The case for international diversification is a powerful one. But what is the most efficient route? Stephen Ryan argues that investors should consider all the tools at their disposal
In the typical multi-asset pension portfolio property is expected to fulfil many roles, such as: a diversifier; a source of regular income; an inflation hedge; a provider of high total returns. A portfolio comprising domestic and foreign assets is generally better equipped to undertake such multi-tasking than a purely domestic portfolio as it can deliver most of the required benefits with less risk. International portfolios are better because the different property markets are not co-ordinated and the opportunity set is always greater.
International diversification will be achieved differently by different pension plans, although it is likely that unlisted funds will be important components for most. Nevertheless, gaining maximum efficiency and coverage may require consideration of REITs, property derivatives or both.
Following are some examples:
A continental European defined benefit scheme with €1.2bn in assets has a target property weighting of 7% and is aiming for a 50/50 split between domestic property and international property. Its current allocation is 3%, all of which is invested in directly-held domestic properties.
The trustees believe that their property exposure should be split in roughly even proportions between Asia, the UK, Europe and the US. Their preferred route is via unlisted funds but they need time to work out the manager selection, tax and currency hedging issues. It will also take time to liquidate their current domestic holdings.
As a first step towards achieving their target 7% weight the trustees decide to invest 1% of total assets (€12m, roughly £10m sterling), in a UK property derivative. This gives them three-year exposure to the total returns of the IPD Annual Index. The derivative is an over the counter (OTC) total return swap and cash flows are annual (at the end of March).
In this first example, a property derivative is used to gain fast access to one of the target markets. Speed is one of the advantages that property derivatives can bring, which are set out below. Another is cost saving - no stamp duty or other taxes are payable on property derivatives, in contrast to physical property transactions. Including stamp duty, round-trip transaction costs for physical property in the UK might be in the order of 5-7%, most of it incurred on investment. The market for property derivatives is well established in the UK. Derivatives have also been trading on property indices for France, Germany, Australia, Japan and the US (although trading there is more developed for residential property).
Here is a brief summary of UK property derivatives: The most commonly used property derivative contract is the property total return swap (‘TRS'). Effectively, by using such a contract the investor would receive annual payments related to the total return on the IPD Annual Property Index in exchange for a series of fixed payments (this contrasts with many other forms of TRS where the convention is to swap the total return on an index for a LIBOR-related and therefore variable payment).
No capital changes hands at the inception of the contract (with the exception of transaction costs), although collateral would be posted on a regular basis. The payments are calculated with reference to a ‘notional' amount.
It should be noted that the value of the TRS will not respond only to changes in the perceived value of properties, but also to the following: supply/demand within the property TRS market, particularly large trades which could have an impact on prices; changes in interest rates, which will affect the value of the fixed payments.
Counterparty risk: A loss would be experienced if the counterparty to a TRS contract were to default at a time when the TRS has a positive mark to market value to the investor. To reduce counterparty credit risk, a process of collateralisation would be put in place. Counterparty credit risk does not affect physical property holdings and is therefore a drawback of using property derivatives.
Additional risks: liquidity may decrease, making the continuation of such a strategy impossible. And in order to maintain exposure, TRS contracts would need to be rolled at maturity. This creates some risk in that the pricing of the new contracts may be less attractive than the old pricing. This rolling would need to be managed carefully to avoid moving the market.
Structured notes are another relatively common method of accessing property through derivatives. The idea is that the investor would pay a fixed rate to the bank in exchange for the total return on the IPD Index +/- a margin.
A defined contribution scheme with €100m in assets offers its members eight funds choices - a cash fund, a bond fund, two balanced funds and four equity funds (one domestic equity fund and three regional equity funds). All the funds are actively managed. The members can switch their investment choices at any time online.
The default investment strategy is a lifestyle arrangement that invests 100% in global equities until the member reaches 55 years of age, at which point it starts to de-risk by moving 10% of the member's account per year into cash and bonds. By normal retirement age (65 years) the member's account is 100% invested in cash and bonds.
The trustees wish to broaden the range of asset classes offered to members. At the same time they are concerned that the members are over-exposed to active management. They have asked their consultant to advise them on whether (a) property could be added and (b) if so, whether this would necessitate taking further active risk.
