen: In a way.

  I've recently updated the data on this study. Between 1970 and 2006, large-cap U.S. equities had about an 11% return. But there were eight years in that 37-year period where large-cap stocks had a negative return. Moreover, the worst 3-year cumulative return was about 38%, from 2000-2002.

  Over that same time period, commodities had an average annual return of 11.5%. They had nine years with a loss, so one more than large-cap U.S. stocks. But the worst 3-year return for commodities was only 26% - much better than equities.

  I think that surprises people. It runs up again the idea of commodities being risky investments.

  Another important factor is timing. Take foreign stocks. The worst 3-year drawdown for non-U.S. stocks was 43%. That drawdown came at the same time as the worst 3-year drawdown for large-cap U.S. stocks: 2000-2002. When you have two assets that both have their worst 3-year periods at the same time, that's not helpful.

  By contrast, the worst 3-year period for commodities was 1996-1998. That offset was helpful for portfolios.

  Raw correlation is only a starting point. Most people use it as a starting and ending point. You really have to look at year-to-year returns and look at the patterns of major upside moves and major downside moved. If they don't overlap, I'm willing to be less worried about high correlations. If the correlations are high and the worst-case periods occur at the same time, that's not good.

  HAI: What do you hope people take away from your study?

  Israelsen: That retirement portfolio may be improved by being a little bit more exotic.

  One of the things people have objected to about my seven-asset class portfolio is that it has a pretty high commitment to so-called alternative assets. It sounds pretty iffy. But over this 37-year period, the worst 3-year return for large-cap U.S. stocks was bigger than the worst 3-year return for commodities. So which is more risky?

  Commodities live with a stigma that they are incredibly volatile. I think that's because people look at short time periods. I haven't studied it, but I think commodities may have more upside and downside moves over short time frames, but when you measure them annually, I would make the argument that commodities have demonstrated lower volatility than large-cap U.S. stocks.

  I think what happens in equities is that you get momentum that stays. If you have a bad year in equities, you might have another bad year after that. But with commodities, it can turn around more quickly. The year after the worst 1-year drawdown in commodities, for instance, commodities returned 41%.

  Volatility is often measured by standard deviation, and on that measure, commodities do poorly: They have a standard deviation of 24% versus 17% for large-cap U.S. stocks.

  But standard deviation is more a mathematical concept than a useful investment figure. I would argue that the worst 1-year return or worst 3-year drawdown is a more compelling statistic. Most investors would have no idea how to calculate standard deviation, or what it means. But they all know what a drawdown feels like.

  If you look at other measures of risk besides standard deviation, commodities aren't as radical as we want to believe.

"China, If You Think the U.S. Real Estate Bust Is Bad..."

There's a big reason why, before rebalancing our underweight equity allocations, we're waiting for financial crisis to hit the Developing Economies. In particular, China's real estate boom could end very badly.

Today a WSJ article provides more fodder for this line of argument, especially because it's attracting so little attention from Developed investment markets, as this link sensibly points out.

Read the WSJ article today titled, "Tables Turn Quickly on Chinese Developers."

From our past readings, we understood that the inflationary roots in China's real estate development story run deep and wide: (1) an enormous amount of Chinese property development was premised on the certainty that values would increase in the future (sound familiar to the U.S. mortgage lending bubble?). We also understood that (2) a major source of financing for China's development boom has been city governments evicting poor residents and giving the land to property developers as partial compensation for developing the land (same as printing money) -- and that China's many large cities have been aggressively competing to add real estate capacity in this way for most of the last decade. We also understand that (3) low-to-negative real interest rates in China have financed a significant portion of China's stock market boom -- consumers have been borrowing to speculate in stocks despite the government's efforts to enforce rules (remember, China is a DevelpING economy), and the too-easy money has surely found its way into the pockets of individual home buyers. We've read that (4) there is almost nothing like a developed market "credit score" for individual Chinese borrowers. Isn't that even worse than the widespread "no-documentation" loans that epitomized the U.S. mortgage boom-bust?

