The Maximum drawdown as a Risk Measure: the Role of Real Estate in the Optimal Portfolio

In this paper we investigate the role of real estate in a mixed-asset portfolio when the maximum drawdown (hereafter MaxDD), rather than standard deviation, is used as the measure of risk. The recent crash of equity markets around the world, and the consequences this has had on the balance between assets and liabilities for most pension funds, have lead to an increased interest in alternative measures of risk, both from a theoretical and a practical point of view. We argue that the MaxDD concept is one of the most natural measures of risk, much more so than measures such as Valueat- Risk (VAR) which have gained popularity in recent years. To assess the practical implications of the use of the MaxDD, we investigate optimal portfolios obtained under the MaxDD criterion for a Swiss institutional investor who is faced with legal constraints on the weights that can be allocated to the various asset categories. The asset classes considered are: Swiss and foreign equities, bonds, and indirect real estate, as well as Swiss direct real estate. We show that most portfolios optimized in Return/MaxDD space, rather than in Return/Standard Deviation space, yield a much lower MaxDD, while only a slightly higher standard deviation (for the same level of return). The reduction in MaxDD is highest for portfolios situated halfway on the efficient frontier, typically close to those held by pension funds.