Assessing the "Santa Claus" Approach to Asset Allocation: Implications for Commercial Real Estate Investment

Abstract

Casual observation suggests that there is wide industry practice of a Santa Claus approach to fund allocation, i.e., giving more money to fund managers whose performance have been nice (good) in the recent past and giving less money to fund managers if their performance has been naughty (poor). Using the market timing test of Henriksson and Merton (1981), we show that this backward-looking Santa Claus approach to asset allocation is not consistent with optimal portfolio management and that this Santa Claus strategy may have contributed to the poor performance of financial institutions' real estate portfolios. We also discuss the role of loan-to-value ratio analysis, and point out how this standard bank loan underwriting procedure may have affected commercial banks' Santa Claus strategy. We propose that the backward- looking Santa Claus strategy should be replaced by either a simple Buy-and-hold strategy or a contrarian investment strategy of increasing real estate exposure after a market downturn and reducing real estate exposure after a real estate market rally.