As in other asset classes, falling returns in real estate have increased the focus on manager-specific risk, as Greg Wright explains
Investors play close attention to achieving sufficient diversification within their portfolios, and their real estate portfolios should be no different. In most cases nowadays, there is generally good diversification within such portfolios eg by sector, geographical region and increasingly also by country. This clearly helps tackle the risk associated with an individual property or a sector of the property market. The purpose of this article is to look at the options open to investors to tackle manager-specific risk. To begin with though, it is worth outlining the possible sources of manager risk, and whether these are significant issues. We finish by looking at the risk mitigation options open to investors.
One often quoted statistic is that manager risk is typically relatively small in the context of overall investment risk, the strategy decision forming perhaps 80% of total risk. This has been particularly true in the past because of (a) the dominance of equities within portfolios, with equities exhibiting high volatility and (b) the relatively low levels of targeted manager outperformance. Looking forward, this is less likely to be the case as, according to our evidence, (institutional) investors focus on less volatile assets but with a greater proportion of manager skill. A key initial question is, therefore, how significant the manager choice might be on expected returns?
There are a number of data sources available to answer this question. We focus on the UK real estate market as this is where most data is available to us. Figures 1 to 3 shows the spread of manager returns within our real estate universe of balanced property unit trusts (PUTs). We have analysed returns up to 31 March 2007 and looked at the last eight calendar quarters and rolling five years.
Clearly there can be outliers in an individual quarter even within the balanced PUT arena - separate articles have discussed the issue of gearing and the effect this has had on returns which is picked up again later. The interquartile range has tended to be around 1% or a little more.
Given that quarterly performance can be volatile, what is the picture over a rolling five years? As Figure 2 shows, there can still be outliers even over this period, but the interquartile spread still tends to be about 1% a year.
Is 1% a year significant? Perhaps not when markets are returning 20% a year but in a lower return environment which most commentators are predicting, this will be much more valuable. Out of interest, while the rolling five-year interquartile range for UK equities has been higher at nearer 3% a year (see figure 3), investors have historically chosen to diversify their active managers in that asset class.
Investors might believe that choosing one of the largest funds is a safe way of reducing volatility versus the peer group. In the absence of a passive option, this is intuitively appealing if only one balanced fund can be chosen (eg, for governance reasons). Unfortunately, this is not always the case.
Figures 4 and 5 repeat figures 1 and 2 but overlay the actual performance of four of the largest funds. You might want them to lie near the median return if they are to be seen as providing the market return, and sometimes they do. However, it is apparent that the largest funds can suffer periods of out and underperformance versus their peers. Safety in numbers is not guaranteed, and nor should it be - even the largest funds want to generate outperformance for their investors and so take active decisions. (Note also that being around median each quarter is no bad thing, as this will usually accumulate to upper quartile performance over the longer term - see fund D as an example.)
If dispersion of results by managers is therefore an issue, why might this arise and how can investors protect against it?
When we try to identify those we believe will be the better performing managers, our research focuses on four main factors: idea generation, portfolio construction, implementation and business management. Failures in any of these areas can lead to underperformance, although an inability to generate good investment ideas is probably the major consideration. What then is the blend of ingredients that should lead to good idea generation and successful portfolio construction? We think they should include the following:Experienced investment professionals; A culture which allows expression of ideas from all individuals; Key professionals being focused on investment, not management tasks; Good industry and market contacts; A combination of top down research and bottom up stock picking (although the balance between the two can differ between firms).
These factors might help us separate managers and thus those at the top or bottom of the performance charts. However, even with all these factors in place, the best managers can still suffer leaner periods. As with all investments, there can be periods of good and bad luck (although these should even out over the long term).
Investment style can also be an issue - while there is arguably less demarcation between styles of property managers and equity managers (say), some organisations focus on certain styles of property. One example is a focus on high-yielding properties instead of development profits, or a focus on secondary rather than primary properties.
There can be periods when, however skilful that manager may be, their style of investment cannot keep pace with the wider market.
