Short-term traders don't bother diversifying to maximize returns without taking on undue portfolio risk. They don't bother understanding fundamental drivers of earnings growth. They don't bother with governance, transparency or alignment of interests-they care only about the latest hot tip leading (they hope) to a lucky strike. Oh, and they typically lose their shirts-if they're not already sitting in their boxers.

Your clients want something different. They understand the value of diversification, though they may ask you how to achieve it. They recognize the importance of earnings growth, though they may need help foreseeing it. Above all, they're not looking for a winning gamble today; they're looking for a portfolio of healthy investments that will carry them to, and through, a worry-free retirement.

In that, your clients are like most institutional investors, including pension funds, endowments and charitable foundations. Your clients and institutional investors both want to put together a well-diversified, optimally performing investment portfolio-one that will continue to perform for years if not decades. The difference? Your clients aren't going to pay tens of millions of dollars

for that investment advice-but that's okay, because

they can learn from the investment experience of the biggest pension funds and other institutional investors in the country.

Building Blocks

Burton Malkiel, the Princeton professor and former member of the Council of Economic Advisors who wrote the famous investing manual, A Random Walk Down Wall Street, said, "There are only four types of investment categories that you need to consider: cash, bonds, common stocks and real estate." Mark Anson, who led the largest pension funds in both the

U.S. (CalPERS) and the U.K. (British Telecom), completely agreed: "Equity, fixed income, cash and real estate are the basic asset classes that must be held within a diversified portfolio."

Yes, your clients can benefit from holding other assets-my portfolio, for example, includes commodities-but if they don't have substantial allocations to those four building blocks, then they're not benefiting from the most amazing force that exists in the world of investments: diversification. Diversification doesn't mean merely "spreading your risk"-that's prudent, but hardly amazing. It means this: If your clients hold assets whose returns move differently from each other, then their portfolio can include assets with superior returns even if those assets are individually volatile; overall their portfolio volatility will be relatively low.

In other words, there are two ways of getting strong returns: choosing a portfolio of high-return but not diversified assets and accepting high-portfolio volatility, or choosing a portfolio of high-return assets whose asset-level volatility is eliminated through the power of diversification. Put another way, there are two ways of getting low portfolio volatility: choosing a portfolio of low-volatility assets and accepting low-portfolio returns, or choosing a portfolio of high-return assets whose asset-level volatility is eliminated through the power of diversification.

Real Estate Investments

As one of the "basic" asset classes, pension funds have been investing in real estate for decades through several different strategies, and for more than 22 years they've been collecting data on which strategies work best. The results have probably surprised even them. Of course, a large pension fund such as CalPERS can make real estate investments that simply aren't available to individual investors, even in the high-net-worth segment. But you can make use of the findings from the pension funds' data collection activities to help your clients do a better job of selecting their real estate investments.

There are five basic investment strategies that pension funds have followed on the equity side of the real estate market:

* Buy a finished building and receive lease income.

* Invest in a fund that makes core real estate investments-that is, the fund buys finished buildings and passes on the lease income to

their investors.

* Invest in a value-added fund, meaning the fund looks for chances to "add value" by renovating run-down buildings or replacing underperforming property management.

* Invest in an opportunistic fund, meaning the fund looks for high-risk "opportunities," such as unfinished buildings that it may (or may not) be able to complete and lease up.

* Invest in the stock of publicly traded real estate investment trusts (REITs), companies that buy and manage buildings, passing along the lease income

to their shareholders.

The pension funds' data has revealed important differences in the investment returns of the different real estate strategies, differences that can work to your clients' advantage.

(By the way, owning a home-or even a vacation home-shouldn't be counted as part of your client's real estate investment portfolio. Even if these are important components of your client's wealth, these are not assets chosen for their investment return characteristics; they're consumption goods chosen because that's where your client wants to live or vacation. Think of it this way: If your client needed to rebalance her portfolio, would you advise her to sell off part of her son's bedroom?)

Question

1. How Do They Perform?

Comparing the investment characteristics of different real estate investments can be tricky. For example, REIT investments have roughly tripled in value in the last two years, while property values remain mired near the bottom they reached during the Great Recession. To make a fair comparison, it's a good idea to look at real estate investments' performance through an entire real estate market cycle, including the bad times as well as the good times.

Over the last real estate market cycle-which lasted 17½ years, a fairly typical length for the real estate asset class-investing in high-quality commercial buildings provided net total returns that averaged about 7.58% per year. That performance was measured by the National Council of Real Estate Investment Fiduciaries (NCREIF), whose NCREIF Property Index (NPI) tracks some 6,000 properties in which NCREIF data-contributing members-pension funds and their investment managers-invested. That total return was entirely from income; in fact, institutional investors actually lost money on the value of the buildings themselves, with capital appreciation averaging -0.26% per year over the cycle.

Core real estate investment funds make pretty much the same investments, with two differences. First, funds don't invest all of the investor's money; they keep part of it as a cash buffer in case any investors want to redeem their shares. Second, funds borrow part of the money to buy properties: Core funds typically use leverage of about 20%, although more recently their use of debt has averaged around 30%. Leverage increases the returns to investors, but it increases their risk correspondingly.

