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The available historical data and how to interpret it
Correlation with other asset classes
Consequences for portfolio allocation
This paper analyses for France, indices that represent physical real estate and shows that they differ from one another in terms of assets which are included or their valuation methods. They are constructed in such a way that comparisons with listed asset indices must be done with care. In particular, they exhibit smoothing and time lag. We investigate the hierarchy of risks and we show that residential is less risky than offices, prime real estate in Paris’s “Golden Triangle” is the riskiest.
The long-term risk is greater than what a simplistic calculation would show, and may be as high as the risk level of equities. Over the long term, there is a positive correlation with equities and a negative correlation with government bonds. Again, the phenomenon may be concealed through careless work on series with too high a frequency.
Consequently, the diversifying power of physical real estate is very attractive in the long term for bond-heavy portfolios, but less so for equity-heavy portfolios. The smoothed valuation method, however, has a favourable optical effect on short-term risk.
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The benefit of an asset class is explained by the expected return given its risk, as well as its impact on the total risk of the portfolio via diversification. It is hard to extrapolate from past returns, but observing historical series is helpful for quantifying risk and correlations. Here, we are interested in the risk of physical real estate and its correlation with the listed assets to be taken into account for long-term allocation in the case of France.
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Factor investing is currently very popular among investors. This investment approach was developed following the publication of a report by Ang, Goetzmann and Schaefer (2009), who were asked to evaluate the performance of active management for Norway’s sovereign fund.
Marie BRIERE, Alessandro RUSSO, CFA, Eric TAZE-BERNARD
Insurance companies accuse Solvency II regulation of being too pro-cyclical; in the event of sudden adverse market movements the marked to market price asset valuation may result in a strong erosion of the solvency situation of insurance companies, forcing them to sell risky assets at the worst possible moment. The primary purpose of this Special Focus is to offer a pro-cyclicality measure for assets under the solvency II standard formula. We will also make a few comparisons between asset classes. Under a buy and hold approach, if the SCR (Solvency Capital Requirement is representative of the risk to which an asset class is exposed, resistance to pro-cyclicality is all the greater when the asset class has a high SCR. Assuming the same SCR, less risky assets resist pro-cyclicality better. The crisis hurts "rich insurers less than poor insurers": insurance companies with a comfortable starting solvency position suffer less from such pro-cyclicality but this better resistance is noticeable only for assets with a high SCR. The equity dampener sharply reduces pro-cyclicality under certain circumstances and may even occasionally render the equities themselves counter-cyclical. But there is a very high degree of variability in pro-cyclicality associated with fluctuations in the dampener. For corporate bonds, the level of SCR plays the main role, and for the lowest ratings, downgrades lower resistanceto pro-cyclicality; the convexity effect slightly reinforces this resistance. Taking account of the liability structure could alter the assessment of the bonds’ pro-cyclicality once the rules for calculating the discount rate based on the counter-cyclical premium risk are known. There are indications that in the portfolio construction process controlling the SCR and pro-cyclicality are, to some extent, conflicting objectives. To optimise yield, both the SCR and pro-cyclicality must be considered.
Sylvie de LAGUICHE
Head of Quantitative Research at Amundi