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In organisational terms there isn’t a stone unturned at University of Toronto Asset Management (UTAM). The organisation has a new board, new staff, new risk and reporting systems and has restructured its portfolios, including a new policy portfolio.

Where previously the assets were managed in a traditional method, with public market assets and alternatives allocated across a benchmark portfolio, now a low-cost passive reference portfolio is the starting point for investments. The portfolio is assessed in risk-driver terms including equities, interest rates, cash, inflation and currency.

The settings

This passive, low-cost easily implementable reference portfolio was set at Canadian equities 16 per cent, US equities 18 per cent, international developed market equities 16 per cent, emerging markets equities 10 per cent, credit 20 per cent and rates 20 per cent.

Of course the actual portfolio in 2012 was quite different to the reference portfolio, with UTAM “believing” in active management.

The actual allocations at the end of 2012 were Canadian equity 15.9 per cent, US equity 17.9 per cent, international developed market equity 16.4 per cent, emerging markets equity 10.2 per cent, credit 19.8 per cent, rates 10.9 per cent and absolute return 8.9 per cent.

“We have changed the place quite considerably in the past four years,” Bill Moriarty, the chief executive and president of UTAM, says.

“We have gone to a simple reference portfolio concept. It’s easy, implementable and passive. What drove the allocations was the risk tolerance and budget of the organisation. We also acknowledged that risk, in terms of volatility and other risks, is not static, so the risk budget should be reference portfolio plus an element of active management,” he says. “We looked at it as beta risk and active risk, then created a portfolio around that.”

Once the reference portfolio was approved, he says the team “looked inside each area and then found the best way to gaining exposure to the risk over time”.

“It gave us the basic beta portfolio, then we look at whether we can build a better beta portfolio with strategies and then we think of the best managers,” he says.

University of Toronto Asset Management manages three pools of money on behalf of the university. The endowment and pension portfolios have a target return of 4 per cent plus CPI, the target of the Expendable Fund Investment Pool, which is the university’s working capital pool, is the 365-day Canadian treasury bill plus 50 basis points.

Positioning risk

Over the past 12 months UTAM has also implemented a position-based risk system, which went live in December 2012.

“I have more grey hairs than I did a year ago,” Moriarty says. “This is easier to implement for traditional long-only strategies but is more complicated with hedge funds and privates.”

University of Toronto Asset Management has also been working with Morgan Creek Capital, which is an investment adviser, built specifically to advise clients on the endowment model.

It has used State Street’s web-based truView market risk-management tool, which feeds into other international fund services applications, and is specifically aimed at the needs of hedge funds and hedge funds of funds.

“The hedge fund strategy is an evolving area where we are working with the university,” he says.

“On the private side, we pulled apart the commingled funds to understand the investments, proxied them with public investments and everything was put into portfolios. It means we can now look at our allocations across, say, regional or industry concentrations.”

“This has taken a lot of time to implement. We’ve found it very useful, and it’s told us some things that weren’t obvious, like some of our currency risks weren’t quite as obvious from the top down as when you look at granular level.”

The foreign currency hedging policy has also been changed, and is now set between 5 and 25 per cent of each portfolio’s total value.

One of the results of the new risk allocation model is that the portfolio is very underweight interest rate risk.

“Our rates exposure is now half of the policy portfolio and we have no exposure to high yield,” he says.

Performance plus

Moriarty is proud of the team’s performance, which he says has been steadily improving relative to the benchmark over the years.

Tens of millions of dollars in costs have been taken out of the portfolio as it comes up with strategies to create a better beta portfolio. Despite that, UTAM still has a large number of service providers, with more than 50 managers under the growth/equity critiera, 22 in income/credit, two in rates and 11 in the other category.

One of the enabling factors for all of the change at UTAM has been a new governance structure.

A large board has been reduced to five directors, which deals only with operational risk, strategic vision and budgets. The university has an investment advisory committee, with investments delegated to and implemented by UTAM.

“This structure focuses the board on the critical elements of managing the portfolios, which is setting the long-term risk and return targets,” he says. “Before the board was much larger and there was perhaps some lack of understanding or explicit statement of responsibility.”

Geraldine Leegwater, ABN AMRO Pensioenfond’s director, talks about her fund’s investment strategy process with a matter-of-factness that possibly belies how far it has moved established ground. While Leegwater sees logic at every vantage point behind the changes that she helped to introduce at the Dutch banking giant’s €18-billion ($24-billion) fund in 2007, she skips from one of its remarkable features to the next.

