Economic crisis has not changed pension scheme approaches to risk, but it has increased property portfolio managers' scrutiny of funds' risk controls, Shayla Walmsley finds

It's easy to see why market volatility might divert risk-averse pension funds from investment in real estate. If you invested in property as a diversification tactic to mitigate volatility associated with equities, current volatility in property markets will come with a less-than-welcome sense of déjà vu.

Return-seekers in some markets, especially those that invested when it seemed the trajectory was unidirectional, are now disappointed. For those sold on the idea that property is a long-term investment, with liquidity sacrificed for stability, the speed of the market's demise has been precipitous.

So how to explain the absence of evidence to date that pension funds are rethinking their approaches to risk? Most pension schemes have their risk management processes already firmly in place and in theory, at least, they should be in a position to resist the temptation of an impromptu switch between asset classes.

It is difficult to tell which pension funds or kinds of pension fund are more likely to respond to the perception of increased risk in real estate. Michael Preisel, head of quantitative research at ATP, the Danish DKK350bn (€46.9bn) labour market supplementary fund, distinguishes between the management of short-term portfolio risk and overall, long-term scheme risk. Broadly speaking, operational and financial risk are the scheme's concerns, while market risk is the portfolio manager's concern.

"If you look at the overall approach, it's based on long-term estimates of risk, rather than being responsive to spikes in volatility," says Preisel. "Individual portfolio managers must respond to current market risk. They're quite different risks and must be measured differently. Portfolio managers are concerned with the short-term risk of losses. If they don't like the position, they can take appropriate action. The fund's overall concern with risk is to keep it in healthy shape for years to come."

If the internal risk models advised by consultants and embraced by pension schemes determine overall approach to risk, the real change shows most clearly in a new level of due diligence. According to John Forbes, UK real estate industry leader at PricewaterhouseCoopers (PwC), portfolio managers are asking more questions, more sceptically, about more risks.

"They're asking about more things, including transparency, valuation and gearing. They want to know about the real levels of gearing - about operational gearing, as well as a headline gearing. If gearing affects 70% of the assets' loan to value, it could mean some have no gearing and others are geared to the eyeballs. Investors began to realise that there's more to it than headline risk."

Although he doesn't designate it a problem, the problem here is that these concerns are unlikely to become formalised in new risk systems or approaches. In fact, says Forbes, once you incorporate this kind of scrutiny within a risk management system, it loses its effectiveness. "Once you formalise the checklist, there is a risk you're not really probing any more," he says.

Fund managers will have to work harder to persuade investors to put up the cash - and it will certainly take longer - but it also means investors need more expertise, quantitative expertise included. The question for a pension fund is whether it should source this analytical ‘quant' expertise in-house or contract an external provider. The sharpened focus on risk will increase pressure on fund managers not only to prove their operational credibility, or their historical performance; now they also need to demonstrate their risk controls.

Although Prupim's Neil Southerly says the information should carry a health warning because research for it was carried out before the credit crunch, nevertheless he sees as significant the recent finding that both pension funds and their consultants identified operational risk as an issue.

When it came to selecting a fund manager, diversification and low correlation with other asset classes still topped the list of pension fund criteria.  But when it came to firing a fund manager, risk assumed an additional significance. The upshot of the study - which admittedly only analysed UK pension funds - is that 50% planned to maintain their exposure to real estate, and a further 25% planned to increase theirs. Significantly, 73% of pension funds said that recent market volatility had not altered their perception of the benefits of investing in real estate.

"Pension funds have to invest somewhere. Once they decide on the allocation, the question is who they invest with," says Forbes. "The emphasis is on quality. For some, the infrastructure is in place to do it well, with others to do it less well. But there's more emphasis on risk and less on historical returns, though historical performance is still important."

If the attachment to historical performance prevails, it is out of habit rather than usefulness. Jenny Buck, head of indirect investment at Schroders Property, points to the limitations in risk approaches based on historical data during a crisis that marks a market history hiatus. "Now what's gone before isn't going to help them," she says. She points out that managers across all asset classes are asking whether current market volatility will alter investors' appetite for risk.

No less than pension funds, fund managers rely on what they see as their own robust risk management systems. Quantum, the risk management system developed at Schroders Property for its fund of funds, measures asset risk, such as exposure to development risk; wrapper risk, including the clearing structure and vulnerability to cash flow calls; and fund management risk, including the strength of the team and fund management house. "Although we're in the eye of the storm now, the risk tool is robust in any event," says Buck. 

It isn't hard to see why they're probing. Pension fund real estate exposures are most likely to come from investment in funds operated by banks in trouble. Arcadis invested in funds managed by ING Real Estate, recently bailed out by the Dutch government. "Real estate is vulnerable," says Rob Schippers, risk manager at the Dutch Arcadis pension fund.  "It wasn't news but we were surprised how fast it could go, especially the prospects for new funds. The prospects for these are not good."

