Understanding Allocation Benefit: Europe, country, sector or stock?

Executive Summary and Key Calls

Key call 1: From country/stock selection in 2001-2016…

For the first 16 years of the 24-year period examined, and over the 24-year period as a whole on average, getting country calls and asset calls correct offered a wider path to outperformance than accurate sector calls.

Key call 2: ….to sector in 2017-2021…

But, in the 2017-2021 period, sector allocation benefit dominated. On a one-year view, sector allocation benefit averaged 7.8% from 2017-2021, almost double that of country allocation benefit (4.4%) and selection benefit (4.5%).

Key call 3: …and back again in 2022-2024

Sector allocation benefit faded fast in 2022-2024, however, averaging only 2.5%, well below country allocation benefit (3.7%) and selection benefit (5.3%).

Key call 4: Country/selection likely to remain at the fore, but investors must be ready to be nimble

Our expectation is that the next few years will see a return to an era when selection benefit and country allocation benefit will offer greater outperformance, but investors should be mindful of the outsized returns on offer when sector allocation benefit comes to the fore.

A way of quantifying the drivers of performance

Top-down vs. bottom-up?

We previously looked at the impact on portfolio performance of top-down allocation versus bottom-up stock selection over the last 44 years (1980-2024) in the U.K., based on the 44-year history of the MSCI UK Annual Index. With the recent publication of MSCI’s European Annual Index, we now replicate this analysis for the continent. We also added a third dimension to our approach. Whereas, previously we thought of things as being top-down sector allocation versus bottom-up asset selection, there is now an additional top-down allocation aspect to factor in—that of the country-level.

In this paper, we will consider which of three factors have been the driving force behind outperformance of European real estate portfolios over the last 24 years: choosing the right sector, choosing the right country or choosing the right assets.

As we demonstrated in our U.K. paper, the reality is that a blend of expertise in all three, not excellence in just one, is the ideal. The best investment and research processes are collaborative across departments rather than siloed. There are periods when the extent to which being good at one discipline offers a greater or lesser chance of outperformance; when returns can be enhanced more by being better at stock-picking or sector or country allocation.

Quantifying allocation and selection benefit

To understand the extent to which stock-picking and sector allocation played, or could have played, a part in determining investment performance, we needed a way to quantify the potential impact of each, and so we repeated the methodology used in our U.K. paper.

• For sector allocation benefit and country allocation benefit: We calculated the average uplift an investor would get by being in the top-performing sector or country rather than any other for each sector or country average total return.
• For selection benefit, we took the average difference between the total return of the median asset and the 75th percentile asset for each country or sector.

Performing this calculation over time, and for longer rolling periods (e.g., five years), reveals when and to what extent sector allocation benefit or country allocation benefit or selection benefit has been the more dominant driver of portfolio performance.

There is overlap across the two allocation benefit dimensions—country allocation benefit plus sector allocation benefit will be greater than total allocation benefit.

Country allocation and stock selection appear to have driven returns…

Stock selection benefit, a narrow one-year winner over 24 years…

In Figure 1 we show sector allocation benefit, country allocation benefit and selection benefit. Figure 1a displays a one-year view and Figure 1b a rolling five-year view. On a one-year basis our analysis shows that:

• Over the full history, on a one-year basis, the average selection benefit has been 5.3%, a shade above the average country allocation benefit of 5.2%. Both are higher than sector allocation benefit, averaging 4.2%.
• Selection benefit and country allocation benefit have each been the most dominant factor in 10 years, selection benefit winning out in the remaining four years.
• Selection benefit has been a more constant provider of outperformance; its standard deviation has been 1.0 over the 24 years, less than half that of country allocation benefit (2.2) and less than a third of sector allocation benefit (3.2).

Figure 1a: Europe, Allocation and stock selection impact on one-year total return*

Figure 1b: Europe, Allocation and stock selection impact on five-year total return*

…but on a five-year basis, country allocation edges out

The rolling five-year outcomes provide a different story. Selection benefit is less prominent on a five-year basis than on a one-year basis, suggesting that country or sector outperformance is more likely to persist year-to-year than asset outperformance.

• Over the full history, on a five-year basis, the average country allocation benefit has been 3.7% per annum (p.a.), slightly above the average selection benefit of 3.3%p.a., which is a little higher than the average sector allocation benefit of 3.0%p.a.
• Country allocation benefit was the most dominant factor in 10 out of 20 five-year periods and sector allocation benefit was dominant in seven and selection benefit was dominant in three.
• The volatility pattern has remained the same as on the one-year basis. The standard deviation of selection benefit was lowest at just 0.2, followed by country allocation benefit at 1.3 and sector allocation benefit at 1.7.

…but recently it has all been about sector allocation

Sector allocation benefit dominated from 2017-2021…

For eight successive years from 2009-2016, sector allocation benefit offered the lowest outperformance of the three dimensions, only for a dramatic shift to occur from 2017-2021 when sector benefit offered the highest outperformance in four out of five years (in 2019, there was little difference between the three factors).

