Real estate investment trusts can't get any love from institutional investors.
While REITs had the highest average net return, investors had the lowest allocation to the securities, on average just 0.6% of total assets, according to a new study of 17 years of data.
The study, by C.E.M. Benchmarking Inc., a Toronto-based research firm, was commissioned by the National Association of Real Estate Investment Trusts, Washington.
“What we didn't expect was the relative performance of REITs to other asset classes,” said Alexander D. Beath, a senior research analyst at CEM and co-author of the report, which studied the asset allocations and returns of 12 asset classes from the beginning of 1998 through year-end 2014.
REIT allocations during the period stayed at very low levels during the survey period, “and that is despite the fact that they were the best-performing asset,” said Ronald C. Kuykendall, vice president, communications of NAREIT.
“Meanwhile, investors' private equity allocations nearly tripled and hedge fund allocations increased sixfold” during the survey period, Mr. Kuykendall said.
“So, there is a disconnect between the performance the different investments are providing and the decisions the managers (asset owners) are making in terms of asset allocation,” Mr. Kuykendall said.
U.S. pension funds' asset allocations migrated into a broader set of asset classes, including alternative investments, during the survey period. The average allocation to non-U.S. equities increased 7.27 percentage points to 20.9% in 2014; a 6.9-percentage-point rise in hedge fund allocations, to an average 8.36%; and a 3.96-point increase in private equity allocations to 5.93%.
During that same period, the highest-returning asset classes on an arithmetic net return basis were REITs, at 11.95%; private equity, 11.37%; and U.S. small-capitalization stocks, 10.3%. On a compound net return basis, the best performing asset classes were REITs, with 10.14%; private equity, 9.34%; and other real assets, which included commodities and infrastructure, 8.34%.
Investors' allocations to other real assets increased 1.38 percentage points to 1.39% of total assets as of 2014.
By comparison, the arithmetic net return of equity real estate was 8.59% and the compound net return was 7.21%. However, some of the difference in return between REITs and equity real estate could be due to the fact that the equity real estate returns are reported to CEM without leverage, while the REIT returns are with leverage, Mr. Beath said.
Private equity had the highest average gross return at 13.5%, but it also had the highest average fees of any asset class studied — 2.08% — which brought the asset class' returns to second with 11.37% average net arithmetic return and 9.34% compound net return.
“Private equity is one of the best asset classes … but the fees bring it down,” Mr. Beath said.
CEM's study also revealed that after adjusting for lags in reporting by illiquid alternative investment asset classes, the diversification advantage provided by the illiquid assets melts away.
Private equity, for example, is highly correlated to stocks. Private equity's correlation to small-cap U.S. stocks is 0.89.
“Real estate and private equity returns are stale by anywhere from eight months to two years,” Mr. Beath said.
Indeed, U.S. large-cap stocks, U.S. small-cap stocks, non-U.S. equities, hedge funds and tactical asset allocation strategies are all highly correlated, the study found. Correlations of these asset classes ranged from 0.79 to 0.93.
REITs and equity real estate also are highly correlated — 0.91 — mainly because REITs and equity real estate invest in the same type of assets, the report noted.
“Private equity is very similar to small-cap equity and equity real estate looks a lot like equity REITs,” Mr. Beath said. “When you take away the lag, they perform the same.”
Because costs are so much less in the liquid version of equities and real estate “instead of chasing returns in the high-cost version, why not go after the lower-cost option?” Mr. Beath asked.
CEM executives studied the investment allocations and realized investment performance of more than 200 U.S. public and corporate pension plans with a combined $3 trillion in assets from 1998 through 2014. CEM executives used 1998 as the starting point because it coincided with the addition of REITs and hedge funds as separate categories in its database.
The worst-performing asset class during the survey was fixed income, with an average annualized net return of 4.52% (arithmetic) and 4.46% (compound). This underperformance was caused by the inclusion of cash, the CEM report states. Excluding cash, the worst-performing asset class during the survey period was hedge funds/tactical asset allocation at 5.5% (arithmetic) and 5.04% (compound).
Broken out into separate asset classes, U.S. broad fixed income had an arithmetic net return of 6.1% and a compound net return of 6.03%; U.S. long bonds were 8.69% arithmetic and 8.39% compound; other domestic fixed income was 4.52% arithmetic and 4.46% compound and international fixed income was 7.17% arithmetic and 6.93% compound.
Allocations to all but U.S. broad bonds increased: U.S. broad bonds dropped 14.56 percentage points to an average allocation of 12.11% over the 17 years; U.S. long bonds were up 15.52 percentage points to 16.43%; U.S. other fixed income was up 2.88 percentage points to 4.84%; and non-U.S. bonds were up 2.05 percentage points to 2.89%.
The study attributed the decrease of broad fixed income and the increase of long-bond allocations to the emergence of liability-driven investment strategies among some U.S. pension plans, in which cash inflows from investments and contributions are matched to cash outflows in the payment of benefits.
CEM's study also reviewed volatility, concluding that private equity was the most volatile at 28% annualized volatility after adjusting for reporting lags. However, the volatility included market risk, the standard deviation of average returns, and idiosyncratic risk, the differences in returns between funds. Private equity's market risk of 20.9% was close to U.S. small cap stocks at 20.1%.
While equity real estate is less volatile than REITs even when adjusting for the reporting lag of equity real estate, there is not a large difference in volatility between the two investments, the report noted. Listed equity REITs' volatility is 20.7% and equity real estate, 19.6%.
Adjusting returns and volatility for the lag in reporting is an important feature of the new report, Mr. Beath said.
Failing to account for lagging of alternative investment and equity real estate returns adds 12% to to13% average volatility, he said.
“That's a lot of risk. That's 5% to 10% of a total risk budget that is not being reported,” he said.