Diversification, return enhancement and liability matching are three good reasons why investors should consider property as a key component of their portfolio construction, as Richard Cooper reports

Property has principally been seen to provide diversification from equity risk within pension scheme portfolios. Over the long term, UK property has also been a more effective diversifier from UK government bonds. Nevertheless, diversification is sensitive to the time periods across which the assets have been combined.

Illustrating this point, figure 1 shows the correlation over the preceding 10-year periods for the main UK asset classes. Over the period of analysis, the correlation between property and UK government bonds has been flat. Conversely, the correlation between property and equities has increased. This is not altogether surprising given that returns to commercial property are linked to the fortunes of corporate occupiers.

Real estate securities, such as real estate investment trusts, tend to fluctuate with the property markets in which they are invested, albeit leading cycles observed in the direct market indices such as those published by IPD. However, they correlate highly with movements in the equity markets in general. Offering a hybrid style of return, for diversification of equity exposures, real estate securities are consequently not as effective a diversifier as direct real estate.

While property's diversification characteristics are an undoubted attraction, its return potential is critical for pension schemes. As a tangible asset, property provides investors with the opportunity for active management of their investments to improve returns - this scope to produce ‘investment alpha' by improving the performance of the asset held is not available in other asset classes.

For example, returns can be enhanced by:

Taking on letting risk through acquiring properties that are vacant or occupied on short leases; Investing in less transparent markets and/or emerging markets where mispricing can offer more profitable opportunities; Developing, redeveloping or refurbishing buildings.Additionally, where returns are expected to exceed the cost of debt, using third-party financing will improve returns, but simultaneously increase volatility.Moreover, investors can select different styles of property investment that change the return potential together with the risk profile, as seen below.

An agreed over-arching investment strategy should guide the extent to which pension schemes diversify their portfolio and make asset allocation decisions.
One approach that has increased in popularity in recent years is liability-driven investment: matching liabilities to asset allocation decisions. For example, where a scheme has pensioner members, property's relatively high income return secured under leases can be attractive in meeting ongoing, longer-term liabilities.

Portfolios can be created that combine characteristics such as:

Income yield - Investment properties are often classified as prime, secondary or tertiary according to a combination of factors, such as property specification, location, lease terms and tenant credit risk. Consequently, the yield level will be determined by a combination of these factors, compensating investors for the level of risk they are accepting as well as the property's rental and capital value growth potential; Income length - Subject to a tenant's credit risk, longer leases offer more certain income streams and are usually more valuable to pension fund investors;
n Income growth - Many markets have leases with rents indexed to an inflation measure with periodic review to the market rent upon lease renewal or re-letting. In the UK it is standard market practice for leases to include periodic review provisions to market rent, but indexed leases are becoming increasingly common; Credit risk - Default risk of tenants encompasses the whole risk spectrum from virtually negligible for government occupiers to high-risk residential tenants.
The overall split between ‘matching' and ‘return seeking' assets is driven by a number of factors with a notable shift in recent years to a higher weighting in matching assets across many pension schemes.
Factors include sponsor desire for lower risk pension schemes, an increasing ability to diversify risk in the return seeking assets, trustees' increased comfort with the use of swaps to hedge certain risks, as well as scheme closures leading to changes in the maturity profiles of schemes.

Set out below are contrasting asset allocation profiles for two pension schemes:

Scheme A - Split of 50% bonds, 45% equities and 5% property.Such an asset allocation would be typical of schemes looking to outperform their liabilities with a large exposure to market risk in the form of equities. This would be more of a traditional approach, with property's main role being to diversify and smooth returns. Scheme B - Split of 30% cash, 20% equities, 30% absolute return funds (eg, hedge funds and currency funds), 15% property and 5% infrastructure.

There would also be a swaps overlay to hedge against changes in interest rates and inflation expectations. In this instance, the allocation to property has been increased significantly and reflects a desire to spread market risk across a wider basket of assets. Property here is incorporated for its diversification benefits as well as its potential to add to returns positively over the longer term.

No other asset class probably attracts the amount of attention that property does. However, a real understanding of its characteristics reveals its wider potential for inclusion within the asset structure of a pension scheme. Bricks and mortar are classically viewed as something for the long term. Matching the benefits they can bring with a clear investment strategy can draw the similarly long-term gains that almost any pension fund seeks.

Richard Cooper is a member of the global investment practice at Hewitt Associates