Research from Maastricht University has criticised the fund-of-funds approach. Christine Senior seeks a response from the industry

Research from Maastricht University concludes that institutional investors should consider ditching some of their fund of funds investments and instead invest in real estate investment trusts (REITs).

The paper, ‘Value Added From Money Managers in Private Markets? An Examination of Pension Fund Investments in Real Estate’ suggested that investing through funds of funds results in substantial underperformance compared with other investment approaches. The paper partly attributes this to different layers of fees but, more surprisingly, to the fact that fund-of-funds managers are not particularly skilled at choosing investment managers. Pension funds could, it concludes, get better returns from REITs than from investing in funds of funds, while also benefiting from lower costs.

The authors of the Maastricht research, Nils Kok, Piet Eichholtz, and Aleksandar Andonov, examined data from 880 pension funds investing in real estate from 1990 to 2009.

The criticism that investors lose out from the double level of fees associated with funds of funds is not new. And fees make a bigger dent in returns when markets are performing badly than when performance is soaring.

As fees have begun to shrink over recent months, criticism of them might be less valid. However, there is still room for improvement, according to Allison Yager, global head of Mercer’s real estate boutique.

“Only over the last 18 months have fees come down,” she says. “But some are still too high. Some funds of funds, initially, were trying to charge the same asset management fees as the underlying investment managers were charging. We would never advise clients to invest in a fund of fund that has really high asset-management fees. The fees would have been higher, particularly over the period the research looked at.”

But investors appreciate that high fees are fair in certain circumstances – for strategies where special skills are demanded and results justify them, says Roddy Sloan, head of global multi-managers and securities at the real estate arm of UBS Global Asset Management. “Much depends on the type of strategy an investor wants to pursue,” he says. “If they are looking for a global customised solution, investors are grown-up enough to realise that for them to go and build a team with that expertise is tough and expensive to do. Investors are very willing to pay fees for more sophisticated solutions.”

The period over which the research was carried out is key to the findings. The research could be based on an outdated model of fund of funds, and they did not exist until well into the period of the analysis, from 1990 to 2009. From 2006 to early 2007, real estate performance was strong but collapsed in 2008, and during the final year of the data in 2009, conditions were challenging. The 2008 crash – and the consequent discontent of investors – forced a root-and-branch examination of the vehicles, driving fundamental changes in the format.

“Funds of funds haven’t been around for long,” says Yager. “They are longer-term investments – 10 to 12-year funds. They unfortunately invested in the market upswing and got caught in a number of closed-end funds that hit the bottom significantly when the market turned down. The performance from the first or second funds from a lot of these funds of funds isn’t good because of that.”

Presenting the case for funds of funds, John Gellatly, head of UK and Europe for the global real estate multi-manager group at Aviva Investors, says the research seems to cover a small sample and the data is more skewed towards the US. “When people take what is essentially a data-mining exercise of a US heavily skewed database and say that means funds of funds don’t work, I think it’s dangerous. What we’ve seen is some of the funds of funds, particularly in the US, can be quite highly leveraged, tend to be private bank-oriented and tend to have high fees. Maybe that small sample didn’t look good.”

It is obvious that the timing of fund launches was unfortunate. Many coincided with the top of the market in 2004-07, and many were highly leveraged, but they were unable to reposition themselves when the crisis hit. Listed real estate companies, on the other hand, were better placed to deal with the crisis aftermath through their access to capital markets.

Patrick Sumner, head of property equities at Henderson Global Investors, says: “The real advantage of listed companies in the last five years has been access to equity markets. They have been able to repair their balance sheets, whereas the unlisted funds have not. Unlisted companies haven’t been able to issue new equity to rescue themselves because the unitholders have preferred to hope for the best in long run. And, in any case, value destruction has not been evident because the assets are valued by valuers rather than priced by stock markets.”

The authors’ conclusion that fund-of-funds managers lack the skills to select managers seems to strike at the heart of the product. But Paul Jayasingha, senior investment consultant at Towers Watson, makes a point in favour of fund of funds managers: “The fund managers would say they are taking strategy decisions as well as picking outperforming managers. If you have a global mandate, the asset allocation decision is important as well. And another thing is that leverage can have a disproportionate effect on the outperformance or under-performance of a manager.”

Towers Watson no longer advocates funds of funds as a solution for certain domestic or regional property mandates. Global and Asian mandates are a different matter. Jayasingha says: “We would argue a UK fund of funds looks like a more leveraged, more expensive and less liquid version of what you can buy in a single well diversified core fund. The same would apply to Europe.

“But good fund-of-funds managers can justify themselves in a global context. Some clients want a simple structure, want to focus on key decisions such as investment strategy and limit the number of managers they employ. If they are keen on funds of funds, we would encourage those clients to look at a global property mandate rather than a single region mandate.”