If portfolio managers are demanding more of fund managers by way of risk reassurance, there's little chance of pension funds significantly altering their allocations to real estate. It's a question of how, rather than whether, they continue to invest. "The question is whether investors will opt for pure vanilla products, retrenching within their domestic market, or for more exotic products, for example with higher gearing," says Buck. 

She predicts a split. "Some will say: ‘We got our fingers burnt' and stick with what they know," she says. "Others will see diversification as the right move. The split may be correlated with size but not necessarily. Pension funds have their own trustees and their own concerns."

The problem, she says, is not with fund managers somehow missing potential risks. The likely risks have largely been factored into pricing. Rather, there is the difficulty  "when it happens".  She adds: "When the numbers come through, the market could overreact, though it will be a short-term overreaction and it will correct."

Pension schemes overall don't make scheme-critical investment decisions based on external market shocks. "The model is independent of what's going on in the market, but accounting standards are a strong driver," says Preisel. "We measure risk against the institutional setting, such as funding requirements set by the regulator." He points out that ATP's approach to risk management has been influenced by the traffic-light system imposed by the Danish regulator. Under this system, pension funds are ‘zoned' green, amber or red based on their ability to meet required return targets.

Where short-term - tactical - market-responsive risk decisions get made is in portfolio management, but it would be a mistake to see these as made in a vacuum, or in a direct response to market conditions, unmediated by the scheme's broader approach. It is the pension fund that sets the risk rules for specific portfolios.

Research published in September by Towers Perrin suggested pension funds boost their risk management systems with longevity swaps, interest-rate matching and deferred transfer. Overall, the point is to quantify risk, decide which risk is a priority for removal, and develop a strategy to remove it. It suggests that now is the time to review existing strategies - effectively to see whether they've worked.

Although pension funds with significant investments in opaque assets might be most concerned, there is a possibility that pension funds will steer away from what they consider to be riskier property options because they're unfamiliar. Mercer's study claimed that derivatives, which up to now have  been perceived by pension funds as useful hedging strategies because they protect their funds against adverse market movements, now appear vulnerable to underlying contracts with potentially insufficient collateral. 

It is perhaps an accident of timing - or the result of investment managers' caution - that real estate derivatives have yet to take off among pension fund investment managers. Frédéric Ducoulombier, director of asset management education at EDHEC, the French business school, has argued in IPE Real Estate that using property derivatives to hedge exposure to real estate market risk or beta so that it produced alpha would make sense only for the largest property investors.  Now, he says, even ineffective hedges would have provided some protection against market falls. "The fall in the market will certainly make the idea of hedging more attractive to those who got burnt," he says.

"If the property derivatives market had had the time to develop into a deep and liquid market, sophisticated investors faced with an illiquid underlying market would be in a position to turn en masse to synthetic liquidity today," he says. Yet he acknowledges that they would still need to manage counterparty risk "There is no clearinghouse in the market and your counterparty is an investment bank which some will see as unsafe as houses - pun intended - these days," he says.

Not that pension funds up until the credit crunch considered themselves immune to counterparty risk, but most likely only because they rarely considered it. The demise of Lehman Brothers provoked increased scrutiny not only of losses sustained by investments in funds but also of losses resulting from counterparty risk - a position that Arcadis found itself in when it discovered that Lehman Brothers was counterparty to some of the assets in its portfolio."It went well - we could renew the contract with another counterparty - but collateral is an issue," says Schippers. "We learned that we have need of buffers." 

What portfolio managers have learned about risk from the current crisis will stay learned. In other words, the change of heart among pension fund property managers when it comes to risk will continue once the immediate market crisis is over.

"Most investors have only known good times - this the first downturn since the explosion of the property funds industry," says Forbes. "It will take a very long time to forget. This is not a short-term blip. If those behaviours come back, it will be a very long time before they do."

In the meantime, says Stephen Ryan, an investment consultant at Mercer, pension fund managers will most likely hold firm. "It is reassuring that people haven't reacted intuitively to what's going on. It can be a nerve-racking affair but people are holding on. Funds will revisit the assumptions on asset allocations every three years. There's so much going on that there's no point trying to catch a falling knife."

Schippers agrees the danger is that pension funds will be panicked into abandoning their strategic approach to risk for a new one driven not by long-term strategic imperatives but by short-term market movements. Not so Arcadis. "The impact? We're here for the long term. The first lesson is: don't change policy quickly - stick to it. The second is: watch industry funds and watch how they are affected, because this says something about the management of the fund. Trust in the asset class when the economic deterioration happens. Bad things happen. Whether the shock comes from the market or a manager, you need to have the usual risk control."