Consultants have been accused of stifling innovation in the property asset class. Shayla Walmsley asks are they simply carrying out their orders?

Fund manager Robert Houston recently claimed that investments consultants, the so-called pension fund gatekeepers, were stifling real estate innovation by indulging their fixation with benchmarking when advising clients. His accusation may be impossible to prove or disprove - there is no benchmark for innovation - but consultants have responded by arguing that they only do what their clients ask them to do.

That pension funds ultimately decide how innovative they want to be is the crux of the consultants' argument. Mercer senior investment consultant Stephen Ryan points out that it is not in a consultant's interest to hide the market (so to speak) from his or her clients.

"There's no point in clinging to the old truths when the market has moved on. It would be remiss of us to do so," he says. "Our clients want us to be ahead of the curve. The majority know they want something in broad terms but they want the consultant or fund manager to remind them what's out there."

Aon Hewitt's innovation committee is a case in point. It has proved popular internally because consultants know where to take new ideas. Whether those ideas reach pension fund clients depends on the consultant's judgement. "Consultants should always be innovative, but whether that innovation is appropriate to clients is another question," says Richard Cooper, a consultant at Aon Hewitt.

Every couple of weeks, Hewitt's ideas development group considers a new idea. If the committee approves the paper, consultants then make a decision on whether to take it to their clients.

Asked about the group's efficacy, Martin Kraus, principal at Aon Hewitt, says the firm sees the group's success in terms of its existing relationship with clients, rather than as a quantifiable revenue generator. The point is to present them with topical ideas, he says. But knowing when to present takes judgement.

"If the piece is on investing in real estate, and the client has no interest in property exposure, it would be pointless to pass it on to them," he says. "But at the same time you have to challenge clients. Many of our pension fund clients will feel that what we're doing is leading edge, but we want them to know that we're progressing ideas, even if they're not directly interested in a specific idea."

If the options a pension fund is willing to consider range from core to core-plus, there is little innovating to be done. But if the same pension fund were to hand over discretionary management to a fiduciary manager, there is a somewhat greater chance that manager will be more willing to take a walk on the wild side.

What this means in practice is often a willingness to re-think the link to a physical asset. Cardano investment manager Richard Urban contrasts his (discretionary) approach, which looks at real estate equity but also at loans and structured products, with "the approach consultants usually take, which is focused on bricks and mortar".

"It all comes together when you can look at the equity side with as much confidence and rigour as the debt side," he says. "In real estate, there is a disparity between a credit mindset and an equity mindset. Most people on the equity side think of real estate only as bricks and mortar and in terms of ownership and management of a physical asset. But if you come from the debt side, and that usually means from a bank, you see real estate as a different investment opportunity, because you're used to making loans and getting a return on them."

Urban cites collateralised mortgage-backed securities (CMBS) as an example of helping to bring equity and debt mindsets together. But the consultancy is also looking at US distressed debt - especially on smaller loans. Buying non-performing loans means investors can create a return by solving problems the current loan owner cannot, he says. A large bank, for example, may lack the capacity or skills to work through loans, and will often prioritise by size, de-prioritising the smaller balance loans.

Defaulted construction loans likewise offer opportunities for some investors because they present banks with the worst of both worlds. "If a developer defaults, the bank can try to sell the debt or take the asset and attempt to sell it, but trying to sell ownership of a half-completed hotel or office is difficult," he says. "Who would want to buy a concrete shell, even if it's well located?"

If you take the growth of fiduciary management as a proxy for innovation, there may be more to come. Towers Watson announced in December it had set up a 35-strong fiduciary management team under CIO Chris Mansi. In common with other consultancies, Towers Watson does not plan to separate the advisory and delegated businesses, only the delivery mechanism.

In any case, there are opportunities for innovation short of risky CMBS and distressed debt. Cooper cites derivatives as an example. Some pension funds are put off by the difficulties of gaining access; although there are ways around it, such as derivatives funds, gaining exposure is not as straightforward as buying a contract.

"For most, their basic position is that they are long-term investors and they want to hold the asset," says Cooper. "But clients with a short-term view of the property market might consider derivatives products."

One of the approaches Aon Hewitt recommends to pension funds is core-and-satellite, which could include what Cooper describes as an "appropriate" exposure, for example, to recovery or opportunistic funds at the end of 2009.

