Some fund managers will talk about their outperformance of the market but investors should listen to such claims carefully. Paul Mitchell sheds light on a contentious area

Alpha - outperformance arising from the skill of the fund manager - is an attribute that has long been highly prized by all. More fundamentally, it has taken on extra resonance over the last 10 or so years, affecting the structure of the wider fund management industry and the strategies followed by investors.
Central in this respect are:

the shift away from active fund managers in traditional asset classes where alpha is low towards cheap (sometimes derivative-based) passive strategies:  Increased allocations to alternative asset classes perceived to be characterised by fund managers capable of delivering alpha;  The adoption of portable alpha strategies.

Such trends have been facilitated by research identifying the existence, or not, of systematic alpha in these asset classes.
Real estate so far appears to be little affected by these trends and there has been surprisingly little research, like that undertaken on equities from the mid-1990s and in recent years on private equity and hedge funds, on the extent of systematic alpha in the asset class. This was the motivation for the research - undertaken with Shaun Bond and sponsored by the Investment Property Forum as part of its 2006-2009 Research Programme - examining the extent of systematic alpha in UK real estate funds and the implications for real estate fund management and investors' strategies.
The research drew on IPD's database, which, according to IPD, accounts for over half of "professionally managed" funds in the UK. Two things need to be emphasised about this data. First, it is reasonable to say that these professional fund managers collectively add something to performance over and above what the ‘man on the street' can do. However, this alpha, which the average professional fund manager adds, for example through asset management, will not be observed in the IPD data.
On the other hand, because many of the funds are in IPD to benchmark themselves against their peers, the data may exclude those funds that are looking to generate alpha by doing something different. If this is the case, our research might understate the alpha available in UK real estate.
The extent of alpha was explored through analyses of persistence in fund performance. Good performance may be due to skill but it may also be a one-off, a lucky deal or just chance. The acid test is whether or not such performance can be sustained over successive periods.
The research therefore examined fund performances over two consecutive periods. For example, we compared the performance of a fund over the 10-year period 1987-96 with its performance over the following 10-year period 1997-2006. We also looked at consecutive five-year periods (four sets in total:  1982-86 versus 1987-91, 1987-91 versus 1992-96) and three-year periods (seven sets since the early 1980s).
While there were indications of persistence in fund performance over consecutive one-year horizons, this was not reviewed in any great depth. One reason being that, from a practical perspective, lags in performance reporting, real estate's illiquidity and high transaction costs limit the extent to which any such persistence can be exploited.
Furthermore, it was also clear that good short-term performance was not indicative of sustained medium-term performance.
Two measures of performance were examined. The first was simply performance relative to the average of all the funds in the sample. In this respect, Table 1 shows the likelihood of top performing funds over the initial 10-, five- or three-year period remaining top performers over the following period. The results for the five- and three-year horizons are the averages of the four and seven sets of data described earlier.
Random luck would point to 50% of the funds remaining in the top 50%, 25% in the top quartile, and 10% remaining in the top decile. The proportion of funds in the top 50% over two consecutive periods was around 50% whereas the proportion in the top quartile was in the region of 35%. By and large, the actual proportions were not statistically different to the expected values.
The very best top decile performers, however, stand out. The proportion of funds consistently in this group tended to be two to three times higher than expected. Persistent out-performance, therefore, seems to be limited to an elite group of funds. It is also clear that the way to achieve this is to play a long game - the likelihood of a fund consistently delivering this elite, top decile performance was much higher over 10-year horizons than over shorter periods.
There is also the possibility that such out-performance may be associated with greater risk in the fund, for example through gearing or an opportunistic strategy. Investors see such out-performance as not a return due to skill but a reward for risk (beta). The performance over and above that associated with risk is the true, technical definition of "alpha" and this represented the second measure we used to assess the persistence of fund performance.
To isolate alpha, the return due to risk must be stripped out. While techniques to do this are well developed for equities, this is less the case for real estate. Our approach was to develop so-called "factor" models that related the performance (in excess of the risk-free rate) of each fund to IPD sector returns for the 10-year horizons and to the all-property IPD return for the five-year horizons (it was not possible to undertake analysis of the three-year horizons on a risk-adjusted basis).
Controlling for risk and thereby focusing on alpha, table 2 shows that, for the five-year horizons, the proportions remaining in the top rankings are typically lower than for simple relative performance. This suggests that some of the good relative performances were a reward for risk rather than being due to fund manager skill.
However, for the 10-year horizon, the proportions tend to be higher, thereby indicating greater persistence in performance over this longer duration. From the more detailed examination of the data, our overall conclusions were that evidence of systematic out-performance in UK real estate fund management is tentative, at best focused on the elite performers and partly associated with risk.
