Too much control?

Swedish pension funds have a long history of investing in real estate. It is surprising that many of them pursue what their counterparts elsewhere in Europe would consider rather a narrow - if not plain unsophisticated - policy when it comes to investing in real estate.

"Only Alecta has had a large allocation to international property," says Nicklas Fahlström, senior consultant at Wassum in Stockholm.

So why this focus on domestic real estate? Isn't it rather insular? "It is, but we have a competitive edge in domestic real estate," says AMF Pension's CEO Christer Elmehagen. "We have also seen that the costs of investing abroad are quite high in terms of management costs.

"But we have good control and knowledge of our real estate investments and I think that we can adjust to the risks. So viewed in the context of the total portfolio it is a superior bet."

AMF will continue to focus primarily on Stockholm office and retail shops. "So far it been very good and we don't see that it will perform any worse than other cities," Elmehagen explains. "We will expand to two or three other cities in Sweden."

Currently Stockholm office accounts for almost the entire real estate allocation. So hasn't the fund got all its eggs in one basket? "Exactly," says Elmehagen, "the total portfolio is well diversified, so high volatility and good returns in a concentrated real estate portfolio are possible." But the fund will diversify to shopping centres and residential.

Foreign real estate assets have accounted for over half of Alecta's real estate portfolio for more than a decade. "Most of our foreign investments are located in the US, the UK and the Netherlands" says David Sherwood, Alecta's head of real estate. "Our portfolio is focused on a few of the most liquid and mature markets, where we have a long established local presence. We are considering investing in other markets but our propensity to expand has been constrained by our preference for high levels of transparency."

Sherwood says that Alecta is actively considering investing in other markets but would not comment as to which these would be.

So what are the benefits of investing in real estate as perceived by Swedish institutional investors? "Historically real estate has been regarded as an inflation hedge," says Fahlström. "The larger investors have built their (direct) property portfolios over many decades and have had an allocation of 5-10 %; among smaller investors it has varied significantly."

Fahlström believes that there is "significant interest" on the part of Swedish institutional investors in real estate. He also points to forecasts about increasing inflation and there is a general search for alpha. "And we believe that real estate offers huge opportunities for active management. All these factors point in favour of increased institutional investment in indirect property products, such as funds by market/type and funds-of-funds. Decisions on investing in alternative investments tend, however, to take longer than expected."

Elmehagen points to real estate's low correlation with the other investments. "It also helps to improve the fund's solvency level," he says.

AMF has a solvency of 240% so it is not affected by Sweden's traffic light system introduced last year, which focuses on a pension fund's solvency level and the appropriateness of the corresponding asset allocation. "But if we were at a more marginal funding level real estate could help us improve it," he says.

AMF has 5-6% allocated to real estate. The target is up to 10% but, as Elmehagen explains, "we have not seen good opportunities to invest in real estate at the level that we would have wished. We don't feel the need to optimise the real estate portfolio regardless of market situation. For us it is still a more question of achieving an optimum allocation to real estate within the total portfolio."

Smaller funds have limited themselves to investing in real estate securities. But as has been noticed elsewhere these have been reflecting stock market risk rather than real estate risk. But they remain poplular, as Fahlström explains. "As real estate securities have performed so strongly, many smaller institutional investors have not necessarily seen the benefits of diversifying into real estate funds," he says.

Another interesting feature of the market in Sweden is the strong preference for directly held real estate. For example, direct investments account for 95% of Alecta's real estate portfolio. Sherwood explains: "The preference for direct investing by Alecta is largely due to cost efficiency and optimal control from a management and liquidity perspective.

"Such a strategic bias to direct investing can however only be justified by good results. Fortunately, we have has regularly delivered total returns which exceed local index benchmarks and we are well ahead of our peer group in Sweden over all time series up to 15 years. A unique aspect of our programme is the existence of Alecta offices in the key foreign markets. A local presence with good competence is fundamental to our success". Outside Sweden Alecta has a local presence in the US, the UK and the Netherlands.

In explaining the small role that indirect investments play in the Alecta portfolio Sherwood notes that "we use funds to reach parts of the market which require special knowledge or skills which we cannot easily replicate by investing directly. I doubt the indirect portion of our portfolio will ever be very substantial, but it will always play a small but important role."

Elmehagen is not planning to move into the fund market. "The structure is immature," he says. "For example, managers want to be paid up front - the client gets anything that is left after that. So the fees are not correlated with performance. There is also the issue of lacking transparency. AMF sees the supply side as not very customer friendly."

Does he see any encouraging developments in that regard? "Not yet, and this is also the case with international managers."

Nonetheless Fahlström notes that "the trend is definitively from direct to indirect investment. Various (direct) property funds have been launched and are attracting much interest, particularly those with exposure to the different Nordic countries."

Those choosing to stick to the direct route have their work cut out. Elmehagen notes that it is "a huge challenge" to access the right buildings in Sweden "because we have been invaded by US, German UK and Dutch investors. A lot of international players have dived into the Swedish market and bought up everything. But I don't think it will be a problem to keep the portfolio Swedish. Many foreign investors are here to make a quick buck and once they have gone we can move back in."

Meanwhile Fahlström points to the fact that "a downturn in the current property cycle has been expected for some time now. Such a development would negatively impact the will to start investing/increase allocation to (indirect) property holdings. But such a downturn would, in all likelihood, happen in conjunction with other asset classes. Real estate is likely to remain resilient in such an environment, not least on the back of the healthy direct yields and much higher vacancy levels are not expected."