The most innovative part in her view is the setting of the fund’s strategic asset policy. The ABN AMRO pension fund trustees theoretically wipe the slate clean and pick their favoured policy from a wide-ranging list of 10 options every 12 months or so.

To keep any subjective views on asset classes out of the equation, the options are presented to the board of trustees purely on the basis of figures representing the most relevant criteria for them, such as indexation potential and downside risk. The underlying asset mix is then only revealed after the most suitable option is chosen from the range of projections. Leegwater recounts how there were some shocked faces at times in the first few years when the underlying strategy was unveiled, but these would fade when the reasoning was discussed. Regular asset-liability management studies are conducted, after all, to inform the risk-return forecasts at these all-important strategy meetings.

The trustees are nonetheless given the chance to launch a radical break in strategy on an annual basis. “The goal of our trustees – to generate sufficient return to pay indexation to participants with the lowest risk – has remained the same over the years, but the amount of investment risk you need to achieve this goal can differ over time,” Leegwater explains.

Remarkably though, the risk return-focused process has led the fund to continually reselect a dynamic liability-driven investment (LDI)-based asset allocation strategy. This has been in place from the first decision meeting under the new structure in 2007 to the most recent in December 2012.

Dynamics, not tactics

The LDI component of the strategy has resulted in a familiar separation of assets into matching and return portfolios. The matching portfolio invests the majority of the funds’ assets in interest-rate swaps, government bonds and highly rated short-term paper.

The return portfolio is the smaller alpha-seeking segment. It is dominated by developed market equities (70 per cent) with smaller emerging market equity, corporate credit and real estate buckets taking 10 per cent each.

The weighting between the matching and the return portfolios is set at the strategy-selection meetings and, like the investment strategy itself, can be revised dramatically. An increase in the return portfolio from 14 per cent to 43 per cent throughout the course of 2009 is the best evidence of that. Leegwater explains that this leap was made as during the selection meeting it became clear that a higher allocation to the return portfolio was required in order to achieve the goal of the board of trustees for a high indexation potential against acceptable risk.

The current dynamic strategy is such that during the year the matching portfolio is fixed to a set level. However, the dynamic element sees the weighting of the return portfolio float in relation to the latest funding ratio at predetermined rebalancing moments during the year. The exact consequence of a given funding ratio for the return portfolio is determined by the annual strategic asset allocation decisions. All in all, this helps to ensure that the focus is on the primary goals of the fund at all times.

Leegwater explains that an intriguing consequence of the dynamic asset allocation approach is that the natural bias of the strategy is for pro-cyclical investing in between the usually counter-cyclical moves at the yearly strategy meetings. This approach seems to be working well for now, with Leegwater happy to let the structure run its successful course. However, she is fully aware that this is dependent on the behavior of financial markets, with high volatility presenting a risk between annual strategy-setting decisions.

Another consequence of the dynamic strategy is that Leegwater and other managers have no tactical asset allocation calls to make whatsoever, and can therefore focus on liability projections. Leegwater is content with that too. “We don’t have any illusion that we can beat the markets,” she says, conceding the approach is not dynamic enough to react to rapid changes in markets as the portfolio is assessed only a few times per year for deviation from the planned strategy. Nonetheless she argues that each strategy-setting meeting offers a chance to compensate from any unintentional surfeit or deficit of risk taken into the portfolio over the last year due to market biases.

The refusal to make tactical investment calls means that the weightings within the return portfolio are followed entirely without any under- or overweightings. The strategic make-up of the return portfolio is currently under review “and if we find a portfolio with more efficient risk-return qualities, that will go under consideration”. Leegwater admits that this could see alternative asset classes make an appearance in the ABN AMRO fund’s portfolio.

Liberated leverage

When Leegwater says that the fund has around 80-per-cent exposure to the matching portfolio and another 40-per-cent exposure to the return portfolio, it is obvious that an added piece of financial wizardry is at play. The ABN AMRO fund leverages it assets, an action it first embarked on in 2009. Leegwater says the fund is not unique in leveraging its assets, but possibly unique in openly reporting it. “I think there are many pension funds that have, say, a 50-per-cent fixed income and 50-per-cent return portfolio and state they are hedging what they call 70-per-cent of the liabilities,” she says.