"We're looking at opportunities created by anomalies in the market. The outlook for this year is average to poor and it's a difficult sell for us to put new money in the UK market. But if you're looking at a probable derivatives fund, it is both innovative and not influenced by the market cycle."

In fact, the demand for innovation in some cases comes from the same pension funds. "One pension fund I deal with comes to us with research ideas," says Cooper. "Pension funds are, on average, conservative but we have clients who are prepared to consider innovative products."

Pension fund appetite for non-traditional options will depend largely on their internal governance structures. Ryan claims that, in a meeting involving nine of 10 trustees, the one or two cautious committee members will tend to have most influence.

"A pension fund will often set up an investment subcommittee to avoid group-think instead, then that subcommittee will work with the consultant," Ryan says.

Lloyd Raynor, a senior consultant at Russell Investments, agrees that "quarterly trustee meetings find it difficult to cope" with innovative strategies - which is one reason why fiduciary manages are better set up to manage them. He cites Russell's house view that pension funds need to have the appropriate resources in place to cope with an unconventional strategy.

"Appropriate" resources include time to apply to the investment, expertise, and governance structures, potentially including a subcommittee and additional executive nous. "That can mean larger funds have an advantage but smaller ones can delegate," he says.

"Innovation could lead to better outcomes but only if handled appropriately. There's no point if the pension fund hasn't got their structures in place to manage it," he says.

"It would be a dereliction if a consultant didn't bring new ideas, but it would be irresponsible if we didn't take into account governance as well. As a consultant you need to be able to update clients on the marketplace, but you should recommend a course of action only if clients are willing to restructure their governance."

Is the onus on fund managers?
Once the finger-pointing eventually reaches pension funds, it can easily turn back to fund managers themselves.

Fund managers regularly approach consultants with the latest investment products, but consultants also send out requests in the market for specific solutions they believe would benefit their clients, and which do not already exist, Cooper says. Consultants' influence applies to the terms of the funds, and their focus, as well. "Gearing levels were pushed down as a result of demands to focus on real estate beta, not gearing," he adds.

In fact, it could be fund managers stifling innovation by reducing it to a choice between funds. "To fund managers, innovation often means different products, but there are other ways to innovate," says Cooper.

Even if you limit innovation to funds, you could argue that, with exceptions, managers are just failing to come up with sufficiently attractive investment proposals. Recent reports have suggested fund manager and investor perceptions not only of the market but also of the funds they invest in are at variance.

A report produced by PricewaterhouseCoopers for the Association of Real Estate Funds (AREF) in January suggested institutional investors favoured oversight of the fund independent of the fund manager, with larger investors calling for more representation.
Ryan recalls two recent conversations with pension funds that wanted to know how many other investors would be in a fund and what percentage they would own. "There is an increased awareness of [the risks associated with] illiquid assets and the difficulty of getting out," he says.

The potential for tension is strongest where fund managers are trying to raise capital quickly and pension funds are reluctant to be first or second investors, says Ryan. "The client may be happy to invest - but in the second phase, not the first," he says. An earlier survey by law firm Nabarro found that investors willing to cornerstone the fund could effectively dictate their own terms, including a veto over subsequent investors.
The same survey also found that, while fund managers identified Europe, the US and China as top destinations, pension fund interest in Asia was much more tightly focused on China than fund managers had imagined. "Trustees can't be too adventurous," says Ryan.

Graeme Rutter, UK head of multi-manager at Schroders, suggests that, to invest in complex vehicles, he had to construct them in-house. "As a property specialist with a large department, you get more insight into complex vehicles. Because of our scale and size, we can structure products ourselves and create our own vehicles in-house for discretionary mandates," he says.

"We get a minimum of one fund through the door every week. In the past few years, some of those haven't been able to raise finance. In other cases, the structure in terms of fees and governance was not what we wanted.

"It makes sense to structure products because we have a feel for the best opportunities in niche markets; we can create acceptable terms and we have total control to shape the fund. It's easier to do if you've got critical mass. It won't be as easy for the small investor," he says.

Rutter, who recently predicted that consultants could get a feel for what works in core funds but would run into trouble once they moved into the multi-manager space, believes large investors will develop more products in the near future, but with better terms. Meanwhile, larger investors will invest in more club and bespoke deals.

In fact, the Nabarro survey found only 13.5% of investors would choose to invest in funds at all, compared with more than 60% preferring either direct ownership or joint ventures.

Funds, regardless of how innovative, were the least popular option.