After the contribution holiday of the early 1990s, which saw the funding level fall to 65%, the Clwyd Pension Fund has worked steadily towards improvement. Property has been one of the fund's best performing assets with returns around double the fund average. Martin Hurst talks to Philip Latham, head of pensions/funds at Flintshire County Council about the fund's strategy and challenges, one of which is to take advantage of the opportunities created by the credit crunch crisis.

Please explain the role which real estate plays in your portfolio

The original purpose back in the 1980s and early 1990s was probably largely diversification. However, from the 1990s the nature of property as an asset class changed, as the volatility of returns reduced and it became a very steady performer - that is, until the second half of 2007.

With property producing returns (to 31 March 2007) of 13.7% over 10 years and 11.5% over 20 years, and with annual returns over the last 15 years rarely below 9%, it has become a ‘must hold' (high information ratio) and even, in one sense, a liability match.
With local government pension scheme (LGPS) liabilities increasing at 7-8% per annum (inflation, mortality etc.), an asset class that can deliver 9-10% consistently is clearly very attractive, particularly as in most market conditions it still delivers diversification and thus reduces risk at the total fund level.

The funding level has stood as low as 65%. What role has real estate played in increasing the funding level?

Property and private equity have been the fund's best-performing asset classes over any five-year period in the last 15 years. The fund's property portfolio (excluding infrastructure) produced 17% per annum over the five-year period and 21.4% over the three-year period to 31 March 2007 (valuation date). The total fund produced returns of 8.6% and 14.3% respectively for the same period.

Infrastructure has also performed well and this combined with the fund's above average allocation to property (including infrastructure) has made a sizeable contribution to the fund's bottom-line performance, and thus its increased funding level.

How do you create a diversified real estate portfolio?

As a result of its size, the fund has never invested in direct property. In addition, it does not invest in land or building stocks, on the basis that this could create a conflict with the fund's equity exposure and would probably reduce overall fund diversification, as such exposure would not be a pure property play and could be subject to equity market impact.

Real estate investment trusts (REITs) have been looked at more recently and, so far, rejected on the same basis. However, the pension  fund does have some small indirect exposure to REITs through its pooled vehicles (usually pending direct investment in properties).

Derivatives are relatively new to property (they are used extensively in other asset classes within the pension  fund) and certainly will be considered as a means of achieving tactical exposure, but they have not been used so far.

In what way has the underfunding influenced your investment strategy?

As noted already, optimisation is used to help determine allocations to main asset classes at total fund and property, with its solid returns and reducing volatility, has seen its weighting increase significantly since the early 1990s, with diversification increased since 2000.

Within property, formal optimisation is not used. Risk, return and correlation data are patchy across geographical areas and sectors and specific funds tend to have their own profile anyway. However, in developing the portfolio, there has been a focus on diversification, as well as risk and return through analysis of current and potential holdings over the usual categories of core(+), added value and opportunistic, as well as determination of the overall portfolio return expected.

Certainly since 2000, the fund's portfolio has been moved up the risk/return spectrum (see table).

These developments were driven by the moderating volatility on UK property holdings, allowing more risk to be taken; the need to maximise returns, without increasing risk too much, in order to address the deficit situation as quickly as possible; the need for broader diversification on the basis that, after such a strong and sustained run, UK property returns were bound to moderate in the medium term back to long-term trend (7-8%). As can be seen from the table, the expansion in property holdings and the diversification added was not at the expense of the Clwyd fund's five core UK PUTs - these were not reduced and are still held, but the profile of the overall portfolio has been changed dramatically through acquisition and growth. The expected returns of the portfolio have been increased from 7-8% to around 10%.

What challenges do you face as a local authority pension fund?

The fund is fortunate in having strong continuity both at officer and elected member level and, when carrying out their pension duties, members have always followed the principle of placing fiduciary duty first.

A great deal of emphasis is also placed upon member training and the fund's unique structure compared with other local authorities is a direct consequence of being able to introduce new concepts and products to members at an early stage.

The fund has never invested directly in property, local or otherwise, and on private equity it has an unwritten policy of not investing in local or regional funds. Similarly on equity investment, there are no restrictions placed on managers, with financial considerations always taking precedence.

The pension fund did establish governance and SRI guidelines well before these became mandatory for local authorities, but relies on active engagement by managers to effect this. Its foray into infrastructure is on a UK, European and global basis, not local, and was approved by the fund's elected members when many other authorities were shunning such investments on political grounds.

In brief, members are very much a positive for the fund and very supportive of the in-house team's actions, providing that these are fully justified.

Sustainability, both from the property and private equity perspective, has become an issue recently and is likely to be a key theme beyond this year. However, it is the members of the panel, rather than political pressure, that are driving this on the basis of investment opportunities and sources of return going forward.