Leegwater explains that the leveraging can be gained by investing in interest-rate swaps that don’t require up-front funding. Interest-rate swaps are a necessity for a Dutch pension fund looking to hedge risk on long liabilities, she points out. Leveraging is a position that has its natural limits though, as it requires both sufficient liquidity (interest-rate swaps expose a fund to short-term interest rate movements) and collateral.

Flexible fund

Altogether the approach has led the ABN AMRO fund to a fairly serene position for the time being. The latest funding ratio is 119 per cent under new Dutch central bank criteria – ahead of the 114 per cent legislated solvency target – although the funding ratio is a more modest 111 per cent in the fund’s own calculations, based on market rates.

The healthy surplus has seen steadiness become the current flavour of the dynamic strategy, with only minor changes made to the size of the return portfolio in the past year. The surplus contributed to a decision for the risk appetite to be slightly lowered by reducing the return portfolio at the last strategy-setting meeting in December. “The better the coverage ratio, the less excess return you need,” Leegwater points out, despite conceding that the fund’s capacity to take risk has also increased.

Few could argue with Leegwater’s reasoning when the ABN AMRO fund boasts investment returns of 14.3 per cent for 2012 and 16.1 per cent in the difficult year of 2011. While Leegwater reckons much of the success of the new investment structure and dynamic strategy came from its flexibility to shed risk at the right time, the complex pension solution is fully answering its sponsor’s needs for now.

Mention any asset class to John Pearce, chief investment officer of Australian superannuation fund UniSuper, and he will doggedly set out the good and bad thinking around it. A common source of his ire is the sight of investors herding around a belief based on a lack of rigorous thinking. Good practice for him involves standing up to accepted thinking or at the very least, like a chess player, anticipating the permutations ahead.

It is the mindset one would want from someone responsible for 479,000 members and $36 billion, but it also comes with a dose of self-righteousness quite understandable in someone who has called a lot of good decisions since the global financial crisis.

The complexity of equities

One of his favourite topics is the right way to invest in equities.

They are too broad to be dismissed in a simple growth-versus-income argument he reckons, distinguishing this by comparing an equity in a small-cap mining company that has not yet made money with low-geared companies such as Telstra or a property trust, which, as he says, “spits out cash”.

“Around 12 to 18 months ago, we had a bunch of prominent people coming up and saying Australian superannuants were crazy for having so much of their exposure in equities, and that there should be much more bonds. [Since then] we have had a 20-per-cent rally in equities, so hopefully nobody took their advice.

“If they are saying that superannuants should not have a lot of their life savings in high risk mining stocks, I totally agree. But I would prefer to own these lower risk equities than government bonds at 3 per cent. Absolutely I would prefer to own the equities.”

While he recognises that bonds will occasionally outperform equities, in current markets no one is going to convince him that bonds will do better.

“Australia has a real problem keeping inflation below 2.5 per cent, so you have got real returns of 0.5 per cent or 1 per cent [on a bond yielding 3 per cent],” he explains.

This reasoned bet has worked well for UniSuper’s defined benefit scheme, which holds 40 per cent of his fund’s total assets. Its funding fell to as low as 82 per cent during the global financial crisis, but has now rebounded to 96 per cent.

“A lot of defined benefit funds around the world after the GFC went about neutralising their exposure, duration matching, etcetera. We bought equities – not a scatter-gun approach – we bought moderate-risk equities, REITs, Australian banks. We loaded up on those and we benefitted from this massive rally in the equities market.”

Asia calling

Sitting behind Pearce is one of the strongest investment committees in Australia. One of its specialties is Asian investment. Most recently Ian Martin, the former chief executive and chief investment officer of BT Financial Group, joined as independent director, and he combines this role with acting as vice chairman of Berkshire Capital Securities Asia Pacific. Another director, Professor Michael Skully from Monash University, is an expert on Asian finance.

Asia is another of Pearce’s favourite topics, and UniSuper’s bias and knowledge of the region makes it more bullish about global growth and the future than other institutional investors. Close to half of its equities are offshore and most of that is based in Asia, where the opportunities for growth make Pearce passionate.

“If you spend some time in Asia, you will find a different outlook,” he says. “In the West you have rich westerners worried about preserving their wealth rather than Asians, who are much more positive about the future and looking to increase their wealth. They have a different perspective on the world.”

It is as if Asia has the same take on the future as him. He cites the region’s positivity about the next 20 years as one of the reasons he is bullish on investment returns staying high, in contrast to doomsayers who believe global warming, conflict and a lack of resources will slow growth.

