Miguel Sosa is a research and product strategist at Bluerock Capital Markets, which has $15 billion in AUM.
At the 2022 CAIS Alternative Investment Summit in Beverly Hills, Miguel and I discussed a paper he wrote on Advanced Diversification, where he used modern portfolio theory to deconstruct the three elements of diversification to quantify the benefits of each of those elements. We then discussed how to apply those three elements to build a more efficient portfolio. We get a little technical in this one but I think you’ll really appreciate how this type of knowledge can help you build higher performing risk-adjusted portfolios.
Correlation and Volatility
Miguel says that you can find references to diversification of assets in the Bible and Shakespeare, so on some level people have always understood that it’s not good to have all your eggs in one basket. In the 1950s, Harry Markowitz’s modern portfolio theory helped advisors quantify diversification by focusing on two inputs — volatility and standard deviation — and the correlation between assets in a portfolio.
“What we did in our research is use that modern portfolio theory formula to look at the two asset classes that most people use when they’re thinking of investing: equities and fixed income,” Miguel explains. “But also, let’s look at the realized correlation between the two asset classes. Let’s assume different levels of correlation. Instead of the -0.4 correlation that has existed for decades between equities and fixed income, what would it look like if there were zero correlation? What would the results be if it were a 1.0 correlation and they were perfectly correlated? And so we did that little bit of stress testing to see which contributors would improve diversification.”
Miguel and his team determined that there were three components of diversification:
- Decorrelation Effect (Low correlation)
- Buffering Effect (Low volatility)
- Hedging Effect (Negative correlation)
The good news is that, for the last 70 years or so, advisors have done a pretty good job of finding the right mix for their clients. And, of course, the generally bullish market environment didn’t hurt either, especially after the Great Recession.
Allocating to Real Estate
But, according to Miguel and many other advisors I spoke to at CAIS, we may be in a very different environment now. Rising interest rates, inflation, and high equity volatility have really tested the limits of a traditional 60/40 portfolio in the past year. In order to maintain that essential mix of low correlation and low volatility, more advisors are starting to broaden their horizons — and their offerings — to include more alternative investments, such as private credit and private real estate.
Miguel’s focus is on real estate. After analyzing nearly 50 years of data from the NCREIF Property Index, Miguel and his team’s research concluded that contributing private real estate to your portfolio significantly improved the portfolio’s overall risk/return profile. That was due not only to the low volatility of private real estate, but also because of the significant returns that it can offer in addition to the less than 0.1 correlation.
Some of private real estate’s stability comes from its illiquidity. There’s also the role of institutional investors in the private real estate market, who generally are operating on longer timelines than individual investors. So while “real estate is real estate,” the structure of how you invest in it can significantly affect its return and volatility profile.
Historically, real estate has also proved reliable in inflationary and high-interest environments as well. “The typical concern that comes up is if interest rates are higher, that means the cost of servicing the debt within real estate will also be higher,” Miguel says. “Therefore, real estate must perform poorly. We’ve also done research and realized real estate actually performs strongly and has outperformed its long-term since inception return in higher interest rate environments. So if you look at the periods when the Fed has raised rates over the last almost five decades, private real estate has outperformed. That actually follows economic theory, which would say rising interest rates happen during strong economic backdrops. The Federal Reserve is actually trying to slow down the economy because the economy is doing well. Vacancy rates are low, occupancy rates are very high, rental rates are increasing. And therefore valuations are increasing as well. On average, if you look at those periods, including the late seventies and the early eighties, where inflation was high and interest rates were high, real estate has outperformed by a 400 basis point margin if you annualize the figures.”
Private Real Estate vs. Public REITs
So why not just direct more of your client’s money to a publicly traded REIT?
Because based on Miguel’s research, for the last several decades public REITs have experienced 20% annualized volatility, which is less stable than equities. Working with CAIS allows Miguel to help investors solve for that volatility problem by providing efficient access to a variety of innovative private real estate products that have different liquidity and return profiles.
“We have about 35 different private REIT investment strategies in our portfolio,” Miguel says. “So one can get the benefit of accessing what we believe are high quality investment strategies in a single investment strategy. It would take hundreds of millions of dollars for an institution to access these individually, given the minimums are, on paper, $5-10 million, sometimes 5-to-10 times that given the long queues or the demand for those particular products. So it’s a very efficient method of accessing high quality and diversified private real estate.”
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