One issue that has had an effect in recent years is the use of gearing. The general consensus is that the more highly geared portfolios have seen higher returns in recent years, although this effect is now flattening out with the convergence of the property yield and the cost of borrowing. Understanding the manager's position on the use of gearing is important in assessing their potential performance.
In our experience, the investment process at most organisations strikes the right balance between the need for due diligence and the desire, on occasions, to act relatively quickly to secure a deal. Nonetheless, those organisations with cumbersome organisational structures and decision making processes will arguably fall behind their peers in the longer term.
Finally, all the right ingredients may be there but there is insufficient support from management - perhaps real estate is not a core line of business, and this can lead to prolonged underinvestment and potentially the walkout of a team. There will undoubtedly be a variety of other factors for underperformance in addition to those above.
The section above indicates what might lead to good performance and the reasons why even the better managers can suffer periods of poor performance. In the same way that investors look to gain diversification across the properties held, they are now of course able to diversify the manager risk to a much greater extent, and this is discussed below.
The evolution of property mandates over recent years has been quite startling. Previously, larger investors typically ran a portfolio of directly held properties and smaller investors may have held a single balanced unit trust (perhaps as part of an overall balanced mandate at one manager). Incidentally, this was one occasion where the smaller investor was arguably achieving the greater diversification.
In recent years, and certainly in the UK, we have witnessed the rise of the multi-manager/fund of funds mandates, where investors are now also diversified across the fund managers themselves. This clearly must have the impact of reducing manager- specific risk. Investors have the choice of investing in a fund or asking the multi-manager to run a bespoke account for them. Both routes achieve the same aim but the latter route, often only available to mandates of £25m or more, gives greater flexibility.
Multi-managers have different investment philosophies. At outset, these mandates consisted of little more than a basket of balanced funds. The investor had diversified the manager risk discussed early on in this paper. As time has gone by, we have seen less use of balanced funds and increasing use of specialist funds. Why has this happened? You might argue that there is little additional risk reduction benefit in holding more than three or four balanced funds (and to be fair, this is the sort of thing investors can do themselves without paying the additional fee). Alongside this, where value is really being created is in the use of and access to specialist funds which would normally be beyond the investor.
Taken to its extreme, it is possible to create a multi-manager account with few or no balanced funds in it, although they do provide useful liquidity. As the number of underlying funds increases as a result, the exposure to any one manager has become low enough not to be material. Moreover, the multi-manager has dedicated teams looking for problem signs at the funds in which they invest, and so another layer of manager-specific risk protection is incorporated.
In the same way as we might try to identify the strongest managers, we can also try to identify the strongest multi-managers. Additional factors here would include separation of the multi-manager team to manage conflicts of interest, together with a good mixture of quantitative tools and ability to cover the ground in terms of manager meetings.
Many multi-managers will invest a proportion of the client money in their own funds but this is itself often split across more than one fund. It would be surprising if there were not exposure to close to 10 managers in this approach. Moreover, the larger direct accounts have typically been looking to address this issue by moving part of their portfolio to an indirect basis, often using vehicles of other fund managers.
Either way, we have seen manager-specific risk typically being addressed by both large and small investors, and the increasing move to pan European and global mandates would appear to support this trend. Given that global property markets are essentially an amalgam of local markets, many investors will appoint a specialist provider in each region or, as we are now witnessing, a number of organisations have put together global multi-manager teams. The more complex real estate portfolios become, the greater is the likelihood of a suite of managers (either directly or indirectly) being used.
Individual manager risk exists in real estate portfolios as much as in other portfolios. This can be down to lack of skill, which itself can arise for a number of reasons. Consultants and other advisers can help in this regard by recommending the highest quality managers.
However, even skilful managers can underperform at times. Indirect investors have been able to diversify this risk in the past by holding more than one fund, although this can create governance issues. The use of multi-managers is the simplest way to reduce manager-specific risk and retain access to high quality vehicles.
The multi-manager also brings to bear the monitoring process which aims to head off problems at underlying managers before they manifest themselves in underperformance.