Laurence B. Siegel

Real Estate Returns: A Comparison with Other Investments

Real estate returns, measured unleveraged, have been between those of stocks and bonds over 1960-1982. Due to appraisal smoothing and imperfect marketability, one must be careful about directly comparing measured real estate returns with those on other assets. It is likely, however, that low correlations with stocks and bonds make real estate a diversification opportunity for traditional portfolio managers. In addition, the issue of how various assets are priced is addressed. While stocks are priced primarily on market or beta risk, and bonds are priced primarily on interest rate and default risk, the real estate pricing mechanism includes residual risk and non-risk factors such as taxes, marketability costs and information costs. Copyright American Real Estate and Urban Economics Association.

The Dimensions of Active Management

When one eliminates all the market factors that active managers deliver (and that are available almost for free through index funds), what remains is the pure alpha. The cost of seeking this alpha is that one is forced to take on active risk. The authors draw on these observations to argue that building portfolios of active managers is an optimization problem that may be solved separately from the asset mix optimization problem (because pure active risk is uncorrelated with policy risk). They suggest that portfolios constructed using this approach emphasize index and risk-controlled active funds, while giving lighter allocations to traditional active funds and almost none to highly concentrated funds. For investors who are allowed to sell short, market-neutral long-short funds also have a place in the optimal solution.

The World Market Wealth Portfolio

T hree years ago in this Journal, we presented returns and market values for the United States Market Wealth Portfolio.’ That hypothetical portfolio included the principal investable asset classes in the United States: equities, fixed income securities, cash, and real estate. The wealth of the United States makes up onlya fraction of the world’s wealth, however. Indeed, this phenomenon is not purely a recent occurrence. Great Britain, for example, had the world’s largest capital markets in 1850. In the twentieth century, United States capital markets have been larger than those of any other single country, but they account for appreciably less than half of the world supply of equities, bonds, and real property. The sheer size of the foreign capital markets motivates us to reexamine the concept of a market wealth portfolio from a world perspective. In addition, returns in foreign markets have proved attractive to United States investors. Therefore, we have constructed a World Market Wealth Portfolio consisting of equities, bonds, cash, and monetary metals plus real estate in the United States (the returns on foreign real estate being difficult to measure). The analysis covers the capital markets of the United States, Northern and Western Europe, Japan, Hong Kong, Singapore, Canada, and Australia. Our study runs from the beginning of 1960 through the end of 1980. Our World Market Wealth Portfolio consists of a value-weighted combination of five major categories of assets: (1) equities (stocks), (2) bonds, (3) cash, (4) real estate, and (5) metals. Each category of assets includes several components. United States equities are a value-weighted aggregate of the stocks listed on the New York and American stock exchanges and NAS-

Alternatives and Liquidity: Will Spending and Capital Calls Eat Your “Modern” Portfolio?

High allocations to alternative investments by investors, such as foundations and endowments, raise infrequently discussed concerns about liquidity. As the percentage of assets under management invested in alternatives rises, the availability of liquid equities and bonds available to meet spending requirements, capital calls, and margin calls plummets. A series of simulations shows how severe this problem can become in bear markets. The remedy for this problem is to ladder gradually into illiquid assets, so that expected future cash flows from these assets partially or fully offset capital calls and other cash requirements. New and enthusiastic investors in illiquid alternative investments sometimes forget this principle. By adhering to it, an alternatives program can be successful, but not on an unlimited scale. It is also necessary to hold a considerable portion of a portfolio in liquid stocks and bonds.

Portfolio Theory is Alive and Well

n a recent article in this Journal, Rom and Ferguson [1993] state that the importance of downside risk to some investors renders modern portfolio theory (MPT) obsolete. In fact, portfolio theory (we drop the “modern,” given that the concept dates from 1952) says nothing about what kind of risk investors are averse to. Portfolio theory says: If we understand the investment opportunities in the market (in terms of their statistical properties), and if we understand investor attitudes toward these characteristics (in terms of which asset characteristics investors want and which they hate), we can tell the investor what portfolio to hold. Mean-variance optimization (MVO) is an application of portfolio theory. I t assumes that investors like expected return (the mean) and hate dispersion (as represented by the variance of returns around the mean). I t concludes that investors should hold efficient portfolios; these are typically diversified across asset classes.’ The assumption MVO makes about investor preferences is reasonable for a wide variety of utility functions. For this reason, MVO is widely used and is sometimes mistaken for the far broader theory of portfolios (MPT) or of decision-making under uncertainty (an even more inclusive cate-

Debunking Some Myths of Active Management

Too often, active managers promote their services in ways that help perpetuate a number of myths and misconceptions about active management. These include the confusion of alpha with beta, skill with luck, expected return with realized return, and style bets with true active bets. Managers sometimes also claim to be absolute return investors, neglecting to note that all active management is about adding value relative to some sort of investable benchmark. The authors address these and other misconceptions.

