The fund of funds sector is growing and attracting a wider range of investors. But, as Richard Lowe discovers, the issue of cost and how this affects performance concerns pension funds
The role of the real estate fund of funds is to offer immediate diversification and manager selection expertise to smaller investors - ie, those investors without the substantial volumes of capital and in-house resources enjoyed by their larger counterparts.
This is a traditional view, but it is being challenged. A recent survey by the European Association for Investors in Non-Listed Real Estate Vehicles (INREV) concluded that funds of funds are no longer the preserve of smaller investors.
In the last edition of IPE Real Estate, Andrea Carpenter, director of research and market information at INREV, referred to this: if you take into account that INREV investor members tend to be relatively large, the fact that 43.3% are already invested in funds of funds immediately "starts to knock this preconception".
Fund of funds managers themselves appear to have anticipated the potential to market their products to a wider range of investors. For example, when ING Real Estate launched its global fund of funds product, Global Osiris, this summer, fund manager Damien Smith seemed to think the vehicle might well attract capital from larger investors.
"ING Real Estate Select has been running fund of funds products now for the last six or seven years. Traditionally, they have been targeted towards investors who are seeking higher levels of diversification with smaller amounts of capital," he said. "We may actually get some investors with larger ticket sizes or larger levels of investment than we would have otherwise expected."
The €5.27bn London Pension Fund Authority (LPFA), which provided the initial €150m of capital to get Global Osiris up and running, is hardly ‘small', being one of the biggest local authority pension funds in the UK.
However, the larger West Midlands Metropolitan Authorities sees no role for fund of funds vehicles in its real estate portfolio. Brian Bailey, director of pensions at the €11.7bn pension fund, cites two reasons for this.
First, the pension fund prefers - and has the necessary in-house resources - to select property funds itself; second, the volume of capital it is able to commit is large enough to gain diversification without the aid of a fund of funds structure.
"We can make meaningful investments in a number of targeted funds we have selected," he says. "If we were much smaller I think we would say, to get the spread we want around the world, we would probably look at being part of some funds of funds."
This is also the case at Danish labour market supplementary fund ATP, the largest pension fund in Denmark. "As a large pension fund with our own team in place to deal with manager selection and fund selection, we simply find that funds of funds will just be another layer of costs," says Michael Nielsen, managing director of ATP Real Estate, the body that manages ATP's indirect investments.
"We can do exactly the same job the fund of funds manager can do. Fund of funds products are more relevant to smaller and medium-sized pension funds that are not able to make large commitments and get favourable terms with the managers."
One potential role of funds of funds for larger investors is to offer immediate access to new markets in which they have little experience, allowing them to build up their knowledge with a view to investing directly later.
Nielsen does not rule this out as an approach for the future. ATP Real Estate is yet to invest in the Asia Pacific region, and would consider investing in a fund of funds structure to learn about the Asia Pacific markets.
But Nielsen stresses that this is purely theoretical, and that no discussions to this effect have taken place. What is more, ATP Real Estate began investing in the US for the first time this year and opted to work with consultants The Townsend Group, rather than investing through a fund of funds.
"We did not decide to take the fund of funds route there, due to the fact that from the beginning we said the US should end up being a substantial proportion of our total exposure," Nielsen says. "Instead of doing it via a fund of funds, we teamed up with a local adviser and educated our own team to do manager and fund selection in the US."
The Danish occupational scheme AP Pension can be a considered a large investor, with more than €4bn of assets under management, 12% of which is allocated to property. Its initial exposure to Asia came via a global fund of funds, the Sparinvest Property Fund, but in the future it is aiming to hold a diversified portfolio of country and sector-specific funds in the region.
Meanwhile, the German pension fund for chartered accountants WPV, which allocates approximately 17% of its €1.1bn assets under management to real estate, has invested in one fund of funds vehicle targeting Asia. The rest of its portfolio consists of single funds investing in Europe, but a fund of funds vehicle was seen as a way to learn about the region.
"We are not acquainted with the market and we want to have a diversified entrance into the market," explains Hans-Wilhelm Korfmacher, managing director at WPV. The pension fund has already invested in one single Asian fund in addition to its fund of funds exposure.
The €9bn Nordrheinische Ärzteversorgung (NAEV), the German pension fund for doctors in the North Rhine region, is taking a slightly different approach. Eighteen months ago it invested in a European fund of funds, not to learn about the European market - it was already well acquainted and invested across the region - but to learn about the nature of the vehicle itself.
"It was to get to know the product and to see if there is any advantage," explains Hermann Aukamp, managing director at NAEV. "We just moved in with a small commitment to learn how the product works and see if it fits into our investment strategy, because we really did not know if it was worth doing or not."
Aukamp thought it was important to experience such a vehicle first hand, rather than only debate the various pros and cons. "We decided to go in with a small commitment, not only to talk about it, but to see it in practice," he says.
The INREV survey suggested that the extra cost associated with funds of funds - ie, an additional layer of fees on top of the fees payable to underlying funds - remains the main obstacle or the principal deterrent to investors, with 93% of investor respondents seeing it as a drawback.
This is the main reason, for example, for the €2.5bn Teesside Pension Fund not to invest. Fred Green, head of investment at the UK local authority scheme, believes that investing in non-listed real estate funds can be relatively expensive to begin, even before introducing a second layer of fees.
