United Kingdom pension funds will increase their real estate allocations as bond and equity investments continue to disappoint, according to new research by property consultancy Jones Lang Lasalle. The funds typically hold around 5 per cent of their assets in real estate, but the recent findings predict the pendulum will swing in favour of much bigger allocations in coming years.

The reason is part of a structural shift away from traditional holdings to more “real assets” including property, infrastructure and transport, argues Joe Valent, in JP Morgan’s global real estate team, who believes these alternatives could account for up to 20 per cent of UK pension fund portfolios in the next 10 years. “We’ve all grown up with the idea that pension funds split their assets between equities and bonds,” he says. “But this was when economies were growing at around 5 per cent, bonds were paying 8 to 10 per cent and equities were booming. Economies aren’t growing at the same rate and bonds pay nothing. What is the rational for holding such a high proportion of these assets in portfolios?”

UK funds will look for opportunity in their home market first as big foreign funds continue to swoop on the asset class in their own backyard. The UK has attracted around $4 billion of a total $11 billion cross-border fund investment in real estate in the last nine years, with City and West End investments proving most popular, says David Green-Morgan, global capital markets research director at JLL. He believes London will remain a key investment destination despite fierce competition and pricing-bubble worries. Recent forays by foreign funds include the $172.4-billion Canada Pension Plan Investment Board purchase of the Westfield shopping complex in Stratford, East London. Outside the capital, Norway’s sovereign wealth fund paid $560 million for a 50-per-cent stake in Sheffield’s Meadowhall shopping centre last October.

It’s a shift the biggest UK schemes have already embraced, with London also the focus for most, but not all, real estate picks. Strathclyde Pension Fund, one of the UK’s biggest local authority schemes, plans to up its UK allocation to 10 per cent of a total 12.5-per-cent property allocation. Managed by DTZ Investment Management, the scheme’s UK investments are focused on central London office and retail space. Railpen, inhouse manager of the $30.5-billion pension scheme for Britain’s rail industry, has around $2.25 billion invested in UK property managed by Orchard Street with a focus on the UK’s fast-growing regional cities such as Cambridge.

Competition, oversupply and strategy

However, some trustees say competition means investment opportunities in the best located and managed properties has become thin on the ground; values in “good quality but not A-grade” investments have plateaued with oversupply weighing on commercial rents. Proponents insist there is enough product to support a substantial switch in allocation – all that’s lacking is imagination. JP Morgan estimates $450 billion in global distressed real estate is coming to the market in the next year as assets that have sat on banks and deficit-laden government balance sheets are sold off. Here the opportunity won’t be in “tier-two markets like Spain or Eastern Europe”, but in key capitals in locations close to central business districts and prime grade-A zones. “There will be opportunity to buy assets that have, for the last five years, been in a state of suspended animation,” says Valent, who puts net returns in these kinds of investments at 15 per cent.

Strategies include buying the buildings directly, accessing the market via fund-of-fund investments or through real estate investment trusts (REITs). The UK’s Pension Protection Fund, $14.5-billion lifeboat fund that takes on the assets of UK schemes if the employer goes bust and honours its pension promises, has a 5 per cent real-estate allocation in its conservative investment strategy that includes REIT investments in the US. “We are exposed to London retail and office space though a fund of funds,” says Martin Clarke, executive director of financial risk at the PPF. One strategy could see more foreign funds partner with local institutional money, argues Green-Morgan. “As competition grows, we expect to see more joint ventures and partnering with two to three groups working together,” he says. “A 2-per-cent allocation is of no benefit to the portfolio – you need a 10-per-cent allocation for it to be meaningful.”

 

 

An absence of appropriate ethical culture at financial services firms has been the biggest contributor to the lack of trust in the finance industry, according to a global survey of CFA Institute members, which attracted more than 6000 responses.

Matt Orsagh, director of capital markets policy at CFA Institute, says to restore integrity in global markets, change must come from within and that ethical culture within financial firms needs to be addressed to solve systemic problems that led to fiscal crisis.

