Is real estate losing its status as the default alternative within multi-asset portfolios? Shayla Walmsley talks to two pension funds with very different multi-asset approaches, and a consultant who believes that, at least for pension funds, property has probably had its day

Dirk Lepelmeier

*The lesson is to buy bricks - not equities
*The scheme breaks down its forward-planning into strategic and tactical dimensions
*‘In future we'll have to invest where the growth is'

Under its own rules, the Nordrheinische Ärzteversorgung (NAEV), the pension fund for North Rhine Westphalia's doctors, could easily expand the 10% upper limit on its real estate allocation. But it hasn't even been tempted.

To date, the property allocation has largely hovered between 8-10%. Even at the top of the market it peaked at 14%.

"To be honest, the bracket would easily allow us to go above 10.5%. But we defined the brackets for real estate and we've never broken them once," says NAEV CIO Dirk Lepelmeier.

The €10bn pension scheme distinguishes between strategic and tactical planning - especially when it comes to asset allocation. Planning for one year and over it defines as strategic; less than one year it defines as tactical.

NAEV arrives at its asset allocation decisions via a three-stage process. Every year for the past decade the scheme has conducted an asset liability matching (ALM) study with advisers FERI. Each of these studies redefines the scheme's expectations for the subsequent decade.

"It's different every year," says Lepelmeier, pointing to the divergence in expectations between the 2007 study from those conducted in subsequent years. In 2007, it still had an equities allocation in brackets of 14-16%, for example. In 2009, it came down to single digits. The scheme currently has 70% in bonds, with the remainder in alternatives.

In addition to its ALM studies, the scheme conducts triennial portfolio reviews based on its own calculations. Finally, there are one-year projections for different asset classes, such as its current allocation to alternatives of 2-6%.

"That means everything is run within maximum and minimum brackets within that year," says Lepelmeier. "If equities account for more than the agreed 6%, we have to go to a managing ‘super-board' to explain why. If we keep our allocations to specific asset classes within the given brackets, we don't need to explain it to the board."

In strategic terms, there has been a shift in the real estate portfolio away from listed and indirect vehicles. "In the short term, the lesson we've learned from real estate is to buy bricks - not listed property, not property equities," he says. "We buy real estate to get rental fees and we live on that."

Before 2008, NAEV also invested indirectly. But, stung by the correlation-in-crisis, it has shifted away towards buying bricks for rental income and lower volatility. "There were severe breakdowns in value during the crisis. We are more conservative about vehicles now," says Lepelmeier.

Another shift has been that away from domestic real estate - although he points out that ‘domestic' means something very different for real estate than it does for equities. For equities, the home market is Europe; for real estate, the home market is Germany.
"Real estate remain a more local investment than equities alternatives or hedge funds, which are already globally organised," he says.

In the past five to 10 years, like other German institutional investors, NAEV expanded outside the German property market, first to Europe (excluding Germany), then to the Americas and Asia. In the long term, Lepelmeier says the scheme will invest farther afield.

"As with other asset classes, we'll have to invest where the growth is, and focus on countries with a high potential growth path - Brazil, India, China and Indonesia," he says. "To capture the growth, you need to be where the growth is. That means not in Germany, not in Europe."

He adds: "That's the main shift we're confronted with. It's a general shift - what's true for real estate is true for equities and for other asset classes - but it's more difficult and complicated for real estate because if you want to invest in Brazil, you have to invest with a partner and there aren't that many potential partners."

Luc Crabbé
Benefits manager at Umicore pension scheme

*Real estate offers diversification with low risk and returns
*Members need to be kept in the loop
*Empowering external managers is key to the scheme's multi-asset portfolio

Low-risk diversification was the rationale for Pensioenfonds Umicore to allocate to real estate. Until 2010, the €70m domestic defined benefit pension scheme of this multinational metals firm had invested exclusively in equities and bonds via a €68m multi-asset mandate managed by Bank Degroof. The remaining €2m it holds in cash.

"We were looking for diversification without increasing risk or lowering returns significantly," says Luc Crabbé, benefits manager at the scheme. "On the other hand, we don't need extremely high returns, either. We're happy with 5-6%."

The scheme's (and Belgium's) rules mandate triennial continuity tests, which determine each allocation but which also agree governance issues, such as salary increases for scheme staff.

It was as part of one of these reviews, in consultation with external advisers, that the scheme made the decision to diversify into real estate. "We made a calculation from the expected returns for each asset class. For real estate, we figured it would be around 5%," says Crabbé.

If how the scheme invested in real estate was a relatively straightforward decision, where it invested was less so. This was because it had to factor in not only volatility and stable returns, but also the perceptions of its 140-odd members.