Over the same full real estate market cycle, core funds produced net returns averaging 7.68% per year, with performance measured, again, by NCREIF through its Open-End Diversified Core Equity (ODCE) Funds Index. Surprisingly, core fund returns weren't even as good as investors could have earned on their own, simply by borrowing 20% of the money to purchase the same buildings-a result that may be caused by the uninvested cash buffer, typically around 4% of investors' capital.

Value-added funds used substantially more leverage (around 55%), exposing their investors to substantially greater risk in the search for higher returns. As with core funds, though, their returns have been surprisingly weak given their heavy borrowing: Over the last full real estate cycle, value-added funds generated net returns averaging just 8.54% per year, only slightly better than core funds and unlevered properties. Perhaps even more surprising given their investment strategy, they produced hardly

any capital appreciation, averaging just 1.09% per year, only slightly better than the 0.93% per year achieved by core funds.

Opportunistic funds, in keeping with their high-risk profile, use even greater leverage, currently averaging more than 60%. That elevated risk increases their returns too: Over the full real estate cycle they averaged 12.15% per year, net of fees. Their return profile was also quite different: a smaller portion of their total return was from income (6.59% per year), but capital appreciation was much stronger at 5.32% per year, not surprising given their strategy of finding properties with leasing problems and trying to solve them.

The last arrow in the quiver used by pension funds and other institutional real estate investors is publicly traded equity REITs. In a big surprise to the institutional community, publicly traded REITs have provided much stronger returns than any of the other strategies, not just during the last full real estate market cycle, but apparently before and after it as well.

Over the full cycle, publicly traded equity REITs rewarded their investors with total returns averaging 13.38% per year, net of investment management fees-much better than value-added or opportunistic funds, in spite of the fact that publicly traded REITs expose their investors to far less risk by using far less leverage, generally averaging around 40%. Like the other strategies, most of their return was income (derived from the stream of lease payments) at 6.79% per year on average; REITs, however, also produced strong capital appreciation, averaging 6.19% per year.

Why has REIT investment performance been so much better? The answer seems to go back to points mentioned that high-flying "investors" looking for a lucky strike don't bother with: governance, transparency and alignment of interest. It turns out all of these attributes-along with the liquidity that enables an investor to dump a stock if the company blunders-impose a discipline on the executives of publicly traded corporations (including REITs) that encourages them to make better investment decisions and hinders them from making poor ones.

In effect, pension funds ran an experiment that individual investors can learn from: They locked up capital long term under fund managers whose investment decisions were not transparent to their investors (much less independent equity analysts), not overseen by investor-aligned governance structures (including activist stockholders) and not subject to the discipline of an active, liquid market of informed investors. If the idea was to "liberate" investment managers from the demands of the market, it succeeded only in liberating them from accountability, but the pension funds suffered in the form of poor returns.

Question

2. What about Risk-Adjusted Returns?

What attracted pension funds to private equity real estate funds in the first place? The answer is that the funds aren't traded on liquid markets, which means that their short-term returns-from quarter to quarter, in this case-can only be estimated, either by professional appraisers or, more commonly, by the investment managers themselves. That's important because estimated returns tend to be much smoother than actual returns, which means that fund managers have long been able to claim that their returns are less volatile than those of publicly traded REITs. Of course, estimates can disguise actual returns for only relatively short periods.

Conversely, in the public market, short-term fluctuations in asset values tend to iron themselves out fairly quickly. Because of that, investors with longer horizons benefit from lower volatility than short-term traders face. In fact, the decline in volatility is very rapid. For example, the return volatility of publicly traded equity REITs for investors with an investment horizon of even just five quarters is less than half as great as it is for traders with a horizon of one quarter. The other real estate investment strategies don't benefit from that kind of decline in volatility, because their quarterly returns have already been smoothed in the return-estimation process.

Because of the volatility decline, risk-adjusted returns for longer-term investors in publicly traded REITs are dramatically better than for investors following the other strategies. For example, for investors with investment horizons of one year, the Sharpe ratio (measuring risk-adjusted returns: the ratio of average excess returns to volatility) over the last full real estate market cycle was 1.19 for publicly traded equity REITs compared with 1.15 for opportunistic funds; 1.06 for core properties; and 1.03 for both value-added funds and core funds. For investors with two-year investment horizons the difference was even more dramatic-publicly traded equity REITs produced a Sharpe ratio of 1.67 compared with 1.41 for core properties; 1.37 for core funds; 1.28 for

opportunistic funds; and 1.16 for value-added funds.

Question

3. How Should My Clients Construct a Diversified Real Estate Portfolio?

The fact that private equity real estate investments-that is, all of the strategies other than publicly traded REITs-have underperformed over the long periods of available historical evidence doesn't mean that they can't play any role in a well-constructed real estate portfolio. Remember, the wonder of diversification means that investors can benefit by holding assets whose returns move differently from each other. The private side of the real estate market, it turns out, lags the publicly traded side by a year or more, a crucial difference in the timing of returns that provides diversification even though both private and public strategies invest in the same assets.