Stocks, Bonds, and Bills after Taxes and Inflation

DAVID MONTGOMERY is a managing director of Ibbotson Associates in Chicago. hy aren’t we all rich? As Stocks, Bonds, Bilk, and Inflation [1994] shows, a dollar invested in the S&P composite stock W index at year-end 1925 grew to about

The only spending rule article you will ever need

800 by year-end 1993, with other assets providing greater or lesser but still substantial gains. While few investors have a time horizon spanning seven decades, such astronomical growth suggests that long-term, buyand-hold investors should have earned plenty of money in the market. But most of us including those who buy and hold &versified portfolios of assets for the long haul are not rich. This is at least partly because of taxes, transaction costs, and the impact of inflation on real wealth. The classic works of Ibbotson and Sinquefield [1976, 1977, 1979, 1982, 19891, as updated by Ibbotson Associates [1994], form by far the bestknown documentation of returns on the principal U.S. asset classes. These works record month-bymonth total returns (and, where possible, their income and capital appreciation components) starting in January 1926 on six asset classes in the United States:

The Greatest Return Stories Ever Told

After examining an array of approaches to determining a spending rule for retirees, the authors propose the annually recalculated virtual annuity. Each year, one should spend (at most) the amount that a freshly purchased annuity—with a purchase price equal to the then-current portfolio value and priced at current interest rates and number of years of required cash flows remaining—would pay out in that year. Investors who behave in this way will experience consumption that fluctuates with asset values, but they can never run out of money. Investors have long sought a spending rule for asset decumulation in retirement that would assure them a guaranteed stable income while making sure they never completely run out of money. We show that a completely stable income is possible only with riskless investments, such as a hypothetical laddered TIPS (Treasury Inflation-Protected Security) portfolio with cash flows from the portfolio timed to match those required by the investor over his or her planning horizon (a hedge that cannot today be perfected over long horizons), or through a riskless commercial annuity (which doesn’t yet exist). With risky investments, which most investors will hold because they seek higher returns, investors can either receive guaranteed cash flows but for an uncertain period (thus taking the chance of running out of money) or receive variable cash flows (varying with the market value of the portfolio), in which case they will not run out of money if the decumulation scheme is engineered correctly. We show that asset decumulation is an annuitization problem. That is, even though most investors do not buy actual annuities to help with decumulation, annuity thinking is required for setting the terms of the spend-down for a given level of wealth, time horizon, and interest rates. Specifically, each year the investor should spend (no more than) the amount that a freshly purchased fixed-term annuity would pay out in that year if the annuity were bought in a size equal to the then-current market value of the portfolio at then-current market interest rates and with a remaining time equal to the time over which consumption cash flows are desired to last. The annuity must be repriced every year (or on whatever periodicity the investor chooses), with a corresponding reset of spending such that the spend is always appropriate to the wealth available, which will vary with investment returns, as well as the planned time horizon and market interest rate conditions. We call a strategy based on this periodic repricing an annually recalculated virtual annuity (ARVA). The investor that isn’t fully hedged to consumption, then, faces consumption risk—the risk of variability in what he or she can spend—that is almost exactly equal to, and caused directly by, the variability of portfolio values (and interest rates). Smoothing techniques do not help maintain consumption when portfolio values are down; one can borrow from the future only what one is willing to pay back later. There is no free lunch either from a spending rule with risky investments or from a smoothing approach attempting to avoid the consequences of investment volatility. Fixed-term annuities assume certainty about the spending horizon, but because lifespans are uncertain, we experimented with various enhancements that take life expectancy into account. A simple rule is to set the time horizon equal to one’s remaining life expectancy, because this number grows (slowly) as one ages. However, we found that this rule front loads spending unacceptably, with spending falling off sharply in old age to the great disadvantage of those who attain such longevity. One attractive rule turned out to be to set the time horizon equal to the average of (1) one’s remaining life expectancy and (2) the outer limit of one’s possible lifespan, which we assumed was age 120. But the “shape” of one’s spending over time is a matter of personal preference, and there is an infinite number of ways to speed or slow one’s payout from a given amount of wealth. An ARVA strategy is not the only way to protect consumption for one’s entire life. Here are some other options: Annuitize through life insurance company commercial annuities. Create a blend of deferred life annuities and conventional investing using an ARVA strategy. Use insurance riders for lifetime income, such as a guaranteed withdrawal life benefit or a ruin-contingent life annuity. We also propose some market-focused reforms in the commercial annuity industry, in order to create better and safer annuities for retirees in the future and a larger and more profitable annuity marketplace for the issuers. Annuitizing one’s whole portfolio through commercial insurance company-provided annuities is unpopular because of illiquidity, credit risk, and concerns about adverse selection and fair pricing. Some investors commercially annuitize part of their portfolio and manage the rest using conventional investments. A blend of deferred life-income annuities and conventional investments managed using an ARVA strategy has many attractive features, although any commercial annuity portion is still subject to credit risk and other concerns. In conclusion, investors can only spend what they have. There is no magic formula that will stretch dollars available to equal dollars “needed.” However, one can improve tremendously on current practice. A strategy that makes full or partial use of the ARVA concept will succeed where other approaches, such as a fixed percentage (e.g., 4%) of peak assets withdrawal rule, can easily fail if investment returns are disappointing or if the investor should enjoy a long life.

Compensating Fund Managers for Risk–Adjusted Performance

If one wants to compare track records of managers across widely different asset classes and investment styles, the Sharpe ratio (which is both benchmark-independent and scalable to different levels of risk) is perhaps the best measure of risk-adjusted return. The authors collected quarterly track records, covering 495 mutual funds, institutional commingled funds and separate accounts, endowments, and other asset pools, and ranked them by their Sharpe ratios over the long period from January 1980 to March 2000. Some of the high-ranking funds are well known, such as Berkshire Hathaway and Fidelitys Magellan Fund; but a number of surprises emerge. The number-one Sharpe ratio fund over that period was a tactical asset allocation product managed by Barclays Global Investors. Most managers underperformed their benchmarks, but the number of truly exceptional track records should give pause to those who assume that active management is fruitless because of the efficiency of markets.