• On a one-year view, sector allocation benefit averaged 7.8% from 2017-2021, almost double that of country allocation benefit (4.4%) and selection benefit (4.5%).
• Sector allocation benefit was high at 16.0% in 2021; the next-highest level of outperformance was country allocation benefit at 9.9% in 2014.
• On the five-year rolling view, the large sector benefit in 2021 leads to sector allocation benefit being highest in all seven five-year periods ending 2018-2024. During this time, sector allocation benefit averaged 4.8%p.a., versus 3.2%p.a. for selection benefit and 2.8%p.a. for country allocation benefit.

…but times have changed

As discussed, sector allocation benefit was enormous in 2021, which continues to feed through to the latest rolling five-year periods. But one-year periods for 2022-2024 appear to show that sector allocation is once again being relegated to the status of a minor power.

• Sector allocation benefit ranked second, third and third, averaging 2.5%p.a. over the three years and just 1.9% in 2024
• Country allocation benefit ranked third, second and first, averaging 3.7%p.a. over the three years and reached 5.1% in 2024.
• Selection benefit ranked first, first and second, averaging 5.3%p.a. over the three years and 4.0% in 2024.

What if we “fix” country or sector?

“Fixing” the country allocation shows the familiar pattern…

In Figure 2 we show the difference between sector allocation benefit and selection benefit on a one-year basis for six countries and the European average (note that the latter is the average of all Europe, not the average of the six countries we have chosen—the average can and occasionally does move outside the range of those six).

• The pattern seen in our previous U.K.-based paper is in evidence again in this analysis—selection benefit was more dominant for most of the period, however, 2017-2023 saw significant sector allocation benefit.
• In total, there are 166 data points on the chart; selection benefit is greater than sector allocation benefit in 61% (102) of cases; if the 2017-2024 period is excluded, this rises to 79%.

Figure 2: Europe, Country fixed, Allocation and stock selection impact on one-year total return*

…but holding sector constant gives murkier results

For Figure 3 we fixed the sector, to show the difference between country allocation benefit and selection benefit, again on a one-year basis. The results on this basis are more erratic.

• Overall, country allocation benefit has tended to exceed selection benefit. In total, there are 144 data points on the chart; country allocation benefit is greater than selection benefit in 67% (96) of cases.
• Most sectors have seen a period of a few consecutive years where country allocation benefit has run significantly above selection benefit; retail from 2004-2008, hotel 2010-2014, residential 2016-2018, office 2013-2014 and 2020-2021. These coincide with periods when individual countries have significantly under- or outperformed.
• On the occasions where selection benefit is higher, however, there is not much of a sustained pattern.

Figure 3: Europe, Sector fixed, Allocation and stock selection impact on one-year total return*

Which, if any, dimension will dominate in coming years?

Which discipline(s) will dominate?

In our initial paper on the U.K., we noted the waning importance of the recently-dominant sector allocation benefit in favor of the selection benefit, and pointed out that the more usual state on the 44 year record was one where the two dimensions were broadly in balance. The introduction of the country allocation benefit as a third dimension adds a level of complication.

On a five-year rolling basis, selection benefit has remained constantly in the 3.1%-3.7%p.a. range. Our U.K. paper made the point that the increasing bifurcation of tenant demand between “the best and the rest” of assets that is increasingly common to all sectors could be a factor in increasing selection benefit, or at least making it the dominant determinant of relative performance. Selection scores do not materially break out of this tight historical range.

Country allocation benefit has exceeded sector allocation benefit in 16 of the 24 years analyzed, with five years (2017-2022) of sector allocation benefit being higher. Sector dominance occurred when industrial and residential sectors significantly outperformed retail and office, as the former benefitted from (while the latter were buffeted by) structural change reshaping supply and demand dynamics. The extent to which this will be the case in the coming years is less clear. Our most recent House View forecast saw only a small difference across sectors. Country-level factors are increasingly important in bond markets, with the sustainability of government debt under increasing scrutiny. It seems likely, therefore, that the resurgence of country allocation benefit over sector allocation benefit, as seen in the last couple of years, will continue.

In summary…

From sector to stock selection and country?

The last few years saw portfolio performance determined by sector allocation to an unprecedented degree—but this looks set to change. Successful real estate investment has almost always been a balance of sector and country allocation and stock selection. A growing importance of the latter two disciplines in driving returns is reemerging as this new cycle takes shape. Understanding the varying potential for income growth of existing assets and potential acquisitions, and managing exposure accordingly, will once again be a cornerstone of investors’ success, as will optimizing allocation to those countries likeliest to see the most resilient economic growth.

However, investors need to understand the impact on performance that a sudden period of sector allocation benefit driven returns could have. Although the historical record is largely one where selection benefit or country allocation benefit often swap prominence, sector allocation benefit can provide the opportunity for outsized, once-in-a-cycle outperformance. Investors need to be ready to change their strategy quickly if they perceive the shift to sector allocation benefit occurring.