The consultant advises that an unlisted property fund may have liquidity problems at times and therefore might not suit a DC scheme where members can switch freely. In addition, unlisted property funds are actively managed. A passively managed global REITs fund is recommended. It should be added as a ninth investment choice. The trustees should also consider adding a modest weighting in global REITs to the growth phase (ie, up to the age of 55) of the plan's default investment strategy, which is currently 100% in equity.
Global real estate securities
REITs were first established in the US in the 1960s as a way for individuals to invest in large-scale income-producing real estate. To be qualified as a REIT, a company must pay most of its taxable income to shareholders in the form of dividends. Until the early 1990s, only a handful of countries (US, Canada, Netherlands, Belgium and Australia) had adopted the REIT structure, but as investors came to recognise the benefits of publicly traded real estate securities, the REIT structure began to spread across the globe.
Until the turn of the century, REIT legislation existed only in equity markets within developed economies and mature legal systems. More recently, emerging and developing economies have begun to establish REIT or REIT-like legislation, providing investors with the opportunity to invest in real estate in countries that were previously inaccessible because of high transaction costs, liquidity constraints and a lack of transparency.
Because real estate is a highly localised business, significant opportunities exist in the market for managers to add value. The global REIT market is largely fragmented and inefficient, so there is potential for skillful active managers to exploit inefficiencies to generate alpha.
The correlation of global real estate securities to other asset classes is higher than that of unlisted funds. However, it is still low enough to warrant inclusion and provide overall diversification benefits.
Global real estate securities provide access to global property markets for investors of all sizes at lower transaction costs than those for direct real estate. Unlike investments in direct property, publicly traded real estate securities offer daily pricing, which provides liquidity not readily achievable from other forms of real estate ownership.
Investors should also be aware that global real estate securities have greater volatility than that of direct real estate investments. A global REIT programme can be implemented via segregated accounts, commingled institutional funds, mutual funds or ETFs. The availability and attractiveness of each vehicle depend on the size and scope of each individual mandate.
3. Unlisted funds
A UK-based defined benefit scheme with £1.5bn in assets has an even split of active members and retired members. Its property weighting of 8% is currently invested in UK only diversified funds. The trustees wish to adopt a global property strategy that is split 50% UK property and 50% international (world ex UK) property. The trustees need property to generate regular income as well as contributing to growth in excess of salary inflation. Their preferred style is core plus.
Following a strategic review, the trustees decided to adopt a strategy that is split 50% in UK high lease value funds and 50% in value added funds outside the UK. The UK component is benchmarked against long gilt yields plus a margin and it requires no currency hedging. The international component is aiming to generate low double digit absolute returns by investing in a portfolio of geared, value added strategies.
By combining an income-oriented lower risk UK strategy with a value added international strategy the trustees aim to achieve an overall core plus style - which suits their overall preference - while simultaneously having regular sterling cash flows and a broadly even split between domestic and international markets.
There are three principal styles in property - core, value added and opportunistic. Core describes diversified, income-driven investment in mainstream sectors and lower gearing levels. The buildings are well-maintained and generally fully let, or close to fully let.
The other two styles seek higher returns than core. Value added portfolios are characterised by returns that combine income and capital, by investment in alternative sectors and by higher borrowing. Returns reflect the value that is added to the property by means of active management (leasing, refurbishment and redevelopment). Value added funds may seek absolute returns (for example, 10% per annum or cash plus 5%).
Opportunistic is the style that comes highest in the risk/return hierarchy and it tends to focus on capital gains rather than income. Active management through development is also a feature. Substantial borrowings may be used. In some cases listed property companies may be taken private, or private companies listed. Like value added funds, opportunistic funds may seek absolute returns (for example, 15% per annum)
‘Core plus' sits between core and value added.
International diversification is well worth striving for and maintaining. The mainstay of internationally diversified property portfolios is likely to be unlisted funds. Nevertheless, whether used tactically, for liquidity purposes, for cost reasons, tax reasons or otherwise, there is likely to be a role for derivatives and REITs in many pension portfolios.
Stephen Ryan is a senior investment consultant with Mercer's investment practice in Dublin