Some pension funds are taking a bigger step into investment alternatives, looking to create efficiencies by rolling real estate into a larger “real assets” bucket that also includes infrastructure, energy, natural resources, timberland and agricultural land.
Pensions first introduced real assets allocations a decade ago. Lessons learned during the global financial crisis have fueled a desire to increase portfolio diversification with alternatives that deliver stable income along with returns that are not correlated with stocks and bonds.
“The experience of the financial crisis reinforced the illiquidity of these private equity strategies,” says Marc Cardillo, managing director at Cambridge Associates, a consulting firm based in Boston.
Many investors are now thinking more broadly across the full spectrum of real assets alternatives. Now they are not only looking at how compelling an investment in an industrial property might be compared with an office or retail property, but also at how compelling that industrial property might be compared with opportunities in energy or infrastructure, says Cardillo.
The $32 billion Utah Retirement Systems reevaluated its portfolio after the financial crisis and ended up designating a 15 percent allocation to real assets for the portfolio. “There is a diversification benefit, but the overarching thing for us is inflation protection,” says Devon Olson, director of real estate at URS. The current target allocations for real assets are: 8 percent to traditional core real estate assets, 1 percent each to timber and agriculture, and the remaining 5 percent to infrastructure, energy and royalties, such as for pharmaceuticals.
So far, the pension’s real assets investments have performed competitively with the broader portfolio, even in the low-inflation environment, notes Olson. “If we do run into a situation where we see a lot of inflation in commodities and wages and the consumer price index, we are trying to make sure that this particular bucket of assets will follow those kind of inflationary movements,” he says.
EVOLVING STRATEGIES
Pensions are at different stages in the move into real assets. It may not be a broad trend across all institutions, but some large U.S. pension funds have established real assets allocations, and smaller pension funds definitely watch what those larger trendsetters are doing to see if they also could benefit, notes Christy Gahr, senior vice president at the Meketa Investment Group, an investment services firm.
Even among those pensions that have introduced real assets allocations, strategies vary. “The major building blocks for real assets allocations are real estate and infrastructure, but it differs by organization,” says Ritson Ferguson, CEO of CBRE Global Investors. Organizations also include a mix of timberland and farmland, energy, natural resources and commodities under that real assets umbrella.
Along with the rise in real assets investments, pension funds are determining how to best manage those allocations. Some institutions group real assets under a single umbrella, while others choose to keep real estate in its own separate category. In some cases, pensions may have a director of real estate and a director of infrastructure, with no common connection between the two. “So, we see it very much evolving,” concludes Ferguson.
The $346 billion California Public Employees’ Retirement System rolled its real estate allocation into a real assets allocation in 2016. As of its latest allocation plan, CalPERS has a 13 percent allocation to real assets, including 11 percent allocation to real estate.
LEVERAGING UPSIDE OF SINGLE ALLOCATION
Some investors have opted to create a single real assets allocation because of the similarities in risk-return profiles among asset classes, as well as some of the efficiencies to be gained in underwriting similar assets.
AXA Investment Managers – Real Assets, which invests on behalf of clients, first deployed capital into infrastructure debt in 2013 and expanded into infrastructure equity investments about two years ago. Investing in infrastructure debt does have a lot of commonalities with real estate debt, notes Laurent Lavergne, head of separate accounts at AXA IM – Real Assets. A lot of synergy can be extracted by using the same tools and teams to manage those debt investments in infrastructure and real estate, he says. Although separate teams for real estate and infrastructure are responsible for underwriting, the same IT system and back office can handle both asset classes. In addition, management of the underwriting and acquisition phases of private infrastructure and private real estate assets has similar features, which was one of the main drivers for the firm to bring real assets under one roof. “Our view is that both types of assets are very close,” says Lavergne. AXA IM – Real Assets also has energy investments, such as power plants and wind farms.
Infrastructure equity and debt investment is still a relatively small part of AXA IM – Real Assets’ $70 billion in assets under management, but the firm expects to grow its infrastructure investment over the next two to three years. “We believe the market is pretty large, and it is very attractive to our investor base, mainly pension funds and insurance companies, who are really looking to this kind of asset that [is] providing stable, long-term cash flows most of the time with some type of inflation protection,” says Lavergne.
Another advantage of a real assets allocation is it can provide added flexibility in managing investment strategy. Investors face more pressure to achieve and maintain their target allocations with stand-alone allocations, even at the risk of a poor market, notes Gahr. “If you have a real assets allocation, you can be a little bit more nimble and have the ability to move in and out of sub-asset classes more tactically than a dedicated asset-class approach,” she explains.
MANAGING THE DOWNSIDE
One of the challenges of a single real assets allocation is covering a larger universe to identify and underwrite opportunities. In some cases, that means more people, time and travel expenses. “You do need greater resources to cover a broader spectrum of real asset opportunities,” says Cardillo.
