Commercial property investment has delivered strong returns in recent years in both absolute terms and relative to other assets. In the UK, for example, the IPD Monthly Index recorded total returns of 11.9% a year over the five years to the end of December 2001. The comparable figures for UK equities and gilts are 7.9% and 8.7% a year respectively. Yet many pension funds – particularly smaller schemes – have a minimal or zero exposure to property and have missed out on this strong performance. This partly reflects the difficulties in assembling a credible direct portfolio.
In recent years, a manager of managers (sometimes known as fund of funds) approach, where investment is made in two or more pooled vehicles, has increased in popularity. This article considers such an approach by examining:
q what are the difficulties in constructing a direct property portfolio?
q how has the UK property market responded in recent years?
q what are the benefits and disadvantages of a manager of managers approach?
Constructing a portfolio of directly-held properties can be more problematic than constructing equity or fixed income portfolios. This is because of property’s inherent characteristics, which include the following:
q Direct property is both heterogeneous (each property is different) and, in most cases, indivisible and ‘lumpy’. This means there is little commonality of ownership between one investor’s portfolio and another. By contrast, equities and bonds can be bought in small quantities. There is considerable overlap and commonality between different investors’ equity and bond portfolios.
q It is therefore difficult to assemble a diversified portfolio of directly-held buildings. Small funds find it particularly difficult to gain exposure to larger assets, such as shopping centres, retail warehouse parks, industrial estates or expensive city centre offices. Even medium and large funds will find that the largest properties may skew their portfolios significantly. By contrast, small investors can secure exposure to the larger value shares or bonds and, if a passive fund management style is desired, index-tracking performance is comparatively easy to achieve.
q Directly-held property is a private (unlisted) market. Financial information is generally not publicly available on individual buildings. Market indices are based on valuations rather than traded prices. Information is only publicly available on aggregated groups of properties, usually published with several weeks’ delay after the valuation date. Transactions are generally made through agents and can take weeks or months to effect. On the other hand, equity and bond prices are available on a minute-by-minute basis on individual stocks. Information on the market is readily available and the more mature markets are extensively researched. Equities and bonds are relatively easy to transact.
q Owning property brings the opportunity (and obligation) to manage the asset. Changes can be made to a building to enhance value, such as through lettings to new tenants, minor refurbishment or even complete redevelopment. Owning an equity does not bring any ability to exercise day-to-day management control.
These characteristics have important consequences for investors seeking to invest directly in property. One consequence is that property portfolios tend to exhibit a relatively high level of stock-specific risk. This is illustrated by figure 1, which is based on research using data from the Investment Property Databank (IPD) on 162 direct property portfolios with a 10-year history of performance. The vertical axis shows the amount of systematic risk; a fully diversified portfolio would be at 100% (with no specific risk); the closer to zero a fund is, the greater the proportion of specific risk as a proportion of total risk. Each fund is allocated to one of five size bands by number of properties, where five equals the largest.
The high level of specific risk of many funds that fall within the two smallest size bands is clearly evident. However, the pattern is not straightforward: some of the smaller portfolios appear to have diversified away quite a high level of specific risk, whereas some of the biggest funds have exhibited high levels of specific risk. Overall, the portfolios probably contain far higher levels of specific risk than would be expected in equity and bond markets.
Data from the WM Company show that weightings to direct property within UK pension funds have fallen significantly over the past 20 years or so. In 1979, property represented over 20% of total assets; it now accounts for around 5%. The reasons for this decline in weighting are outside the scope of this article, although the difficulties investors face in assembling a portfolio of directly-held buildings may be a factor.
But this change in allocation masks significant shifts in the ownership structures of property. In particular, the UK has seen massive growth in the value of property unit trusts, which are unlisted pooled vehicles as figure 2 illustrates.
Research by DTZ Debenham Tie Leung has highlighted the growth of limited partnerships over a similar period as another means of coinvestment.
The initial growth of these vehicles was largely fuelled by smaller funds that have tended to allocate their entire property exposure to one manager. More recently, however, some funds have followed a manager of managers approach, where a manager is appointed to invest in two or more pooled vehicles. The benefits and disadvantages of such a policy are as follows:
q Greater property diversification Exposure is obtained to a far larger portfolio than would be the case if the investment had been made to one vehicle. This helps to provide better diversification. For example, our current model portfolio for manager of managers clients has an underlying exposure to some £2bn (e3.2bn) of property. Therefore an investment of, say, £20m would secure exposure to assets worth 100 times that amount.
q Manager diversification The approach also provides a client with diversification across more than one investment manager. Allocating the entire fund to just one vehicle may provide greater diversification than would otherwise be the case with directly-held portfolios, but there has historically been enormous variability in the performance of pooled vehicles. Figure 3 shows the historic performance of pooled property unit trusts between 1994 and 2001. Annualised returns have ranged from 6.3% in one vehicle to 16.7% in another. The risk (as measured by the annualised standard deviation of returns) has also varied enormously (from 2.4% to 12%). The challenge for any investor considering a pooled route is therefore to choose the appropriate vehicle, and investing in two or more funds helps to diversify manager risk. Clearly, the aim is to select the right vehicles to secure the most efficient portfolio mix (that is, the highest level of return for any given level of risk, or the lowest risk for any given return). Such an optimal mix is shown in red on the following chart.
q Liquidity The spread of units across different funds means that the exposure to any one vehicle can be kept to acceptable limits. It is generally possible to transact units more easily than would have been the case if investment had been made in a single vehicle. In addition, it is often possible to enter and exit the market on a matched bargain basis, whereby the transaction costs are shared between vendor and purchaser. Client performance is thereby improved.
q Active management The ability to invest across different managers’ vehicles enables the lead fund manager to shift the portfolio towards particular asset types or themes (for example, towards a particular sector or yield bias) by investing in certain funds. This portfolio mix can be altered through time to reflect changing market conditions and forecasts.
q Flexibility/relationship with other parts of portfolio For larger funds that are better able to assemble a portfolio of directly-held properties, having the ability to invest in pooled vehicles as part of the overall portfolio can also be beneficial. Such an approach means particular asset types or specialist investment management skills can be accessed alongside the rest of the portfolio.
There are, of course, potential disadvantages with the manager of managers approach. These include the following:
q Overall portfolio management costs can be slightly higher than investing in one pooled vehicle. It is therefore important to ensure the benefits to performance more than compensate for any higher costs.
q Larger funds may find that the benefits from investing all the portfolio through such route do not apply: they are more able to construct a direct portfolio and their desired weighing to some pooled vehicles may be too large. However, as noted above, pooled vehicles may usefully form part of the total property exposure.
q It is important to appreciate that lowering downside risk also means that potential upside performance is limited.
q In most parts of continental Europe, there are relatively few pooled vehicles available to investors, partly due to the differences in maturity of real estate markets. However, new vehicles are being created (including the Pradera fund, which invests in out-of-town retail property). Over time, the market can be expected to grow as more funds are created, thereby widening investor choice.
Guy Morrell is chief investment officer, global property, at Henderson Global Investors in London