"Property unit trusts are quite expensive anyway, in management terms," he says. "If you are adding another layer on top of that it does become even more expensive. Property is a fairly expensive asset class to manage… and so any additional layer on top of that I think you need to take very seriously."
Korfmacher, however, believes that the double layer of fees charged by the Asia fund of funds WPV it invests in is justified by its expertise in the region.
"Normally I try not to pay too much in fees. I am very fee-sensitive, usually," he says. "But I think in this market - in a market or region where I don't know the players well enough - it is a good idea to use fund of funds investments."
Vanessa James, investment director at LPFA, believes ING Real Estate's Global Osiris fund of funds will "earn every penny" of the fees it charges the UK pension fund, simply because of the global investment resources and expertise it is providing.
According to INREV's survey, the most important drawback for investors after double fees was "lack of portfolio allocation/weightings control" (over 50% of investors cited this). What is perhaps more interesting is that "lack of alignment of interest" (40%) and "potential conflict of interest" (over 30%) were seen as significant concerns for investors, while fund of funds managers responding to the survey thought these were marginal issues (both were close to or below 10%).
Certainly, the pension funds IPE Real Estate spoke to were not overly concerned with any lack of alignment of interest, despite INREV's Capital Raising Survey finding that co-investment by fund of funds managers stood at 0.8% compared with 4.8% for single managers.
Korfmacher, for example, does not see any apparent deficiency in this area, although he admits he does not have "an overview of the market".
The potential for conflict of interests that arises from fund of funds managers investing in their own in-house vehicles, meanwhile, appears to be an important area. Korfmacher reveals it is important for WPV to have an agreement with a fund of funds manager that prohibits it from investing in underlying funds managed within the same organisation. If the fund of funds manager wants to invest in an in-house fund, Korfmacher wants transparency.
"Usually there should be a special agreement with the managers that prohibits such a way of doing business, or at least they should have to tell the investors," he says. "I don't think it is OK for them to do this without informing the investors, without transparency. It would be a breach of contract."
He adds: "If I were to see such dealings without transparency, I would consider ending the contract as fast as possible."
LPFA's James believes that fund of funds managers are on the whole keen not to invest in their own products, simply because this avoids raising the suspicions of investors.
"If anything, they strive harder not to [invest in] their internal funds, because everyone asks questions of them the minute they do," she says. Furthermore, funds of fund managers would need to be fairly confident that any in-house fund they invest in would outperform.
The worst case scenario for a fund of funds manager would be to commit to in-house funds only to discover further down the line that they have underperformed their markets or relative to the rest of the portfolio.
Aukamp, on the other hand, is not overly concerned about fund of funds managers investing in their own funds. "That is an issue, but we don't exaggerate it too much," he says.
In fact, Aukamp found evidence to suggest that in-house funds often outperform third-party funds, possibly because the fund of funds manager is more informed about the product he is buying into. "We thought this would be an issue, but later on as we looked into vehicles we saw these vehicles perform even better than vehicles from third parties," he says.
Aukamp admits this may be a short-term phenomenon. Nevertheless, he feels it is "not a big issue" if fund of funds managers have a "limited exposure to in-house funds" that did not exceed 20% of the overall portfolio.
The real estate fund of funds industry has grown quickly over the past decade and looks set to continue expanding. However, since moving into a more difficult financial and economic period, with moderated expected returns across real estate markets compared with recent years, fund of funds managers will have even more of a challenge in convincing investors the advantages of their services outweigh the disadvantages.
An environment with lower forecast returns will certainly put more pressure on fee structures. Aukamp says this becomes a key discussion in weak markets. "In a market that goes up, nobody really cares about fees. But when the performance becomes weak, the fee argument becomes a bigger deal," he says.
Fund of funds managers will say the second layer of fees is always justified, because they give investors access to the resources, market knowledge and expertise that would be expensive and time-consuming to set up themselves.
"A number of institutional investors are realising the amount of time it takes to actually administer a portfolio of these sorts of investments," said Smith in July, explaining why he expected to see investors look to his global fund of funds vehicle.
But conversely, Aukamp believes fund of funds managers are in a very tough business and a number are likely even to have been surprised at "how difficult and time-consuming" the job is when performed to the best possible level.
Aukamp is sceptical about whether the fund of funds industry will continue to grow significantly in the future. "I can't see the fund of funds business will grow a lot," he says. "It is my understanding that a lot of investors are not really sure whether a fund of funds is a product for the future."
Having attracted large volumes of capital in recent years, fund of funds managers will have been under pressure to commit accumulated capital to various underlying funds. Aukamp believes many will have "committed themselves quite eagerly to different products", especially during recent years where all markets have seen positive returns.
The implication here is that a fund of funds manager has the potential to be less discerning than an investor like NAEV when it comes to screening funds themselves. "Sometimes we found [managers] did not look into the products too deep," Aukamp reveals.
Currently there is not enough performance history for investors to really know whether the added expense of investing in a fund of funds is worthwhile long-term or if it is eating significantly into performance. Greg Wright, formerly principal at Mercer, believes that when a substantial "stack of performance history" is eventually built up there will be another "round of debate" among investors.