Continual outperformance is rare, so today's market conditions may make the extra expense of an active strategy particularly hard to justify. Yet some investors are heading further up the risk curve, as Paul Mitchell reports

With property markets universally under pressure for the first time since the early 1990s, it is worthwhile considering if investment strategies and fund management will be affected in the same way as equity investment was in the early 2000s.

The sharp falls in stock markets in that period accelerated the shift on the part of institutional investors from active to passive equity mandates. Behind this was the recognition that few active managers could deliver alpha over sustained periods (especially after fund management fees), and that the fees investors pay could be reduced by moving to low-cost passive index-tracking strategies without undermining their long-term investment performance.

One scenario for property sees investors gravitating to those delivering the best performance. Alpha could feature heavily in this redrawing of the landscape. An alternative scenario involves investors taking the safe route, as they did for equities in the early 2000s, and moving towards low-cost passive styles offering a vanilla market return. So which way can property investment strategies be expected to go?

The first observation is that ‘poor' property fund managers do get punished. In the research that Shaun Bond and I undertook for the Investment Property Forum on alpha in UK property fund management - a summary of which was published in the March/April 2008 issue of IPE Real Estate - we found that the worst-performing funds were least likely to survive, as can be seen in table 1.

The trend in property over the past decade or so has been a big shift away from core strategies, where fund managers aspire to generate a market return plus 50-100bps (and, as this is a zero-sum game, in some cases actually deliver a moderately below market return), towards value-added and opportunistic styles. While virtually all property fund managers follow an active strategy in seeking to improve performance through asset management and taking sector bets relative to their benchmark, value-added and opportunity represent substantially more active strategies, seeking to generate extra returns through intense asset management, development, and also through exploiting distressed situations.

As in active equity fund management, the more intense management involved in these value-added and opportunistic strategies is reflected in higher fees. My research in the UK pointed to management fees for ‘balanced', core funds typically within the range 25-50bps of GAV, in some cases with an additional, modest performance related fee. INREV's research points to management fees for both core and value-added funds averaging about 60bps of GAV. However, the INREV work also shows that, on other bases - total expense ratios, the difference between gross and net IRRs, etc - the overall cost leakage in investing in a value-added strategy is greater than in a core strategy.

Therefore, compared with some of the cheaper balanced funds, the marginal cost (in GAV terms) of a value-added strategy is at least 75bps. To make it worthwhile for the investor, the extra alpha generated by a value-added strategy has to be at least as high as this.

For opportunity funds, fees are more geared towards performance but again, once everything is accounted for, they tend to be the highest cost of all the strategies, most so by comparison with balanced funds. So the alpha hurdle is even higher for them.Gearing is a further complication. Many core/balanced funds are negligibly geared, if they are at all. However, the target level of gearing in value-added and opportunity funds, according to INREV, is high at over 50%.

This compounds the management fee cost to the investor in relation to their equity investment, more than doubling it on the basis of the gearing levels reported by INREV. The corollary is that the return on the investor's equity from any alpha generated by the fund manager is also compounded. But this is all dependent on positive alpha being generated; if there is negative alpha, the geared investor will be hit on two fronts, not only by higher fees but also through accentuated under-performance.

The big question, therefore, is the extent to which the different strategies deliver alpha. A critically important observation is that, even before gearing, value-added and opportunistic strategies involve more risks than core strategies. They require a higher return to compensate for this risk, in the way that investors require a higher risk premium than for property in the equity market and an even higher premium for investing in private equity.

The convention is that it is the investor who should be rewarded for taking on this risk, with the fund manager accountable for the extra return (the alpha) over the market risk. Many investors have explained to me that to achieve a high beta return from property, they could simply borrow money themselves (or, in practice, reduce their bond exposure) and correspondingly increase their exposure to a low-cost balanced fund. There is no need to invest in riskier strategies unless some form of alpha is involved. The perception that they can acquire alpha is the fundamental reason why institutions invest in private equity, rather than just listed equity.

Table 2 presents estimates of the typical levels of beta for the different types of strategy in the UK; they relate to the underlying, ungeared strategies. The estimates are derived from a wide range of work I have undertaken: the IPF study on Alpha and Persistence in UK Property Fund Management, a report for PRUPIM on risk for different ‘styles' of property using historical performance data from a number of its funds, and from IPD data on development returns. They are only indicative, and there is likely to be a wide range of beta in specific value added and opportunistic strategies. The estimates will apply least to strategies in ‘alternative' property sectors where, because of weaker correlations, the beta will be lower.

Given these betas and assuming an overall property risk premium of 2% and a nominal risk-free rate of 5% (this is a UK, long-term equilibrium estimate - in continental Europe, this might be 50bps lower), the corresponding risk premia and required returns can be derived. The required returns with typical levels of gearing are also shown.

The broad magnitude of returns in table 2 represent those which a ‘skill less' (or if it were possible, a passive) fund manager should be delivering to compensate for market risk and which, arguably, should justify the most competitive fund management fee, for example 25-50bps. Extra management fees should reflect the delivery of alpha above this market return.