Consistent with these findings, our analysis revealed that previously top performing funds (and, conversely, poor performing funds) tended to show returns and alpha much closer to the average in the subsequent period. Table 3 shows the position over five-year horizons. The best performing funds, as a group, continue to out-perform in the subsequent period but only marginally (ie by about 0.5%); the exceptions are for alpha in the top and bottom decile funds.
Of course, those funds that continue to outperform show much better performance (by around 2.5 percentage points) but such funds represent a small proportion of the total.
We also explored the fund characteristics associated with performance and alpha and those predictive of the future. Good asset allocation (to segments of market such as shopping centres, city offices etc) made a positive contribution to medium-term performance and alpha up to the mid-1990s since when its contribution has vanished - the latter likely to be partly due to a narrowing in the range of returns across market segments over the last 10 or so years.
A high-yielding strategy also contributed positively to performance and alpha up to the beginning of this decade since when its contribution has reversed. A relatively high exposure to development almost always undermined performance and alpha. However, the most consistent and important factor was having good assets.
This said, it was interesting to note that having "good" assets was not predictive of future performance. Similarly, neither was previously good asset allocation. These observations go a long way to explaining why so many funds are unable to sustain good performance over extended periods - there are limits to the time that a fund's assets can keep on out-performing, while consistently good asset allocation is either not possible or unimplementable.
How does UK real estate compare with other asset classes? Most of the research undertaken since the 1990s has suggested that equity fund managers are unable to sustain good performance other than over short periods. Levels of out-performance for the best funds over the medium term look comparable to those for UK real estate funds but, having adjusted for risk, alpha in real estate is probably higher.
Turning to the alternative asset classes, the level of alpha that hedge fund managers can deliver is subject to intense debate, although if they can, the balance of opinion would again seem to be that this is only feasible over relatively short periods.
This said, many investors do believe that they can get a premium risk-adjusted return through their hedge fund strategies. For private equity, however, the range of returns and the potential for persistently good performance looks much greater than in real estate.
The overall impression, therefore, is that potential for alpha in real estate is marginally greater than in equities but modest by comparison to the alternative asset classes. How does this correspond to the expectations of investors and what might be the implications?
Most of the investors and investment consultants interviewed as part of the study saw real estate as a beta asset class. While there was the desire for out-performance, this was modest (50-100bps per annum) and secondary to limiting the risk of not achieving the market return. Such investors were looking for their managers "to play a consistent game and to avoid mis-hits". In effect, the vast majority of these investors over the medium to long term do get something very close to this beta return.
A minority of the investors spoken to, however, eschewed this balanced approach, instead following what could be loosely termed an absolute return approach to real estate investment. In financial markets generally, alpha plays a fundamental role in absolute return approaches as its return is (theoretically) independent of overall market performance.
This minority recognised that, in following this strategy in real estate, some beta could not be avoided. However, their strategies represented a fundamentally different approach, eschewing reference to "relative" benchmarks, investing only when and where the prospective return was above the absolute return target, explicitly pursuing returns from active management and cash flow, and looking to exploit systematic mispricings and illiquidity.While it may just be coincidence, it was interesting to observe that it was the segregated pension funds, "traditional institutions" and charities that not only were the ones following this type of strategy but were also those that dominated the elite few who could sustain top decile performance over consecutive periods.
There were, nonetheless, some indications that investors more generally were looking for alpha in real estate as part of their quest to reduce risk and maintain equity-type returns in their multi-asset class portfolios. Greater investment in cross-border real estate and in alternative sectors (such as student accommodation, senior housing, etc) stood out in this respect.
Some of these markets were difficult to get into and illiquid - part of the reason why the returns were attractive - and required special expertise to harvest such returns. A form of alpha was therefore available. However, the fundamental point is that investors were primarily looking for a market return in areas that were lowly correlated with their existing exposures, rather than primarily from fund manager skill/alpha. It will be interesting to discover if alpha is more accessible in continental European real estate than in the UK.
Finally, investors and consultants were sceptical of the practicality of applying to real estate techniques used elsewhere to exploit alpha, particularly portable alpha. In particular, alpha in real estate was perceived to be relatively small compared to elsewhere. At the same time, there was concern at present over the liquidity and pricing of the derivatives market - considerations that also made investors doubt that real estate derivatives will become a serious strategic alternative to the underlying asset class in the foreseeable future.
The overall message is that, while real estate may share some of the characteristics of the equity sector, investment strategies and fund manage-ment are unlikely to be as acutely affected by investors' growing demands for sustainable alpha and cheap beta.

Paul Michell runs his own consultancy, Paul Mitchell Real Estate Consultancy. The views expressed are the author's own and not necessarily those of the IPF. To obtain copies of the full report, Alpha and persistence in UK property fund management, contact the IPF's Research Director, Louise Ellison (