He says the focus on short-term incentives and behaviour has contributed to the problem and created a mismatch when culture is long term in nature.

“Culture takes a long time – a long time to get wrong and a long time to get right. It’s the super tanker metaphor,” he says.

But investment banks and investment managers are not the only participants that need a wake-up call, he says, pointing to the role of institutional investors in accepting their contribution to short-termism and changing their behaviour.

Institutional investors part of the problem

“Institutional investors need to examine whether they’re long term enough, and are they part of the problem,” he says.

Orsagh says a previous study by the CFA Institute, Breaking the short-term cycle, found that institutional investors bemoaned short-termism but also judged managers on a one-year basis, and were hiring and firing to chase returns.

“There needs to be people on the boards of pension funds that have expertise and understand decisions that need to be made, how markets work, fight for lower fees and be more long term. It is hard to be that in a political world,” he says.

Orsagh says the fact 56 per cent of respondents said that a lack of ethical culture within financial firms is the biggest contributor to the lack of trust in the finance industry is a wake-up call for industry.

Further, they also said that improved culture established and encouraged by top management and executives is the most needed firm-level action to help improve investor trust and confidence.

Six areas of cultural influence

A change of culture needs to come from the executive and board level, and the CFA Institute in its paper Visionary boards identifies six key areas where visionary boards and directors can influence to ensure to ensure their companies are well positioned for the long term:

  • Quarterly earnings practices. A visionary board expects management to deliver investor guidance with a longer term bias and in greater detail by identifying long-term value drivers for the company. This approach helps to incentivise share “ownership” among the investors the board represents.
  • Shareowner communications. A visionary board proactively listens to the concerns of its shareowners and consistently communicates its long-term vision and strategy.
  • Strategic direction. A visionary board actively oversees and understands the corporate strategy and regularly monitors, along with management, the implementation and effectiveness of strategic plans. It also focuses on the relationship between corporate strategy and risks associated with that strategy.
  • Risk oversight. A visionary board embraces risk as a board-level responsibility. It oversees robust processes for identifying, understanding and, when necessary, mitigating risks to the operations, strategy, assets and reputation of the company. At the same time, a visionary board understands that companies generate profits by taking risks.
  • Executive/director compensation. A visionary board understands a company’s compensation policies and ensures that the underlying objectives consistently support the long-term strategy and performance of the company, as well as the appropriate company risk profile.
  • Board and corporate culture. A visionary board not only understands the business and industry in which the company operates but also recognises that strong corporate and board cultures are essential to the achievement and sustainability of a company’s long-term value. Therefore, a visionary board diligently seeks to reinforce and build such cultures.

The survey respondents are cautiously optimistic, with 40 per cent of the members saying the economy will expand, up from last year’s 34 per cent who said they thought the global economy would expand.

Another signal of a positive outlook is that employment opportunities for financial professionals has slightly improved

Half of those surveyed expect equities to outperform all asset classes, up from 41 per cent a year ago.

The new chairman of EDHEC-Risk Institute’s international advisory board, chief investment strategist at Swedish pension fund AP2, Tomas Franzen, says institutional investors should embrace academia and be open to applying research in the implementation of practical portfolio construction.

He says that while investing is part art and part science, it is important to employ science as much as possible and have a scientific approach as part of the investment process.

“EDHEC is a nice bridge between a scientific approach and practitioners’ needs and methods for implementation in practical portfolio construction,” he says.

EDHEC was born around the same time as AP2 and Franzen says it has made a relevant contribution to his work at the fund.

In particular one of the areas of focus that institutional investors have employed is the academic work on more efficient indices and benchmarking of equities portfolios.

“We’ve been doing this in various forms at AP2 for years,” he says.

In addition, some of the research on hedge funds, in particular style attribution in portfolios, has been applied by AP2, which has been building portfolios around systematic risk premium.