On private equity, the fund has already approved two investments in Cleantech, and on property it has an investment in a regeneration fund as well as a significant allocation to timberland. In addition, all the fund's property managers are now being asked to explain and justify their approach to sustainability. This will certainly be a factor in future investment decisions.

What challenges and opportunities have arisen for you as a result of the ‘credit crunch'?

The fund invests on a strategic basis. With the LGPS largely under-written by government, no balance sheet issues regarding deficits and a positive cash balance (maturing but far from mature), there is no need for knee-jerk reactions to events. The pension fund is set to follow a reasonably long-term track back to full funding.

High employers' rates and their impact on council (local government) tax are clearly a factor, but these have been held reasonably steady at recent valuations. So, what pressure there is to improve performance is largely internal, not external.

The fall-off in UK property returns was anticipated (it had been expected for a couple of years) and consideration was given to reducing the fund's UK property exposure early in 2007 as part of the last fund structure review.

ith a large number of changes to major equity and bond portfolios, some modest disinvestments of UK property was scheduled for later in 2007. However, the speed and extent of the property market downturn was far greater than expected and the opportunity was missed. Instead, and in an attempt to improve bottom line returns, the fund is attempting to take advantage of the opportunities created by the credit crunch through investments in a global property opportunities fund managed from the US, which will no doubt take advantage of the current situation; a specific US residential fund aimed at acquiring selected land banks from distressed house builders for the progression of approvals and the sale back to them in due course (at a significant premium, of course).

What is your view of governance and service levels in the industry?

Compared with other asset categories which tend to have been analysed to death, property is probably still in its infancy as regards the availability of information on returns, risk, correlations, hedging and fees.Despite INREV's best efforts, there still appears to be confusion even over the definitions of core, added value and opportunistic. As part of the last review exercise, the fund's property managers were asked for analysis along those lines. Most understood what was required and had the information to hand. Certainly INREV and NCREIF in the US are doing a lot to try to address this situation and improve transparency and accountability through the collation of survey data on property vehicles, the production of statistics and setting reporting standards. The industry is responding, but there is still a way to go.

The issue of redemption rules has caused some concerns and confusion recently, with trust schemes varying and some managers able to act more quickly than others to agree redemption prices and protect remaining investors.

On the positive side, reports are received regularly and are usually informative and there is not a problem in arranging meetings with managers to discuss the specific portfolio and property market conditions generally.


Portfolio history

A 4% property exposure in the early 1980s had slipped down to just 1% (£3.5m) by the early 1990s as a result of no additions and the advance of equities in the 1980s.  The property portfolio at that time consisted of six PUTs - four UK general commercial and two US specialist, but the US PUTs were already in ‘wind down'. As part of the 1993 fund structure, the allocations available to both property and private equity (also about 1% at that time) were reviewed.  The debate at that time was whether to have a meaningful allocation to both or to hold nothing. The outcome was a 5% allocation to each (the minimum deemed ‘meaningful').  On property over the next few years, the two US PUTs and the smallest UK PUT were disposed of. Allocations to the remaining UK PUTs were increased to meaningful levels and sizable allocations were made to two additional UK PUTs. Private equity went through a similar but more dramatic transformation, but that is a different story.  By 2000, therefore, the fund had 4.9% (£26.8m) allocated to five UK PUTs.  At the 2000 fund structure review, it was decided to retain the 5% weightings on property and private equity as neither had quite reached target allocation, and there remained the tactical range on both of 3-7%, providing flexibility if the need arose.  On private equity, the decision was also made to start investing in infrastructure and the fund's first commitment (£3m) was made in 2001. In fact, over the seven-year period 2001-2007 £27m was committed to infrastructure at around £3m per annum. This reflects the general policy on private equity of committing reasonable amounts on an annual basis.  By March 2003, the amount committed to property through the five UK PUTs stood at 6.8% (£29.1m) - at the top of the tactical range, and the allocation to property (including infrastructure) represented 8.7% (£37.1m).  As part of the 1993 fund structure review, the allocation to property was increased to 7% (5-9% range); private equity remained at 5% (3-7% range).  On property the strong performance of UK commercial was noted, together with the expectation that returns were likely to moderate going forward after such a strong run (although, admittedly, this strong run did last longer than expected). As a result, the decision was made at that time to start diversifying the portfolio in terms of geography (overseas rather than UK), type (specialist rather than general commercial) and risk/return (added value and opportunistic rather than core).  As part of the 2006 fund structure review, the allocations to both property and private equity were increased to 8% (in the range of 6-10%) and the process of diversification continued.  By September 2007, the fund had 8.9% (£83.6m) allocated to five UK PUTs, one global, two Asia Pacific, one pan-European and six specialist funds, as well as a further 2.6% (£24m) in one global and five European infrastructure funds and a further 0.9% (£8m) in timberland  - a total commitment of 12.4%.