Assets such as real estate, infrastructure and natural resources do have some common traits and common underwriting practices. At the same time, there can be very different dynamics and nuances to understanding performance of the different sub-categories within real assets at the macro and micro levels. “It could actually complicate things further because there is a greater need for active involvement and active management,” says Gahr. Potentially, pension plans may need to make more frequent investment decisions with a larger allocation and need to have greater focus on positioning the entire real assets portfolio more tactfully, as opposed to maintaining levels of exposures to the individual, dedicated categories, she adds.
Another challenge is the real assets category as a whole does not have a good industry benchmark. Benchmarks are still focused on individual assets, such as the NCREIF Property Index for commercial real estate. “What we oftentimes see is that those that have real assets allocations are typically very heavy on the real estate side,” says Gahr. “That might lend to benchmarking real assets programs to the NCREIF ODCE benchmark, in which case you are really not capturing the operating risk in infrastructure, or some of the commodity-driven risk with natural resources, with your benchmark.”
Broader real assets allocations may provide an edge to bigger management firms that have more resources, and some managers are working to create a deeper bench to serve clients in the real assets space. CBRE Group, for example, announced last summer it would acquire a majority interest in Toronto-based Caledon Capital Management, an investment management firm specializing in private infrastructure and private equity investments.
CBRE Global Investors provides real estate investment management solutions for both private direct and publicly traded real estate investment. Six years ago, the firm also added listed infrastructure strategies to that menu. Through Caledon, CBRE Global Investors now also can offer private market infrastructure solutions.
A broader trend in the institutional investment world sees investors trying to drive down their number of management relationships. At the same time, they want to make sure they have managers who can deliver top investment performance, says Ferguson. Ultimately, it is still about performance and who can deliver. “I don’t think a manager who is just in the space and does everything in a mediocre way will find much success,” he says.
TEXAS PENSION CHANGES COURSE
The $142 billion Teacher Retirement System of Texas was one of the first pension funds to create a real assets portfolio in 2007. One thing driving the shift was a desire to improve operating efficiencies as its investment in alternatives grew. In particular, the pension was expanding into infrastructure. “To be candid, I’m not sure we knew at the time what it would involve, and we felt it was the best fit based on what we knew at the time with real estate,” says Eric Lang, senior managing director of external private markets, with the retirement system.
TRS Texas is allocated based on three different economic regimes — stable value, global equity and real returns. From 2007 to 2013, the real returns regime included real estate and infrastructure, as well as agriculture and timber. In 2014, TRS Texas added a specialist portfolio of energy and natural resources. At that time, the trust decided to split its real assets allocation into separate portfolios, with real estate in one group and energy, natural resources and infrastructure in a second group — all under its “real return” allocation.
The decision was made primarily because 60 percent or more of the infrastructure investments were tied to the energy complex, such as pipelines, power and wind farms. “We felt it was more aligned with our energy team’s expertise, as opposed to the real estate team,” says Lang.
In the case of TRS Texas, putting infrastructure into a real assets group with real estate was an advantage because the group was learning a new asset class. As the real assets portfolio grew, however, it worked better to separate real assets into two categories, the main driver being specialized expertise for the different categories. “We felt that the real estate team was not adding much value to those assets, and we felt that the energy team was,” says Lang. “So, it was more of a management decision based on specialization and expertise of the asset class.”
TRS Texas has a unique perspective, having managed both a combined real assets portfolio and then reversing course to focus on real estate as a separate allocation. “The main parting thought is, to each his own,” says Lang. Each organization will determine the best way to manage its real assets. Whether that is combined or separate, it is really based on how funds are managed and the best use of the resources available, he adds.
PENSIONS EMPHASIZE COLLABORATION
Regardless of whether real estate is moved into the real assets bucket or kept as a separate category, most pensions are encouraging cooperation and shared expertise within the broader team. Even though the real asset groups are no longer officially under one umbrella at TRS Texas, many of its teams still work together rather than in their own silos. The pension system’s private markets group includes private equity and real estate, as well as the energy, natural resources and infrastructure group. All three of those teams sit next to each other, and a lot of natural cross-collaboration occurs between teams, explains Lang.
An investment in cell phone towers, for example, could fall into a variety of different subcategories — real estate because of the land they are built on, private equity because it requires a business to run the towers, or infrastructure because it provides a needed communications service with stabilized cash flows. “We could have people from each team working on that,” says Lang.
At URS, investments that are more asset-based tend to be handled by the real estate or timber and agriculture teams. Investments in infrastructure tend to have a bigger operational component, which requires more due diligence on the manager. Those types of investments tend to be handled more by the hedge fund or private equity people on the team because of the differences in underwriting, notes Olson. “We really try to emphasize collaboration so that all of these different buckets cooperate, and we get the benefit and knowledge of one group and the knowledge of another group,” he says.
As some investors consider a move toward a unified real assets allocation, it is important to weigh the advantages of each and to find the right balance for each portfolio.
Beth Mattson-Teig is a freelance writer based in Minneapolis.