Perhaps the most important measure of diversification is beta, which represents how the returns on one investment respond to changes in the returns on another asset: A beta of less than one means that diversification brings down portfolio volatility, while a beta greater than one means that adding the asset will boost portfolio volatility. Relative to buying a core property, investing in a core fund gives a beta of 1.24, meaning no diversification benefit-not surprising, given that core funds invest in essentially the same group of properties but add leverage, increasing volatility. Also not surprising, value-added and opportunistic funds have betas of 1.64 and 2.08 respectively, owing to the fact that both are private-side investments that use dramatically higher leverage.

Publicly traded REITs, though, have a beta of just 0.67 relative to owning core properties. That means that, despite REITs' use of leverage averaging around 40%, combining them with direct property ownership actually reduces portfolio volatility, because of the lead-lag relationship between the public and private sides of the real estate market.

An optimal (or efficient) portfolio is one that is constructed to have not just low volatility, but to provide the highest returns possible given the volatility that the investor can comfortably tolerate. Investors with different risk tolerances will choose different combinations of assets to achieve the optimal portfolio.

The available pension fund data over the past 22 years, for example, suggests that the lowest-risk optimal portfolio for an investor with a two-year investment horizon would have been composed of 31% publicly traded equity REITs combined with 69% direct core property holdings. The core property returns lag behind the REIT returns to bring down the portfolio volatility, while the REIT holdings boost portfolio returns to an average of 6.75% per year net of investment management fees.

Of course, that result assumes that the core property holdings themselves are diversified, both in different property-type sectors and geographically across the nation, which is possible for a large pension fund, but not for even the wealthiest individual investor. More realistic for individual investors would be investing in a core real estate investment fund. The pension fund data shows that the lowest-risk optimal portfolio for two-year investment horizons would have combined 45% publicly traded equity REITs with 55% private core funds, for a combined net return averaging 6.88% per year.

Investors seeking higher returns would achieve higher returns optimally by increasing the publicly traded REIT share of their real estate portfolio while reducing their holdings on the private side of the real estate market. For example, a 50/50 split would have produced net returns averaging 7.11% per year over the historical period; 69% REITs with 31% core funds would have generated 8.0% per year net returns while minimizing portfolio volatility; and 90% publicly traded REITs with 10% private core funds would have minimized portfolio volatility while achieving 9.0% average annual returns net of investment management fees.

What about value-added and opportunistic funds? It turns out that value-added funds play no role in any optimized real estate investment portfolio that is constructed on the basis of the returns actually experienced by pension funds and other institutional investors. That's because they have offered no diversification benefit, while producing very poor risk-adjusted returns owing to their weak performance relative to their volatility.

Opportunistic funds can play a role in optimized portfolios, but only for the most risk-tolerant investors and those with the shortest investment horizons. For example, an investor who obsesses with quarterly results could construct an optimized portfolio by allocating 46.3% to opportunistic funds and 53.7% to publicly traded equity REITs, achieving net returns averaging 9.4% per year with annualized volatility of 13.5%. For an investor with a two-year horizon, though, the optimal mix to achieve the same return would be allocated just 1.5% to opportunistic funds and 98.5% to publicly traded REITs-and, though the net returns would be the same, the annualized volatility of two-year holdings would be just 5.1%.

The Bottom Line

Pension funds are only now sorting through the data that they've collected over the past 22 years in the hope of learning from the terrible losses their real estate portfolios suffered during the Great Recession. The main lessons from their experience as long-term real estate investors, however, are equally applicable to individual investors:

* First, the differences in risk-adjusted performance and diversification potential by investment strategy-properties, core funds, value-added funds and opportunistic funds-pale in comparison with the differences between the public and private sides of the real estate market. Core funds look a lot like property holdings, but with more volatility; value-added funds look like core funds but with more volatility; opportunistic funds look like value-added funds with higher returns but with more volatility. Nothing on the private side of the real estate market can substitute for publicly traded equity REITs.

* Second, publicly traded REITs have managed to produce net returns that, even on a risk-adjusted basis, are far superior to those generated by investments on the private side of the real estate market. The reason seems to be that the transparency, liquidity and strong governance characteristics of publicly traded investments result in better investment decisions by REIT executives. This means that your clients can benefit from private real estate holdings only through diversification benefits, not through asset-level performance.

* Third, because private real estate returns lag the public side of the market, optimally constructed real estate portfolios will include investments on both sides, provided your clients can tolerate the illiquidity of private real estate holdings. The optimal allocation will depend not only on your clients' risk tolerance, but also on their investment horizon. Those obsessed by short-term fluctuations should generally have more invested on the private side to take advantage of the artificial smoothing produced by return estimates, while those who can ride out short-term fluctuations should invest more heavily on the public side to take advantage of better performance.

Understanding the critical differences between public and private real estate investments-and recognizing whether your clients are day traders or long-term investors-can help you make use of the lessons suffered by pension funds to improve your clients' real estate portfolios.

Brad Case is senior vice president, Research and Industry Information, NAREIT.