Potential Diversification Benefits In The Presence Of Unknown Structural Breaks: An Australian Case Study

Abstract

It is reasonable to suggest that a portfolio manager with direct property diversified by sector or region is more interested in strategic than in tactical asset allocation. However, even with strategic allocations of property the portfolio manager needs a regular monitoring of the inter‐relationships amongst assets comprising the portfolio to ensure that unexpected events do not ‘permanently’ alter such relationships. One procedure for ascertaining whether assets are inter‐related over the long run (and therefore offer few diversification benefits) is through cointegration analysis. A difficulty with conventional cointegration analysis, however, is that it is unable to accommodate changes in equilibrium relationships that might occur due to unexpected structural changes. In this paper we apply the Gregory and Hansen cointegration procedure to consider how unexpected structural changes might affect the potential long run diversification benefits of assets held in an Australian property portfolio.