As with equities, though, this is no blanket approach and Pearce is quite particular about where he invests.

So, while the fund has emerging markets investments, it has no explicit mandate for emerging markets, it focuses on sector andregional approaches – particularly Asia, where its exposure is managed by T Rowe Price, Schroders and Platinum.

China is central to the Asian growth story, but peculiarly Pearce is not that keen on direct exposure.

Indirectly in China and Japan

“We don’t like investing directly, but we like the Chinese story, so we allocate money to funds and strategies that are going to leverage this great secular Chinese story, but we do not really want to buy Chinese companies.”

For him the company data cannot be relied upon.

“Having worked a few years in China, [I know] it is not a capital friendly place to invest. The main reason is that you have got factor pricing distorted by the government, so when you have got capital sloshing around the system, capital gets misdirected when your factor pricing is not right.”

He points out that while Chinese GDP has outstripped the United States several times over, the US stock market has outperformed the Chinese stock market. He concludes that companies in China are not managed for the benefit of their shareholders, and in particular he avoids Chinese banks.

“We would not override the decisions of those managers, but the one thing we have been strong on is limiting the exposure to Chinese banks,” he says.

In India he sees potential for a boom of the likes “never seen before”, but despairs of a governing system that stands in the way of development and growth.

The fund has recently reduced its “perennially short” position on Japan, but he is unsure if the current round of liberalisation and quantitative easing is a turning point or a “false dawn”. He believes Japan must open up its industry and agriculture to competition from abroad to succeed.

“Let’s see whether [Japanese prime minister] Abe has got the will to bring in reform that is against the interests of his constituency. There is a big question mark over that. But no one can deny that there is not a big sugar shock being injected into the economy right now.”

Better in house

One of the fund’s beliefs is that it can better manage these complex themes – and the external managers who invest in them – if it is running most of its Australian investments in house. Building up this area has been one of Pearce’s main tasks since he arrived three years ago and through a process of “logical incrementalism”, as he puts it, he has built up Australian large-cap equities, Australian fixed interest, cash and listed Australian property in house to a level where it represents 35 to 40 per cent of all assets.

“That is one of the reasons I took the job,” he says. “I came with a mandate to build that capability. We work on the plain vanilla strategies. We know our limitations. I have to be very confident that we can do at least as good a job as an external manager. It does not have to be better because I am doing it much more cost efficiently.”

He is content with what he has built and is not currently looking to expand this expertise externally.

“We are a large fund with steady inflow. We have already got economies of scale. We do not see the imperative to open to the public for the time being, but let’s see what the future holds.”

Even the most successful and well run pension plans are facing underfunding challenges. The $129-billion Ontario Teachers’ Pension Plan is the latest to investigate solutions to solve the mismatch between the pension promise and the funds required to meet that, says Jim Leech, chief executive of the organisation .

OTPP has appointed a taskforce – chaired by Dr Harry Arthurs, former dean of Osgoode Hall Law School in Toronto, president emeritus of York University and chair of Ontario’s pension commission – to investigate how to reduce the cost of the mismatch caused by the difference in the time members spend in work and retirement.

Among other generous benefits, OTPP has generous early retirement benefits and on average teachers work for 26 years and retire for 31.

“We can change benefits to deal with these things or change the rules around some of those promises, and this is what the taskforce is all about,” Leech says.

The task at hand

He says the taskforce will look at how to reduce the cost of the mismatch and is investigating about nine different options. This will be reduced to three and then discussed with the membership.

“For example, we have generous re-employment rules, and we fund the mismatch between a member getting the Canadian pension and retirement. Why? It is just encouraging people to retire early,” Leech says. “All of these things impact the demographic of the workforce. It shouldn’t be the pension plan driving this; the employer should be driving it.”

The taskforce will also look at intergenerational risk, which now falls on the shoulders of younger and needs to be resolved, he says.

OTPP brought in inflation protection, now 100-per-cent conditional, which Leech says has gone a long way to building in flexibility into the fund.

“We are about 75 per cent to solving these problems, and now the taskforce is completing on that,” he says. “Every year a decision is made whether pensions are increased on the rate of inflation depending on the condition of the plan’s funding status. This is the perfect toggle to use in managing the plan. It is now dialled back to 45 per cent, but it can go as low as zero. If times are good, then it can go up.”

OTPP member benefits are calculated as two times the number of years worked multiplied by the best five-year average. Now there is no guaranteed inflation protection on that.

