Seeking Alpha
Long/short equity, value, hedge fund analyst, REITs
Profile| Send Message|
( followers)  

In part 1 of this series we discussed the market's excessive and inappropriate use of asset allocation without realizing its weaknesses. Part 2 will be dedicated to debunking myths about how various assets sum together. Many seem to believe that buying multiple diversified assets will increase diversification summatively, but this is not always the case. We will dig into the underlying details to ascertain the true nature of portfolio diversification and uncover substantial opportunity using this technique. Specifically, we will show how to obtain superior expected returns without sacrificing diversification.

What is diversification stacking?

Anyone who has participated in investment discourse forums has likely encountered someone rejecting an asset because it is not diversified. Similarly, many investors will attribute a premium valuation to assets that are diversified.

This is the core of the fallacy.

Many assume that a portfolio consisting of a bunch of assets that are in themselves diversified is more diversified than a portfolio consisting of a bunch of assets that are in themselves concentrated. In many cases, people end up paying a premium to get the individually diversified assets and thus lose expected returns without any benefit. This leads us to our thesis.

A portfolio of diversified assets is not necessarily more diversified than a portfolio of concentrated assets. This will be proven through a present example.

Compare the following healthcare REIT portfolios.

  1. Ventas (NYSE:VTR), HCP Inc. (NYSE:HCP), and Health Care REIT (NYSE:HCN)
  2. Omega Healthcare (NYSE:OHI), Medical Properties Trust (NYSE:MPW), and Senior Housing Properties (NYSE:SNH)

There are 4 prominent healthcare property types: Senior housing, skilled nursing facilities, medical office buildings, and hospitals. Each healthcare REIT invests in each category in different amounts with some being "pure plays" while others are diversified.

Portfolio 1 above consists of the 3 most diversified healthcare REITs while portfolio 2 contains 3 pure play healthcare REITs.

(click to enlarge)

Portfolio 1 epitomizes the diversification stacking fallacy in that despite it containing all diversified assets, it is actually less diversified than the portfolio containing only the concentrated assets. Let's do the math.

MOB

SNF

SH

Hosp

Other

VTR

18%

23%

52%

7%

0%

HCP

12%

31%

39%

5%

13%

HCN

17%

25%

49%

6%

3%

Portfolio 1 (equal weight)

15.66%

26.33%

46.66%

6%

5.33%

In contrast, Portfolio 2 looks like this

MOB

SNF

SH

Hosp

Other

MPW

1%

0%

0%

98%

1%

SNH

28%

5%

61%

2%

9%

OHI

0%

95%

2%

2%

1%

Portfolio 2 (equal weight)

9.66%

33.33%

21%

34%

2%

Notice that portfolio 2 actually has more balanced asset concentrations than portfolio 1. There are 2 additional benefits to portfolio 2 over portfolio 1.

  1. Valuation: As the market tends to prefer assets that are diversified, the pure plays tend to provide a higher expected return. In fact, portfolio 1 has a P/FFO of 16.9 while portfolio 2 trades at only 14.1X. I am not suggesting that the diversification is the only reason for the premium, but it is a contributing factor.
  2. Increased customizability: If one were to change the weights of the holdings in portfolio 1, the asset type exposure of the total portfolio would barely change as the 3 companies have similar holdings. However, changing the weights of the pure plays affords a high level of customization. One could obtain as much or as little exposure to each asset type as desired.

Conclusion

Diversification within individual assets does not necessarily translate to diversification of the portfolio. It will vary case by case. In certain instances, an awareness of the diversification stacking fallacy can shed light on opportunities. The healthcare REIT sector is an example of this. Purchasing the mixed portfolio of pure plays gives both more diversification and superior expected returns.

Additional Disclosure: 2nd Market Capital and its affiliated accounts are long OHI and MPW. I am personally long OHI and MPW. This article is for informational purposes only. It is not a recommendation to buy or sell any security and is strictly the opinion of the writer.

Source: Diversification Fallacies, Part 2: Diversification Stacking