To what extent do fund managers deliver alpha? The research for the Investment Property Forum concluded that the generation of persistent alpha among UK fund managers was limited to a small elite. There were two fundamental reasons for this. First, fund managers were unable to add much over their competitors from strategy. This could be through inability or just by the limitations imposed by the recent convergence across sectors in medium-term returns in the UK.

The second reason why UK fund managers were unable to persistently outperform or generate alpha was that they could not sustain superior performance from their assets. Good assets were the major factor determining a fund's outperformance but this track record could not be repeated. More recent research analysing individual asset performance confirms this lack of persistent outperformance.

The IPF study covered all the UK funds measured by IPD, although the majority of these were balanced funds. Separate work has explored the extent to which the specialised funds, reported in the UK's IPD Pooled Property Fund Index, deliver alpha relative to the segment of the market they focus on. The analysis was undertaken on a quarterly basis from the beginning of 2001, and was net of fund management fees.

The results reveal a mixed bag, with some funds delivering excess risk-adjusted returns and others showing negative alpha. A minority consistently delivered alpha over two consecutive periods. Echoing the conclusions for UK funds as a whole, it appears that the persistent delivery of alpha in specialist strategies is difficult for all but a small elite.

The picture looks different in continental Europe. At the May 2008 IPD European Property Investment Conference, I repeated for France, Germany and the Netherlands some of the analysis on the persistence of fund performance which had been undertaken for the UK.

This revealed (see table 3) a stronger pattern of persistence than found in the UK; for example, 75% of French funds in the top quartile between 1998 and 2002 retained their ranking over the next five years. This suggests that continental funds, in contrast to their UK counterparts, systematically either outperformed or underperformed. This better record might be attributable to the greater potential from sector allocations and to greater variation in asset management skills on the continent than in the UK.

The results for these continental markets, however, will (in the same way as the UK analysis) have been dominated by diversified core funds, rather than the value-added and opportunity funds which investors are increasingly attracted to. Information on the performance of value added and opportunistic strategies is less readily available than for the core strategies typically reflected in the IPD indices. The INREV indices, for example, have a shorter history than IPD and have not (to date) reported on a down market.

However, a likely attribute of these types of strategy is that, in requiring the most specialist and unique skills, they are the ones least vulnerable to being replicated and therefore having their ‘super-normal' performance arbitraged away. On this basis, they should be more likely to deliver alpha and justify their higher fees.

The work undertaken using the PRUPIM individual property returns was primarily concerned with the existence of systematic relationships between asset risk, return and alpha. Over 400 assets were analysed from the early 1980s onwards. Assets were ranked according to their five-year return volatility and allocated to quartile portfolios whose performance characteristics were then analysed.

The most volatile quartile contained the type of asset likely to be found in value-added strategies. The record over the past 15 years (table 4) suggests that alpha can be derived from this type of asset and strategy. Interestingly, the alpha in the most risky portfolios was at its highest during the early 1990s downturn.

There are, however, two important qualifications. First, any alpha is fleeting - the alpha dissipates the longer the holding period. This is because assets where added value can be realised subsequently become more ordinary. Second, these portfolios contain large numbers of assets across which individual performance varies markedly. Choosing the right properties in smaller portfolios is critical. The same could be said about choosing a value-added fund manager.

A similar observation can be made about opportunistic strategies. In the UK, developments on the whole have delivered negative alpha and, consistent with this, the IPF alpha study found that on average a high-development exposure in a fund detracted from its performance and alpha. However, there is a wide range of performance across funds in the performance of their developments.

Similarly, data collated by NCREIF and the Townsend Group in the US show a wide spread in the five-year performance records of value-added, and even more so, of opportunity funds. Finally, research in the US by Hahn, Geltner and Gerardo-Lietz showed significant persistence among US opportunity funds in both good and poor performance, although this diminished when fees were taken into account.
Overall, the evidence that alpha in value-added and opportunistic strategies outweighs the extra fund management fees is by no means definitive and furthermore, investors in such funds are exposed to relatively high levels of active risk.

To what extent is there potential for funds to become more passive in their strategies? The research undertaken for the IPF showed that a large number of balanced funds in the UK achieved, over 10 years, returns within 50bps of IPD with tracking errors of less than 2%. With a more passive style - involving tighter sector bets, the selection of ordinary assets, and no aspiration to outperform - it will be possible to get performance even closer to the market index, and to run such a fund (in the way the large life funds already do) at relatively low cost. This would be a reasonable proxy for the opportunities for passive strategies facing equity investors at the beginning of the decade. Derivatives also might eventually present such an opportunity.

By contrast, recent research by INREV indicates that investors continue to favour higher risk value-added and opportunity funds over core funds, despite a weakening outlook for property. Therefore, the indications so far are that property investors are not going along the same road as their equity counterparts.

However, with high beta meaning that the most risky styles will be extremely sensitive to changes in overall property market performance, the next few years will be a critical environment for value and opportunity funds to display their alpha credentials.
Paul Mitchell is founder of the Paul Mitchell Real Estate Consultancy