The Chinese government is starting to pull out the stops to rectify these problems (at least they're being more proactive than U.S. financial regulators were during the boom), working desperately to prevent new real estate capacity from coming to market. But it may be too little too late.

From Jonathan Cheng's WSJ article:

• Three months into 2008, China's property developers are under siege. Property prices are showing signs of weakness in many of the country's key markets, and capital markets have all but seized up for these -- and other -- offerings. The Chinese government is on a high-profile campaign to clamp down on new bank loans, hoping to curb inflation, rising at its fastest clip in a decade.
• Companies that leveraged big last year are now strapped for cash, unable to build on the land they have accumulated. Beijing is breathing down their necks, having pledged earlier this year to tax and seize hoarded land.....
• The latest casualty of changed conditions: Guangzhou-based developer Evergrande Real Estate Group, which last week shelved an IPO it hoped would raise as much as $2.2 billion....
• Evergrande's woes illustrate many of the headwinds facing Chinese developers. Despite stock-market turmoil, the developer was so weighted down by debt it had no choice but to take a crack at an IPO. More than half the funds Evergrande was hoping to raise were set aside to pay for plots it accumulated during a furious land grab last year.
• "We are highly leveraged, and a deterioration of our cash-flow position could materially affect our ability to service our indebtedness and to continue our operations," Evergrande wrote in its listing prospectus. With the IPO shelved, the company hasn't said how it will seek funds.
• Even titans have had to trim their ambitions.... Soho China Ltd [co-founder] Pan Shiyi ... told Shanghai Securities News that Chinese developers this year will "find themsevels in extraordinarily difficult financial straits."....
• "The 'model' that worked in 2007 was predicated on prices for apartments growing faster than land costs," says Todd Schumbert, an analyst with Deutsche Bank in Singapore.... Now, with home prices faltering and funding sources scarce, "This game is over."....
• In the past few months, Wang Shi, the head of megadeveloper China Vanke, a Shenzhen-listed company based in that boomtown, surprised the market by slashing prices heavily on new flats and suggested in a recent television interview that people wait three to four years before purchasing a new home.
  

This topic is much bigger than any single article can tell. Back on September 18 '07, I clipped an article by Jamil Anderlini at the Financial Times. A few quotes:

• China Construction Bank, the country's second largest lender, is taking a cautious line on China's economy and is reducing its exposure to an overheating property market, the bank's chairman told the Financial Times.
• [CCB chairman Guo Shuqing said], "The real estate market is more overheated in the coastal areas and the annual price increase is too high." [Oh, only the "coastal areas" of China?]
• Investor interest [in real estate company equity, at the time the article was written] is partly driven by soaring profitability at China's newly reformed banks, but those profits are diverting attention from rising credit risks, according to Standard & Poor's, the rating agency. "The rapid industry-wide expansion of credit exposure suggests many banks prioritise expanding their asset base and market share over strengthening their capital," Ping Chew, S&P credit analyst, said.

A clip from another FT article by Anderlini, this one on 9/14/07:

• Wu Xiaoling, deputy central bank governor, said on Friday that Chinese banks were not heeding the central bank's directives to slow lending growth. Banks are lending out money much faster than the central bank's target, with new loans reaching Rmb3,080bn ($409bn) in the first eight months of [2007], 97% of the total for the whole of [2006].
  

The Chinese real estate situation seems to have the makings of another slow-motion train-wreck. CCB chairman Guo said his bank is 90.67% provisioned, but one wonders how thoroughly he's counting CCB's total exposure. And it's the second-largest lender in China. Smaller banks are probably far less provisioned than CCB.

A real estate banking crisis in China would perpetuate the global contagion, and also soak up a lot of the nation's reserves, creating a follow-on shock wave for the global financial system that China is a central player in.

The most hopeful case is that a serious cooling in China's real estate sector will offset its overheating in other sectors, to produce a "soft landing" for the economy. This isn't where our bets lie right now.