Leech says by introducing that initiative, the liability has been reduced by about $12 billion.

The fund is in a relatively good position, compared with its global peers, and is currently 97-per-cent funded.

Global context

OTPP is globally regarded as a leader in governance among pension plans, and Leech says it is its governance structure allows the sponsors to address the funding shortfall.

“It is 50-50 shared between the employer and employee, so it is in both of their interests to solve this. With most US pension plans, it’s still part of collective bargaining.”

The fund has produced a documentary that highlights the underfunding issues facing pension funds around the world, educating the public on the effects of the financial crisis, low interest rates and demographic changes.

Part of the impetus of the video was to put OTPP’s problems in context, he says, that this is a global pension phenomenon.

“The fallout of the financial crisis, in particularly low interest rates, means the prognosis for growth is not good. Our plan is extremely interest-rate sensitive. If interest rates go down then our bond portfolio goes up, but our liabilities go up even faster. We are constantly trying to manage that. Our liability-driven investing has increased and in the past five years have pushed that way – real estate, commodities, infrastructure. We also have an enormous bond portfolio, about $60 billion, which is almost entirely in Canadian and US sovereign bonds.”

Meanwhile the fund continues to expand, and has just opened a Hong Kong office.

OTPP allocates about 15 per cent of the fund to emerging markets and will increase that to 20 per cent in the next couple of years.

“It is estimated that 80 per cent of the world’s trade will be intra Asia by 2025. If that is true, then we think you have to be there,” he says.

Leech will retire this year after 12 years at OTPP and a tenure as only the second chief executive of the fund. Head of fixed income and alternatives, Ron Mock, will take over the role.

Leech identifies four factors in OTPP’s success, with the governance structure at the top of the list. He also says the culture, which is very learning-based, and humility of its professionals plays a big part. The fund’s proprietary risk system, which is instrumental in the fund allocating according to risk, not asset classes, is its secret sauce, he says.

OTPP has 1000 employees, about 275 of whom are investment professionals.

Australia, the US, Canada and Denmark have all done it. Kazakhstan and even Oman are talking about it. Increasingly, public sector pension funds are merging or pooling their assets into fewer bigger schemes. It’s no surprise the debate is gathering momentum in the United Kingdom, ripe for consolidation with a Local Government Pension Fund Scheme (LGPS) populated by 89 separate funds with combined assets of £187 billion ($288 billion) but all run individually. The government is conducting a review that could lead to mergers or the pooling of assets, and one of the biggest local authority schemes, the $6.5-billion London Pension Fund Authority, is spearheading the push for half a dozen regional funds of $30 billion to $46 billion each in a drive for efficiency and economies of scale. But the UK is behind the consolidation curve because most local authority schemes remain lukewarm on the idea. With the success of large, private sector funds such as the charitable foundation Wellcome Trust and Railpen, the merged fund for the rail industry, showing that big is best, it’s time for local authority schemes to come together.

Matching liabilities and hedging

Fewer bigger funds will mean schemes are better able to invest in the resources and skills needed for liability-matching strategies. Apart from a few exceptions such as the $1.8-billion Cornwall Pension Fund and the $2.3-billion Royal County of Berkshire Pension Fund, only a handful of local authority schemes hold liability-matching assets or have any hedging strategies in place. Yet LPGS’s are beginning to mature because of the government’s austerity policy forcing public sector cuts. As local authorities scramble to save money, many have slashed payrolls and encouraged voluntary retirement, triggering an early maturing in many schemes. Examples include the $15-billion West Midlands Pension Fund, which recently said it is preparing for a shift in investment strategy to reduce risk and prioritise the protection of funding levels, and Scotland’s $17-billion Strathclyde Pension Fund.

In their defence, schemes say they’re not hedging their risk because of a lack of know-how, but because of regulations dating from a 1998 Pensions Act that makes no provision for derivatives in investment strategies. It leaves liability-driven investment difficult and expensive. The $2.6-billion Dorset Pension Fund, a third fund with a hedging strategy, had to set up a special investment vehicle to circumnavigate the restrictions and manage its inflation risk. Schemes also argue that despite their maturing profiles, what they are facing is more like mid-life crises. Most local authority schemes are still open to new members; they are still in growth mode, less mature and with time on their side they aren’t de-risking or wanting to hedge liabilities anyway.