“This is a huge research area and another example of the relevance,” he says. “This is about a scientific approach and dealing with the issues in a way that makes them relevant.”

He also said asset liability modelling has been a focus of EDHEC that is applicable for some investors.

Harnessing long-term investment policy

The 42-member advisory board at EDHEC-Risk Institute that Franzen now chairs is made up of investors and asset managers from around the world. Its purpose is to help the institute assess research projects for practical purposes; to evaluate research outcomes in regard to their potential impact on industry practices.

“It is important to stimulate thinking differently,” he says. “It’s easy to fall into old tracks.”

As chief strategist at AP2, Franzen says his daily duty is to think and harness investment policy as a long-term investor.

His interest is in investment policy design and asset allocation, which is also where he believes the long-term results are.

Since the global financial crisis, there has been more attention paid to dynamic asset allocation, and not just long-term strategic and short-term tactical asset allocation.

“When we think of dynamic asset allocation, it’s a question of addressing regularly whether financial risks are priced to reward taking on the risks,” he says. “It is good to have the mental preparedness to see that traditional risk premium may not be at the right price.”

To this end, AP2 has made a couple of dynamic allocations, including doubling a global credit allocation in 2007 and buying, then selling, out of convertible bonds.

Ensuring reward for risk

Franzen thinks of asset allocation in risk terms and believes there is an overemphasis on expected return in modern-day portfolios.

“It is more of risk management to be sure you get rewarded for risk. It is easier to describe than do in practice.”

According to Franzen, rather than concentrating on return, volatility and correlation, for example, valuation levels are more important in assessing equity risk in allocations over the long term.

AP2 has even integrated an investment policy roadmap, which has guided the fund.

Broadly, it allocates 52 per cent to equities, 36 per cent to fixed income and 12 per cent to alternatives.

However, he says the fund is still working towards finding the ultimate diversification. Recently it has expanded into real estate and has increased its allocation to non-traditional property such as timber and agricultural property.

Also increasing allocations to emerging markets, AP2 recently received its Qualified Foreign Institutional Investor licence to operate in China, and is now looking for investment managers to manage a domestic Chinese and Asian portfolio.

The fund has also undertaken some advice on hedge funds, which has translated to investment in more generic strategies, but with the aim of extracting alternative risk premium.

Franzen says the decision was made to gain exposure to alternative risk premium, but not invest in hedge funds per se.

The EDHEC-Risk Institute has branches in Singapore, at the invitation of the Monetary Authority of Singapore, the City of London and Nice, France.

An Australian superannuation fund with A$6.6 billion ($6.9 billion) under management has achieved number-one ranking in a global survey of how the world’s top 1000 retirement funds, insurance companies and sovereign wealth funds are responding to climate risk.

Sydney-based Local Government Super (LGS) has received the top ranking in the inaugural Climate Index of the Asset Owners Disclosure Project (AODP).

The index was built following information requests to the world’s top 1000 asset owners from 63 countries, with around $60 trillion in funds under management. The survey focused on five main categories: transparency, risk management, investment chain alignment, active ownership and low carbon investment.

“We’ve been working steadily to build a sustainable portfolio for over 10 years,” said Peter Lambert, chief executive of LGS.

“The holistic approach, in which LGS seeks to invest in line with environmental, social and government principles across all asset classes, not just a few that might be considered easier, is what sets us apart.”

Around $3.46 billion, or just over half, of the LGS portfolio is held in responsible investment strategies across Australian and international equities, property, absolute return, private equity and sovereign bonds.

Australian funds made up six of the top 10 funds. South Africa’s AAA-rated Government Employees Pension Fund, which has calculated its exposure to fossil fuel reserves through the balance sheets of investee companies, was ranked second.

Also in the top 10 were Dutch funds PFZW and APG Group, along with Canada’s British Columbia Investment Corporation.

Overall, the creators of the index sounded a warning, with AODP chair John Hewson saying that despite signs of progress, the index “paints a disturbing picture of greenwash and reckless mismanagement”.