Figures from Preqin show a marked drop in funds raised by fund-of-funds managers since the financial crisis: in 2006, 14 managers raised $3.6bn (€2.7bn), and in 2007, 19 managers raised $3.9bn. By contrast, last year 12 managers raised only $1.9bn. And this year, by the end of September four managers had raised $1.4bn.

UBS Global Asset Management seems to be bucking the trend. Around 60 investors have placed $1.5bn into its multi-manager business over the past 18 months. Last year it won an important mandate from German pension fund BVK to manage a global real estate mandate worth €500m, investing in core, value-add and opportunistic real estate funds globally.

There is some evidence that REITs are already being used by pension funds as an alternative to funds of funds to gain exposure to real estate markets beyond their domestic borders. The big downside of REITs is their volatility and correlation with equity markets. Consultants are advising clients to invest in REITs, but it seems a major stumbling block is this volatility.

Yager finds it surprising that REITs are not used more “We always advise clients to consider investing a portion of their real estate through the public market. REITs are a great investment, and an easy way to access particularly global markets. One of the issues for some of our clients who have not invested in REITs is the volatility. Over time you see much more volatility in the public market than the private market. The researchers are right: the public side has had really strong performance and you get that liquidity you can’t get on the private side.”

While US pension funds have been open to investing in REITs, it is not the case everywhere. UK pension funds have been slow to take up the option of listed property. But in some countries pension funds have been particularly active in REITs, using them as an alternative to direct investment, or to complement it. Dutch and Australian pension funds have been enthusiastic investors in listed real estate. Their domestic real estate markets were too small to absorb their real estate allocations and they turned their attention to foreign markets, using REITs as a means of access.

“The Dutch shared quite of bit of their experience with the Australians, discovered after a couple of salutary lessons that investing in REITs was better than trying to do it yourself,” says Sumner. “There are decades of experience among the Dutch. They also realised that in the long run you get real estate returns but you also get the best management.”

Recent developments in fund of funds may have made some of Maastricht’s conclusions obsolete. Funds-of-funds managers are no longer offering a product limited to selecting underlying funds. They can consider a whole range of other types of vehicles or structures – from co-investments to joint ventures, club deals and derivatives.

This is driven by a greater appetite among investors to be closer to their real estate investments and be privy to more information. Funds of funds need to get more involved in the investment strategies of the funds they invest in, and to get closer to the end assets to justify fee levels, says Jayasingha.

“We expect to see funds of funds being quite active on the secondary market. We want to see them obviously being highly conscious of the macro environment and looking at ways they can get better terms for clients by negotiating fees with their underlying funds and by structuring joint venture-type relationships,” he says. “We’ve seen a trend of best-in-class fund-of-funds managers moving closer to the assets by using joint ventures or pre-specified funds so that they can get much greater clarity and a reduction in fees.”

The fund-of-funds model no longer consists just of assembling a portfolio of 10 underlying funds, says Sloan. “It’s very common these days to be looking at joint venture opportunities, club deals, co-investments. In our case, more and more, we have a pool of capital that wants to access a particular strategy. For example, we might want to partner with the best-in-class manager of a Tokyo office in a club deal arrangement to execute on that strategy. We work with the manager who often will be investing their own capital alongside us to customise a solution which meets the needs of our investors. But it goes beyond even joint ventures and club deals; we use derivatives to express our views, and we use secondary markets around the world.”

But Pete Gladwell, product development manager at Legal & General Investment Management says that not all fund-of-funds managers are equal. Not all are able to take advantage of new opportunities as they arise.

“Many funds of funds don’t have sufficient resources, so when a major manager like L&G approaches them with an idea, they haven’t got the resources to evaluate it in order to take advantage of it. It’s extremely difficult for them, because to try to make up for the mistakes of the past the level of due diligence required is now so high that many can’t reach the economies of scale necessary to quickly evaluate and present new ideas to their clients.”

According to Jeremy Plummer, head of the multi-manager arm of CBRE Global Investors, fund-of-funds managers fall into two camps: those with the resources to drive the kind of deals that sovereign wealth funds and other large capital sources can achieve – and the rest.

“The smaller ones don’t have an aggregate ticket size that is big enough to adopt that model,” he says. “Because the model has migrated so much closer to direct real estate, the fund-of-funds manager needs to be doing so much more than subscribing to a blind pooled fund. You have to underwrite what is, to all intents and purposes, a direct property transaction. You have to analyse the real estate, the manager and the structure as opposed to just the manager and structure. That requires a lot more work and much more skill, which I don’t think the first generation of fund-of-funds managers has.”