Simple economies of scale

Where the argument for consolidation makes even more sense is the fact bigger funds are better positioned to either invest directly or co-invest in alternative asset classes. Co-investing in private equity, whereby schemes portion some investment to private equity funds run by managers but the rest goes directly into the same projects in which the fund is investing, incurs a fraction of the fees and enables schemes to better tailor their exposure. But it’s only a strategy open to the biggest schemes. It’s the same when it comes to investing in property or the government’s pet asset class, infrastructure, where giant Canadian and Australian funds’ huge infrastructure allocations have proven that moving as a pack is best.

Encouraging signs of schemes’ willingness to pool funds already exist, such as the $25.5-billion Greater Manchester Pension partnering with Argent, the property arm of BT pension fund in a $154-million office development in Manchester. The Pension Infrastructure Platform (PIP) is another effort by schemes to pool assets in a collective investment vehicle to tap infrastructure.

Larger funds would also have the capacity to build inhouse investment teams. No fund under $15 billion can really afford its own investment team, yet some of the small funds have more managers than the big funds. It can lead to confused, contradictory investment strategies and doesn’t improve performance; the asset management of small council funds comes with much higher fees than larger funds can negotiate.

Any pooling of assets or scheme merger is bound to result in a few years of turbulence and a loss of momentum in investment strategy. And economies of scale can easily turn into diseconomies of scale as asset classes become exhausted. Yet nearly 100 individual schemes of several billion dollars each can’t pack anything like the investment clout of fewer bigger schemes. It will be tricky to keep local accountability, and changing the law or setting up a centralised body would be expensive, but as far as investment strategy goes, big is beautiful.

Real estate is back in fashion, at least according to a range of recent surveys indicating the growing institutional investor appetite for bricks and mortar. After a tough few years for the industry and with European investors’ priorities changing, the possible renaissance might come with a marked change in investing patterns, though.

More control

The talk from large investors is frequently about gaining more control of their real estate investments, says Casper Hesp (pictured below), research director of European non-listed real-estate-fund investor association, INREV. His group has found that there is significant appetite from European investors to access real estate via joint ventures and ‘club deals’ – essentially small funds with carefully aligned investor priorities. The €29.5-billion ($38.44-billion) Finnish fund, Ilmarinen, and the $170-billion Dutch pension manager, PGGM, have both recently announced major real estate joint ventures.

Robert Stassen, head of capital markets research at real estate consultancy Jones Lang LaSalle, agrees there is a growing trend for direct investment. “One of the natural consequences of the crisis has been for funds that may have previously only invested indirectly to look at an alternative way of accessing real estate,” he says. These are generally being explored by the largest funds though, with those lacking the investment infrastructure for novel funding vehicles or direct investing still reliant on real estate funds, according to Stassen. Clemens Schuerhoff, managing director of the Kommalpha consultancy in Germany, says that liquidity crises in both the open and closed-ended mutual real-estate-fund industries in the country have enhanced the trend towards greater direct investing there.

Unipension, the $17-billion Danish pension provider, has recently shown enthusiasm for real estate funds, however, announcing it would sell its entire direct domestic portfolio and invest in international funds in order to gain “better risk diversification”. According to Hesp, “when the market becomes more positive, I think larger investors will turn to funds again”.

Noticeably, recent cheerfulness about real estate investing appears to have infused investors more in some regions than others. Areas where disappointment in the downturn was hardest felt are seemingly slower to return to investing in the asset class.

A study from alternatives research company Preqin found that Asian institutional investors are more than twice as likely as European ones to invest in real estate funds in 2013. “Asian investors weren’t hit as hard in the downturn as US and European investors, and a lot of Asian investors are also more recent entrants to the asset class,” says Andrew Moylan, Preqin’s real-estate data manager.

Investing from the church spire

Moylan says that in contrast to the past few years when investors have sought “core” real estate, “there is now an increased appetite for higher risk-profile strategies with IRRs of 15 to 20 per cent.” He thinks part of this is due to huge demand for core investments, and says that “there have been a lot of people arguing that core real estate investments aren’t attractive anymore as they have perhaps become overpriced because of the capital chasing them.”

“Opportunistic” investments with lower occupancy, short leases or development needs are gaining popularity, Moylan argues, along with debt and distressed real estate funds. He reckons this is due to “confidence and the belief that there are the opportunities out there to deliver that kind of return”.

