The use of gearing has been a relatively hot topic recently. Fund managers (particularly those lagging their peers) have been raising it as a reason for relative underperformance. My field consultant colleagues want to understand the impact it has had on performance and what our (pension fund) clients should do about it.

In this article, I look at the extent to which gearing is used; how much gearing has been used in recent years by property managers; whether it has worked, and whether a point has now been reached whereby the level of gearing should be reviewed.

For the purposes of this article, I define "gearing" simply as when fund managers borrow to supplement the equity or capital raised from their investors.

Gearing is generally permitted for pension funds (subject to individual funds' trust deeds). It is perhaps of interest that it raises few eyebrows, as to do so within an equity portfolio is unlikely to be acceptable. In contrast, gearing or leverage is essential to the performance of tactical asset allocation and even currency hedging.

The latest regulations1 state that schemes should not borrow but the UK Government has clarified that this should refer to cash borrowing only, and is not meant to restrict activity in areas relating to efficient portfolio management. For the rest of this article, we assume there are no legal barriers to pension funds using gearing within their property portfolios.

There are three main reasons for using gearing:

■ It may take time to raise a meaningful level of commitments from investors or a client, which will inhibit the manager's ability to implement a sufficiently well-diversified portfolio. Remember that it now takes tens of millions of euros to start to get reasonably diversified exposure, with individual property lots often running well into eight figures.

■ The fund manager will look at the cost of borrowing, the yield available from deploying the capital available into property, and capture what may be viewed as a "free lunch".

■ Some fund manager products rely on high levels of gearing to achieve high internal rates of return (IRRs).

To develop the last point, Figure 1 demonstrates the broad spectrum of property options. We would expect there to be high levels of gearing for the opportunistic funds but little or none at the low risk, income focused end.

As well as magnifying the performance, the main issue with gearing is that it introduces a new source of risk - namely the potential for returns to be affected by interest rates in addition to the usual market and specific risks associated with property. To date, this risk seems to have worked for investors, but is this likely to continue?

In continental Europe, unlike in the UK, there is a proliferation of new, closed-ended, finite-life vehicles, focusing on specialist areas.

To date, there have been few genuinely pan-European balanced vehicles although the position is changing. Moreover, the use of opportunistic funds with high projected IRRs gives rise to a greater likelihood of the use of gearing.

Data from INREV2 suggests the "value added" funds have gearing levels of 30-70%, and the "opportunity" funds have gearing levels of 60-100%. DTZ3 identify that private debt outstanding to the real estate sector exceeds €800bn, with the German, UK and French debt markets accounting for more than half of this total. In their view, "the privately financed investors are expected to remain the key source of equity [for the UK] over the next twelve months." The upward drift in permitted gearing levels appears to be a European phenomenon
as well.4

The other key differentiator between continental Europe and the UK has been the relevant position of the yields on offer in each market versus the cost of borrowing. The ability to borrow in one region at a low rate and pick up the higher yield from another has been a key driver behind the actions of cross-border investors in recent years. One good use of gearing is that gearing can provide a "tax shield" for investors who may otherwise suffer tax on non-domestic investments.

The classic example is of Irish investors borrowing against European rates to fuel investment in UK property. Figure 2 gives an indication of the relevant costs of borrowing (five-year swap rates in the UK and Europe) and the property yields available in the UK (the IPD initial yield).

The graph indicates how the gap between the cost of borrowing and the yields available has narrowed (and even disappeared) in recent months. The "free lunch" has disappeared (to the extent it was ever there). So what are fund managers doing in terms of gearing, and how should pension funds fiduciaries be reacting?

It is difficult to get detailed data on the use of gearing within segregated accounts. I have therefore looked at data within the HSBC/AREF survey. This covers pooled property funds, namely balanced funds (covering a mixture of PUTs, managed property funds (MPFs) and other structures) as well as specialist funds (typically sector or asset specific funds). Note that there are a vast number of limited partnerships which are not included in this survey, and all data relates to UK vehicles.

One immediately noticeable issue is that the seven MPFs have no gearing. This is because of a legal restriction in their construction preventing borrowing. Of the remaining twenty one balanced funds in the survey at 30 June 2006, fifteen had some gearing. (Note that the other six non MPFs are likely to again have some restriction on the ability to borrow rather than choosing not to borrow). So in total, while only 54% of the balanced funds in the survey by number carried some gearing, this rises to over 70% when MPFs are excluded. The conclusion is that most managers who can borrow within their pooled funds are choosing to do so.

