Investing beyond the backyard for better returns and greater diversification

Chris Bedingfield looks at the advantages of using global real estate to create diversification in a portfolio.

Australian investors who seek diversification by coupling Australian shares with domestic residential investment property are unlikely to obtain the benefits they seek. However, looking outside Australia’s shores to global property may help achieve their aims.

With more than 35 per cent of the S&P/ASX 200 represented by banks and other financials, and approximately 60 per cent of the banks’ assets in residential mortgages, it means any meaningful decline in Australian property values will impact a large proportion of the Australian equity market at the same time.

In an extreme scenario – a time when diversification is perhaps most valuable – a portfolio of Australian residential property and shares may offer no real diversification at all as the two asset classes could turn out to be highly correlated. 

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Any stress in the Australian banking system resulting from a decline in residential property will have a significant impact on the wider Australian economy and therefore a meaningful impact on the entire share market.

Instead, a better option for property investors may be to diversify into a global property exposure.

An important aspect for portfolio construction is to allocate capital to un-correlated asset classes while maintaining an overall return objective. 

Assuming most Australian investors want to maintain a significant holding in Australian equities, and they like the idea of property investments, this means finding alternative asset classes with little correlation.

Low correlation

An obvious option might seem to be an exposure to global equities. But interestingly, our analysis shows the statistic correlation between global equities and Australian equities (sitting at 0.50) is almost the same as between global real estate and Australian equities (at 0.51). 

Putting this into context, the closer the correlation is to a value of one, the more correlation there is between asset classes, hence less diversification.

In other words, there is as much diversification benefit for an Australian investor to allocate to global real estate as there is to global equities; investors who see the benefits of real estate assets could find this attractive.

Greater diversification

In addition, global real estate offers greater diversification against Australian equities (with a lower correlation at 0.51) compared to Australian real estate investment trusts (that sit at 0.62).

Not a bond proxy

Finally, despite conventional wisdom that real estate is a ‘bond proxy’, global real estate has almost no long-term correlation with global fixed income (at 0.05).

The low correlation indicates that holding both asset classes offers significant diversification while providing income-based total returns.

Real assets rarely lose all of their value.

Another big advantage for real estate – and other real assets strategies – is that real estate companies grow by acquiring real assets. 

So long as leverage is managed, real assets rarely lose all of their value. Companies may pay too much – but the assets retain some value even under a worst-case scenario.  The rate of obsolescence for institutional quality property is low.

The same however, cannot be said for equities.

In the world of equity, operational leverage can turn seemingly sensible acquisitions to dust if there is any technology industry disruption (as was the case for MySpace) or if there is poor judgement (as was seen with Slater & Gordon / Quindell). In our view, the rate of business obsolescence is greater than real estate obsolescence.

Unhedged global real estate also stacks up on a total annual returns point of view, and has delivered returns comfortably above the long-term inflation rate and competing assets.

Looking at sector performance since 2000, global real estate has been a top four performer on 11 out of 17 occasions. Australian equities (which has been a top four performer nine times) and US equities (eight times) have not been as consistent.  

Interestingly, whenever global real estate has performed relatively poorly, it has bounced back strongly in the following years. 

Equally, the volatility of global real estate is not significantly different to other risk assets.

For Australian investors, global real estate provides as much diversification as global equities – with a better return track record.  It is likely therefore to provide much needed diversification even for investors who hold domestic property.

Chris Bedingfield is principal and portfolio manager at Quay Global Investors.