US public-pension funds significantly underperform their global peers in real-estate portfolios due to a propensity to manage the assets externally, according to a new ICPM-sponsored research paper by three Maastricht University academics.
Value added from funds management in private markets: an examination of pension fund investments in real estate looks at real-estate investing among the 880 pension funds on the CEM database from 1990 to 2009. On average the allocation to real estate was 5.5 per cent, but fluctuates over time.
The paper by Aleksandar Andonov, Nils Kik and Piet Eichholtz examined the funds’ approach to investing in the asset class, costs and performance.
The paper found that US funds, both small and large, underperformed their self-reported benchmark by a whopping 127 basis points per year. Furthermore, their costs were twice as high as their global peers.
“I would be asking how it is possible that you do this and you keep on doing this,” Eichholtz says.
“This paper found that a fund’s approach, size and geography determine the cost and performance in real estate. You can’t choose to be a US or non-US fund, but you can learn from your peers.”
The paper found that while large pension funds overall are more likely to invest in real estate, they invest internally and have lower costs. They also have some exposure through real-estate-investment trusts (REITs) and few fund-of-fund investments.
Smaller funds are less likely to invest in real estate and more likely to invest in funds of funds.
Eichholtz said with regard to costs, the biggest driver is the approach decision, how a fund invests from internal management to funds of funds.
He said geographically there were some interesting results: US funds were more likely to invest externally, regardless of their size, and pay higher fees.
“It’s as if the real-estate-investment management industry in the US is able to charge higher fees,” he says. “The costs don’t lie in the pension funds but in the service industry, and in the US it is tens of basis points more. US funds pay far more for external managers and are more likely to retain managers. It’s double crazy.”
Eichholtz describes funds of funds as “way beyond expensive” and believes smaller funds would be better off getting real-estate exposure through REITs than funds of funds.
Another finding of the paper was that the more expensive the strategy, the worse the performance.
Internal management was the best performer across the board, both before and after fees. At the same time, Eichholtz says, funds of funds “destroy value in two ways” through costs and picking the wrong investments.
He has some practical advice stemming from the results of the paper: if a fund is big enough, it pays to manage real estate internally.
“There is a lot of low-hanging fruit, funds that are big enough and could go internal, especially in the US.”
If you’re small, he says, avoid funds of funds and invest in REITs, and if you don’t want listed exposure then he proposes investing in a syndicate.
An example of this is in The Netherlands, where there are three large real-estate funds established by pension funds, Amvest, Aldera and Vesteta, the latter started by ABP and now open to a large group of investors.
They key, Eichholtz says, is that the management organisation is owned by the shareholders of the fund (that is, the pension funds) so there is no conflict of interest.
“The owner pays the salaries. There is a 30-basis-point fee, no bonuses or incentives.”