While few would doubt the opportunities exist, the ability of pension funds to pursue these riskier strategies appears muted, however. The pension fund respondents to Preqin’s study showed a greater propensity than other institutional investors to claim they will focus forthcoming investments in core real estate funds. Schuerhoff explains that German investors have coined a phrase for a local focus resulting from a need to scrutinise risk in real estate, investing from the Kirchturm or church spire.

Hesp thinks it is large investors that are more likely to have the desire and inhouse knowledge to diversify beyond core holdings, as well as have more room for experimenting with riskier assets. Stassen sees some evidence that pension funds are upping their risk appetite. He claims that “in the UK, pension funds are looking at Manchester whereas two years ago they probably would have just looked at London.” These initial movements are creating their own momentum he adds, with it proving “difficult to get yield play” as plenty of capital chases slightly riskier yet high quality assets.

PensionDanmark’s head of real estate, Mogens Moff, says his fund has diversified its real estate investments to the extent that just 10 per cent are “retail in top locations” and 20 per cent “high quality residences”.

Stassen says opportunities are opening up further up the yield curve as “an enormous lack of debt financing in the European market”, which affects the riskier end of the market, “has significantly improved over the last six quarters”. His colleague Richard Bloxam (pictured right), head of European capital markets at Jones Lang LaSalle, says these improvements have primarily come in the larger European markets like Germany, the UK and France though. The situation is still “extremely restrictive” in Holland, he adds.

Hesp agrees that investors want to “take this risk in countries that are more stable”. Germany and the Nordic countries are the most popular European destinations for real estate investments according to a recent INREV report.

Hesp believes “that the majority of investors aren’t looking at southern Europe yet as they are still looking at the risks associated with the Euro crisis”. Investors are also not convinced that a “full price reflection” has taken place in the most troubled markets, he adds. Bloxam agrees that a pricing gap remains but says there has been “some movement” from Italian vendors and there is an increased interest in the Spanish market. Moff says PensionDanmark remains focused on the domestic market for its direct investments, despite being enthusiastic on overseas infrastructure investments.

More inflation caution

A combination of the ongoing hunt for yield and heightened inflation fears appear to have swung the pendulum of real estate sentiment back in the asset class’s favor. There is a “huge difference” between real estate yields and those of government bonds, Hesp points out. Jones Lang LaSalle figures indicate a spread of over 400 basis points between prime office assets and local government bond yields in London, Paris, New York, Frankfurt, Sydney and Hong Kong in the third quarter of 2012. Moff says PensionDanmark is doubling its real estate investments to 10 per cent of its $24 billion portfolio to offer a “solid anchor to compensate for the low yields on bond investments”.

Figures from Swiss investors certainly point to increased popularity of real estate investments at the expense of bonds. Swisscanto data claims that around 50 per cent of Swiss pension funds reduced their bond holdings in 2012 while another 50 per cent increased their real estate allocations. Stassen argues that real estate is also benefiting from expectations of “relatively high or increased inflation” becoming more pronounced as the global economy clicks back into gear.

While real estate offers something difference to bonds and equities, it has to compete for attention in investors’ portfolios against a range of alternative investments like never before though. Stassen says (pictured right), however, that increasing number of funds are seeing real estate and infrastructure as individual asset classes separate to their alternative allocations.

“In the medium to long term we expect investors to continue to diversify into alternatives but maintain their real estate allocation” says Moylan, who argues that pension funds rarely real estate for infrastructure or hedge funds. Stassen points out that while the illiquidity premium of infrastructure is an attraction for some investors, the flexibility of real estate tends to suit those wanting liquidity.

Another bubble?

With institutional capital predicted to increasingly flow into the same kind of assets, is there a risk of another bubble in some segments?

“It is important to understand that institutional investors are different kinds of buyers, buyers typically without leverage and with a balance sheet that allows them to sit it out if needed,” Stassen says. However, Schuerhoff argues that there is widespread talk of a bubble in core real estate in the biggest German cities.

Beyond any asset bubble fears, regulation could also seemingly put the break on increased real estate appetites in Europe. Schuerhoff explains for instance that many German pension vehicles are tied by both “very conservative” domestic regulations on asset allocation and the prospect of forthcoming risk-averse Solvency II insurance regulations. While a study from his consultancy has found that institutional investors would ideally like to double their real estate allocations, he expects a much more gradual increase to ensue, pending the impact of new regulation. Modest risk budgets are also making many funds hesitant to increase real estate allocations, a constraint funds the world over might recognise.

Position shift at University of Toronto Asset Management