Those balanced pooled funds with the most significant levels of gearing tend to be funds established fairly recently ie gearing is being used to obtain market exposure while the fund builds up in size. Figures 2 and 3 summarise the position as at 30 June 2006 by identifying the gearing within each fund in the survey, and also the correlation between fund size and level of gearing. Most of the larger funds use relatively modest levels of gearing at this time.

Overall, this initial analysis would suggest that the use of gearing in balanced UK vehicles is prevalent, although it is not always used to a great extent where it is permitted.

The level of gearing is higher in newer (and therefore smaller) funds.

The Reading University report 5 seems to confirm this, noting a steady rise in levels of permitted gearing for funds launching from the mid 1970s.

Moreover, the drift towards offshore status for many PUTs will offer the chance for higher levels of gearing than might have been seen amongst UK domiciled funds due to the different regulatory environment.

Turning to one of our earlier questions, how has gearing affected investment performance? This is a harder question to answer than it first appears. Detailed analysis is required in order to strip out the impact from gearing and manager skill.

The question is worth posing however, not least if there is a suspicion that gearing is actually hiding a relative lack of skill at the fund manager. This is a crucial question for pension funds and consultants, if they are to ensure that they are with the best managers over a complete business cycle.

I understand that this is an area that IPD are looking at, which would be a welcome development. Suffice it to say that the gearing data has now been moved to sit alongside the performance numbers in the survey!

Figure 4 gives some idea of the correlation between those funds with gearing (at the moment) and their performance over the three years to 30 June 2006.

(Noting its technical limitations, a similar analysis could be undertaken to check whether the relationship has been stable at different points in time.) Note that this analysis only picks up funds with a three year track record, by definition excluding newer funds with the highest levels of gearing.

These data exhibit a correlation coefficient of 0.59, and the graph certainly seems to indicate that the managers with best relative performance over three years to end June 2006 are likely to have run higher levels of gearing than their peers. This does lend some credence to those managers who have pointed out their lack of gearing has made it hard to outperform their peers.

A number of fund managers have either made the point verbally, or produced documents, outlining their view that the level of gearing should now be reduced within portfolios. To quote Schroders,6 "most property is no longer self-financing…the rate of growth in bank lending to commercial property has slowed…more cautious attitude from lenders…property looks less attractive to debt-led investors".

From our discussions, we do see some fund managers "walking the talk". They are reducing the level of gearing in their pooled funds. They are doing this in a number of ways. For example, some fund managers will use cash raised from investors or asset disposals to pay down borrowing.

This is potentially a "win/win" for investors - cash levels are kept to a minimum and the gearing is reduced at an opportune time. Other fund managers are increasing the proportion of directly held portfolios in their pooled funds, and reducing the proportion in indirect vehicles (many of which are specialist and thus run high levels of gearing).

We are aware that the multi-managers continue to monitor the level of gearing their portfolios are exposed to from using third party vehicles.

This attitude is undoubtedly also being influenced by the medium term outlook for markets. If property market returns are expected to return to normalised levels in the next few years, gearing is likely to have a lower impact on returns. Moreover, although few (if any commentators are predicting this), were markets to go into reverse, geared funds would normally be expected to perform worse in that environment.

For our part, we would acknowledge that gearing is an inevitable component of opportunistic funds and investors realise that risk levels will be higher in these types of funds.

We see little role for gearing in the income focused funds - why would investors want to pay away the very income they are trying to secure for themselves? As a result, we would have no view on gearing being a good or bad thing per se.

The interesting "battleground" is in the core space. It is unlikely that the impact of gearing will be so pronounced in the next few years although it would appear to have had an impact in recent years.

We look forward to measurement methodologies which help strip out the impact of gearing so that true manager skill can be identified. Consultants should draw out each fund manager's approach to gearing so that its implications can be understood by the client.

Footnotes: 1. The Occupational Pension Schemes (Investment) Regulations 2005

2. INREV Vehicles Database Analysis, November 2006

3. "Money into property", DTZ, July 2006

4. "The use of leverage in non-listed real estate vehicles investing in Europe", Nappi-Choulet et al, June 2004

5. "Financial innovation in UK property markets - a review of trends and prospects" The University of Reading for the Corporation of London, October 2004

6."Drop the debt", Schroders, September 2006


Greg Wright is principal at Mercer Investment Consulting