Volatility presents tactical opportunities to gain from trading into and out of different forms of real estate investment depending on their position in the cycle; often benefits can outweigh liquidity considerations. Greg Wright reports
Real estate has a number of characteristics that make it a suitable strategic asset class for pension funds. It has an expected long-term return that is higher than that of government bonds, so it should more than keep pace with liabilities. It is largely income producing, which is helpful to meet cash outflows. Finally, it has lower volatility than equities and some diversification benefit, so adding it to a portfolio should improve risk-adjusted returns.
However, to date, the use of real estate has been mainly strategic. It is seen as a long-term investment because it has been difficult to trade frequently. The costs of trading have been high and the timescales involved too long. While this was certainly true of direct accounts, pooled funds have started to change the game.
With most open-ended pooled funds, pension schemes have been able to invest or disinvest on a monthly basis. The pooled fund itself may need to carry a certain amount of cash within it, for example, before deployment, but the underlying transaction costs are still reflected in the unit pricing. Nonetheless, through the use of open-ended pooled funds it became possible for schemes to be more nimble in varying their property allocation.
So, can and should pension schemes become more tactical in their use of property? We think so, and this can be done in two ways: within the real estate asset class and between other asset classes.
Adding value within the asset class
There are a number of different ways to implement a property allocation (call these ‘routes to market'). These typically include unlisted approaches (direct accounts and many pooled fund structures), listed approaches (REITs and property company shares) and derivative-based structures such as property notes.
Typically, pension schemes have gone down only one of these routes. However, recent market conditions and the development of new approaches mean schemes can be more flexible than before.
As an illustration of how schemes can potentially capture value by allocating between the different routes at different times, the graph shows the performance of UK listed and unlisted property markets since the start of this decade.
Recent studies have indicated that the long-term return from listed and unlisted approaches should be similar, but that the listed market moves approximately six months ahead of the unlisted market. This ‘lag' would appear to be confirmed in the chart, also noting that the listed market can substantially overshoot (in either direction).
In theory, schemes could add value to their returns by selecting the fastest rising/slowest falling of the two routes at any time, rather than sticking with one or the other.
In practice, though, schemes are unlikely to want to ‘flip' between the two approaches due to the illiquidity of the unlisted approach, fund manager selection issues, etc. They would also need advice on when to make the switch.
There was discussion in the industry of developing pooled funds that would be able to allocate tactically between the different routes, depending on the relative pricing. To date, these have not developed, but they would help in outsourcing decision making from scheme fiduciaries to fund managers.
In the meantime, other opportunities are open to investors. These currently include the following:
Property hedge funds have opened up the possibility of producing positive returns in a falling market by allowing fund managers to short listed securities.
We have seen a number of multi-manager mandates being reviewed to allow more ‘mix and match'. A number of balanced funds are also reconstituting themselves to be able to hold a wider range of property instruments, to add flexibility in future.
The largest pension schemes will have the resources to decide upon the relative merits of each approach, but may well prefer to receive guidance from their fund manager on the issues.
Smaller schemes may struggle to have the governance budget, and a sufficiently high allocation to real estate, to be active in this area. However, the added value from being proactive can still be cost effective for smaller schemes.
Adding value between asset classes
Scheme fiduciaries spend time and resource developing an overall strategic benchmark for their assets, and many now actively manage their asset allocation. For example, when the funding position is unexpectedly strong, trustees will typically look to take some risk off the table. Real estate has often been exempt from these discussions because of the aforementioned liquidity and cost issues.
However, should this still be the case? Many schemes were close to being fully funded in mid-2007 (helped by the real estate and equity markets standing at historical highs). Some equities were switched to bonds, but real estate was often left untouched. The real estate market was looking overvalued on most measures.
Schemes could disinvest from pooled property funds on a monthly basis, and without incurring the full bid-offer spread (as the pooled fund was still likely to be net cashflow positive). As the graph illustrates - and as with equities - this would also have been an ideal time to disinvest and recycle profits (most likely into bonds or a liability matching strategy).
In theory, if liquidity is present, there is no reason why property should not be included in such asset allocation decisions. Although it incurs a higher cost to trade than many asset classes, the potential saving in capital values can still make it worthwhile.
The downside of demanding liquidity for such transactions is that it can also work against a scheme. By having to meet demands for liquidity, pooled fund managers might need to run cash holdings (a drag in rising markets) or disinvest their best assets at an inappropriate time.
If these actions are not sufficient, the liquidity is turned off anyway - witness the experience of most UK pooled balanced funds since late 2007.
Schemes that are prepared to take advantage of tactical opportunities are more likely to meet their long-term objectives. There is also increased scope to, and value to be gained from, investing more tactic-ally within the real estate asset class, and at the total portfolio level. This might require more governance from fiduciaries and/or product development from fund managers. However, the building blocks are largely already in place and continued volatility and dislocation between the routes to market mean that the opportunities should persist.
Greg Wright is director of investment advisory, pensions, tax and people services at KPMG.