Julian Poulter, executive director of AODP, said the index showed that many funds had their “heads in the sand” on climate change and there was a “crisis of transparency” with 91 funds having “absolutely no public information available” on their climate strategies.

In a policy to galvanise pension fund assets to help boost its ailing economy, the UK government wants funds to invest in small and medium-sized businesses. As part of its Business Finance Partnership (BFP), it has named four asset managers to run specialist funds backed by pooled government and private capital. The funds will invest in businesses that struggle to borrow from cash-strapped banks. Chancellor George Osborne announced in his pre-budget Autumn Statement an initial government tranche of £600 million ($962 million) to the scheme that will be matched by $1.04 billion from the private sector.

The nominated fund managers are M&G Investment Management, Alcentra, Haymarket Financial and Pricoa Capital, with an additional $160 million expected to be invested with a fifth fund manger in early 2013. The loans will be made to companies with turnovers of between $40 million and $800 million and promise returns of between 3 to 6 per cent above LIBOR; tenors will be between five to 10 years.

Who’s in?

Trustees have greeted the announcement with interest. Local authority schemes are expected to be the keenest investors since many have delved into the asset class before. M&G says local authority schemes were anchor investors in its first Companies Financing Fund, launched in 2009. This fund has lent around $1.49 billion to larger UK companies including power station operators Drax, logistics group Stobart and housebuilders Taylor Wimpey and Barratt Developments. M&G is matching the government’s $320-million seed funding with $400 million of its own capital, at this stage sourced from its parent group, financial services giant Prudential. “We hope to start lending through the new fund early in 2013. Each company will be assessed for suitability for the fund on a case-by-case basis,” says David Butcher, a spokesperson at M&G. “The fund is designed to offer absolute returns with high levels of security allowing clients to gain a diversified portfolio of companies.”

Investors will benefit from a cash return of around 8 per cent from day one on the interest charged, says Graeme Delaney-Smith at fund manager Alcentra, part of Bank of New York Mellon. Alcentra has matched the government’s $160 million investment in its fund, and expects pension funds to account for up to 70 per cent of its final investor mix. “Pension schemes have liabilities to meet – this cash yield is very attractive because they can use it to pay their pensions.” Once the fund is up and running, distributions will be quarterly and Alcentra will charge fees on a drawn capital basis rather than on a commitment basis.

More details, please

However, some trustees want more detail before increasing their exposure to an asset class abandoned by UK banks. “SAUL already invests in two global funds that provide finance to companies unable to access funding from the normal banking system,” says Penny Green, chief executive of the $2.4-billion SAUL fund, the Superannuation Scheme for the University of London. “We have found that it is an interesting asset class and a useful source of returns. The issue is whether the BFP will be able to put in credit analysis that reduces the risk of non-performing loans being included in the portfolio.”

The effects of “smoothing”

Other aspects of the Autumn Statement will also affect pension funds’ investment strategies through 2013. The government says it will review the way companies measure the financial health of their pension pots, potentially leading to sponsors having to contribute less to their schemes. The move comes in the wake of lobbying from the industry for the so-called “smoothing” of assets and liabilities since liabilities have sky-rocketed because of record low government bond yields. One outcome of any smoothing could be a tumble in demand for the long-dated gilts that funds have been forced to buy to cover their liabilities. “Contribution uncertainty drives many investment decisions at the moment so more certainty could mean funds grow more inclined to take investment risk,” said Schroders’ Jonathan Smith.

In another development, schemes will also have access to longer dated gilts next year with gilt issuance in the 50 to 60-year range from 2013. Investor enthusiasm may only be lukewarm however. “I can’t see these longer dated gilts being attractive,” says Cass Business School’s professor David Blake, who argues funds won’t want to lock into today’s low rates of interest. “The industry wants long-term asset to match its liabilities but they’ll want interest rates at a normal level before they show any interest in this. It’s a good idea but bad timing.”