Instructing the manager on the contours of the allocation was the easy part. "Once we'd decided to decrease the equities allocation in the portfolio, it was quite straightforward. We just give instructions the manager to reduce the equity allocation and invest in real estate," says Crabbé.

Although he insists the scheme's investment committee "just drew big lines, then let the manager get on with the job", those lines allowed the manager to invest in European real estate - not in US or global real estate. So why not invest in the US? "We aren't afraid of the US market but we didn't want the risk. We prefer a fixed return to a high-risk return," says Crabbé.

"We aren't investing money belonging to a company but money belonging to pensioners. At that time, the US market wasn't looking particularly good and to invest in it simply wouldn't be a good message to send out to pensioners. It wouldn't be smart to do it. We'd get too many questions from our people."

Simply switching part of the equity allocation to real estate took almost four months. "It's not something you can get done in a week," says Crabbé. It took a further six months to build the allocation up to the desired size.

Even by the standards of smaller pension schemes, the Umicore pension fund's portfolio is a cautious one. Bonds account for 70% in the current allocation, with 25% in equities, and 5% in real estate. At the same time the scheme decided to invest in real estate, it decreased its government bonds in favour of corporate bonds, with a guideline ratio of 50% in government bonds (down from 66%) and 20% in corporate bonds (up from 4%).
Despite potential flexibility in the allocation, which can range from 0-10%, Crabbé says the scheme will stay with the property allocation as it is for at least 18 months. "When we see opportunities, we could go for less or more, just by telling the manager."

Umicore wholly or partly funds pension schemes in Belgium, France, Liechtenstein, Netherlands, Norway and the US, and operates defined contribution schemes elsewhere.

Bill Holmes
Head of investment consulting at Xafinity

*Pooled products will become the multi-asset default for smaller schemes
*Pension schemes are looking outside property to more esoteric - and liquid - asset classes for diversification
*De-risking will permanently reduce the size of property allocations

Whereas large pension schemes are likely to have a real estate portfolio manager, their smaller counterparts (up to £300m) are likely to opt for pooled products - though not necessarily balanced funds, according to Bill Holmes, head of investment consulting at Xafinity.

"In the return-seeking space, we find our clients understand and feel comfortable with diversified funds," he says. Although diversified funds aren't balanced funds, like them they have real estate as a diversifier and "offer what trustees think should be happening to their portfolios".

Yet how long real estate will remain the primary diversifier in these funds is moot. According to Holmes, funds are replacing property with relatively easily understood diversifying alternatives such as commodities, infrastructure and emerging market debt.

One reason for this has been the stronger than expected correlation of real estate with equities during the financial crisis. "There's not much exposure to property in new funds because of a combination of what happened to property and the waiting lists you saw for investors trying to get out of funds," he says.

Pension scheme trustees expect investment managers to make tactical asset allocations. Yet in the absence of sufficiently development liquid property vehicles, such as derivatives, or proxies for warehouses, tactical management of property is a tall order.
In the meantime, there is no shortage of options for diversification. "Historically, that's where property had a role to play but investors are comfortable with the new asset classes in the sense that they can understand the reasons for diversification," says Holmes. "Investors can see the merits of gold, for example, where funds have been able to get exposure. More esoteric options such as catastrophe risk also provide diversification away from equities."

New funds are offering diversification via asset classes that are more liquid than property - even if they aren't necessarily as liquid as the market. These include commodities futures, which allow investors to get in and out of the market relatively quickly.
Even so, there won't be a wholesale exit from property as an asset class. Holmes acknowledges that there are still reasons to invest in real estate, including capital appreciation and inflation-linked rental income. It's just that allocations will remain small.

"The conventional reasons to invest in property remain and investors are likely to continue to invest in property, but pension funds won't increase their allocations. Pension funds will hold what they've got, rather than upping their allocation. But 3%, 4%, 0% is not a great exposure to property," he says.

"There is a natural place for property in every portfolio but some of its characteristics mean it won't ever be more than a modest weighting. I don't think we'll ever see property get to a sizeable proportion of the portfolio again."

The emphasis on de-risking over the next few years - with pension funds pulling out of return-seeking - will confirm this trend.

"There will always be some pension scheme trustees prepared to take extra risk but a good proportion of pension funds are closed to new entrants, and many are close to future accrueal. The strong message from sponsors is that they are looking to exit final salary schemes," says Holmes.

"The result will be an increase in their exposure to bonds. Return-seeking assets will be a smaller allocation - and that applies, in principle, to a large pension funds as well. If your sponsor is looking to get out of the scheme, it doesn't matter how big you are: the principle is the same."