A new report released by the Urban Land Institute (ULI) at the MIPIM conference in Cannes, France, suggests that European core and opportunity funds have not delivered the level of performance investors expect or that they are led to believe.
The research, which looks at the performance of European core and opportunity funds from 2003 to 2009, found unsurprisingly that opportunity funds delivered higher returns than core funds over the period. However, deeper analysis of the data suggests that the additional returns delivered by opportunity funds may not be adequate to compensate investors for the significantly higher levels of risk taken by fund managers to achieve these returns, according to the report.
With significant levels of beta (around 3) calculated into the opportunity fund samples and the closeness of observed returns to hypothetical geared returns, the research found that opportunity fund returns over the period have been driven primarily through pure leverage and at a cost of huge risk to the investor. Additionally, performance fees charged by fund managers appear to reward pure risk-taking (beta) rather than manager skill (alpha), the report noted.
Still, there is some evidence of alpha being generated by fund managers through skillful transaction activity and asset management. Opportunity fund managers also appear to have generated superior returns by controlling the timing of buying and selling assets, although the report leaves it open to debate as to who benefits more – the investor or fund manager – as performance fees are generally charged on IRRs rather than time-weighted returns.
Generally, core funds were found to have much higher levels of market risk than expected, as the sample was found to have a higher than expected beta of 1.61. (Using the capital asset pricing model, this should add as much as 2 percent plus fees to the required return of a core fund.) The research also found that core funds failed to track the direct property index and have a wider spread of returns than would be expected, which appears to be the consequence of the use of leverage.
Annual total returns delivered by European core funds outperformed the direct market in years of strong performance (2003-2006) but significantly underperformed during years of weak performance (2007-2009). A similar pattern was seen in the European opportunity fund sample, with strong annual total return outperformance of the direct market delivered in 2003-2006 and significant underperformance of the market in 2007-2009.
When annual total returns are compared, the average total return for European opportunity funds delivered outperformance over European core funds of just slightly more than 4 percent over the whole period. Core funds recorded an average annual total return of 3.3 percent compared to 7.4 percent for opportunity funds. The highest annual total return outperformance by opportunity funds occurred in 2004 with a relative return that was 17 percent higher than the core fund sample. The greatest underperformance occurred in 2008, when opportunity funds delivered returns 25 percent lower than core funds.
When time-weighted rate of returns (TWRR) of the fund sample are compared, opportunity funds again outperformed during times of strong direct market performance and underperformed during times of weak performance. During 2003-2006, opportunity funds delivered a TWRR 12.7 percent higher than core funds; during 2007-2009, opportunity fund returns were 5.79 percent lower than those of the core funds. Over the whole period, however, European opportunity funds outperformed core funds by just 1.13 percent on a TWRR basis compared to 4.39 percent for funds targeting global investment. Furthermore, on a risk-adjusted basis, European core funds slightly outperformed opportunity funds, with the core funds delivering a risk-adjusted return of 0.19 percent compared to 0.14 percent for European opportunity funds.
If core funds do not track the direct market, this places a question mark on the rationale behind investing in them, the report concluded. If an investor wants a core fund to be a relative return product tracking a property index or the direct market, core funds are likely to fail to deliver, it stated. If they are regarded as absolute 5 percent to 8 percent return funds, core funds have failed to meet those requirements as well, producing a TWRR of just 2.5 percent, it added. This is an underperformance of 2.5 percent to 4.5 percent on an absolute return basis.
Meanwhile, the wide spread of returns observed in the opportunity fund sample highlights the fact that manager and/or fund selection risk is high. Some managers clearly have performed higher than the market average and delivered value, while others have delivered appalling returns, albeit in a very challenging environment.
With closed-end fund structures, there also is vintage year selection risk. The vintage year IRR analysis clearly shows there is a wide dispersion of returns being generated both within and across the vintage years of opportunity funds. With that in mind, now could be an ideal time to invest in opportunity funds, as the fundraising environment remains challenging and those managers that have raised capital should have a performance advantage due to less competition for opportunistic assets.
The research concludes that real estate funds in general have not delivered the required risk return characteristics that investors expected or are led to believe. The traditional model of real estate sitting somewhere between bonds and equity is challenged, with investors increasing asking themselves, “If real estate cannot deliver the desired risk/return profile, then why invest?”
The research was conducted by Andrew Baum, academic fellow for ULI Europe and professor of land management at the Henley Business School at the University of Reading, in conjunction with Jane Fear and Nick Colley of Feri Property Funds Research. Firms that participated in the research include Aberdeen Asset Management, Aviva Investors, AXA Real Estate, The Carlyle Group, CBRE Investors, F&C REIT Asset Management, ING Real Estate Investment Management, JPMorgan Asset Management, Schroder Property Investment Management and Tishman Speyer. The findings were then debated at a symposium of 35 leading fund managers, investors and academics, hosted by AREA Property Partners in London late last year.