CAIA Level II: Advanced Core Topics in Alternative Investments, 2nd Edition

CHAPTER 20

Portfolio Allocation within Real Estate

The top-down decision of how much of a portfolio of traditional and alternative assets should be allocated to real estate is a complex one. Institutional real estate investing is increasingly moving away from allocations being driven by naïve diversification. Naïve diversification refers to simplistic allocations of a portfolio to a variety of investments without careful reasoning. Naïve diversifiers often place a small percentage of their overall portfolio in real estate or other alternative investments in the hope that risk will be diversified and return will be enhanced.

The chief investment officer (CIO) of an institution should avoid an asset allocation process that searches available investments in order to scatter portfolio allocations among diverse opportunities that appear to offer attractive returns. Since virtually all analysts make errors to a degree in predicting future returns, a disorganized search that focuses on locating attractive returns runs the risk of suboptimal diversification among opportunities that overweight assets with benefits that have been overestimated.

Diversification by institutions should be driven by reason and evidence in the pursuit of an optimal portfolio. A starting point for optimal diversification is to begin with a target portfolio equivalent to the market portfolio prescribed by the capital asset pricing model (CAPM), and to adjust from market weights to optimal weights that include ...