Tuesday, August 27, 2019

Investment Insights

Do Your Kids Still Watch TV?

Shifting Dynamics in the Media Industry 

By James Golan/William Blair Investment Management

There has been an unprecedented degree of change in the media industry, made clear by a recent research trip to Hollywood.

While the growth of streaming media is a big part of this change, we have also seen mergers, management changes, new entrants, and studios starting to withhold content from the market. In addition, the economics for new programming are changing. This new reality is shifting the investing landscape in the media industry.

After meeting with studios, talent agencies, and cable and broadcast networks, here are some key takeaways—all with implications for investors.

Viewers are migrating away from traditional television.

Broadcast networks haven’t had a blockbuster hit show since NBC’s This is Us reached blockbuster status three years ago. Not long before that, several shows reached blockbuster status every season.

Underlying this dynamic is growing fragmentation of the market as viewers migrate toward streaming content (which is distributed directly to viewers over the internet, bypassing the television platforms that traditionally act as a controller or distributor of such content). It also illustrates the role played by streaming services such as Netflix, Amazon Prime Video, and Hulu.

The decline in linear viewership (i.e., traditional television viewership) is most notable with millennials, but we’re also starting to see it among Generation X. The trend will likely continue as new streaming services emerge.

Going forward, I believe that the only real value provided by linear television will be in live programming, such as sports and news.

Demand from streamers is creating opportunities for independent studios.

Studios, particularly smaller ones, are also gaining traction as barriers to entry have fallen.

Production studios are typically on the hook for a significant portion of the production costs for new movies and shows. A broadcast network typically covers just 45% of production costs, while cable networks cover around 70%. The streaming services, however, are willing to pay around 125% of production costs.

However, there is a trade-off. The streaming services will pay that price in exchange for lengthy distribution rights (including international)—which could last five to 10 years. This limits upside potential for the production company. In contrast, a broadcast network is typically allowed to run a program a few times, after which the production studio gets the syndication and international rights. So while the studio absorbs more of the production cost risk associated with unsuccessful programming, the studio’s economics improve dramatically for popular programming that can run for several years in syndication.

The effect will be new opportunities for smaller studios that can’t cover up-front production costs on their own.

Studios could be more hesitant to launch new programs on traditional cable networks.

Cable networks are also concerned about their ability to stay relevant. A continued decline in subscribers could mean that the networks won’t be able to generate enough advertising dollars to cover the costs of new programming. And studios could be more reluctant to launch new programs on cable networks given a falling number of subscribers.

As a result, there is a growing belief that cable networks will rely more on the syndication market than on new programming to fill hours.

Cable distribution companies will also have to be more creative in keeping subscribers with a la carte packages with networks that viewers actually want to watch. The days of paying upwards of $100 per month for 200 channels are numbered.

Studios will withhold content.

As distribution contacts come up for renewal, some studios will likely pull content off the market to support their own newly launched streaming services. For example, one studio could walk away from $1.5 billion to $2.0 billion of annual license revenue from cable networks in the near term to support future growth of its streaming services. Other studios, are hinting at withholding content to support their own streaming services.

As this happens, the value of remaining content libraries to streaming services should rise. Earlier this year, a streaming service paid an estimated $100 million for rights to stream one more season of Friends, a show that hasn’t produced a new episode in 15 years, to satisfy subscribers.

Naturally, this will lead streaming services to place more emphasis on original programming. This could place traditional cable networks in a bind given that their strategy will likely rely increasingly on studio libraries (i.e., syndication). If studio libraries are pulled from the market, cable networks could find themselves disadvantaged in competing for the remaining libraries against streaming services.

The value of sports programming should continue to rise.

The value of live programming, driven by mass viewership and favorable audience demographics, makes sports programming an ideal place for broadcast networks to invest.

This is particularly true for the National Football League (NFL). The next round of NFL contract renewals, which starts in 2020, is expected to result in additional price increases. The size of the increase will be determined by whether new digital platforms, such as Facebook or Alphabet, enter the bidding or if Amazon becomes more aggressive. The NFL is savvy in carving out different programming packages and staggering renewal dates, which should allow it to capture attractive prices for its compelling programming.

Investment implications: Advertising dollars will need a new home.

With all of these shifts beginning to take place, it’s hard to make the case that traditional linear television will remain an attractive platform for viewers.

The question is how these trends will affect advertising. We’ve seen a move toward digital advertising over the past several years, and linear television is the only media industry player that hasn’t yet been meaningfully impacted. I think we’re very close to a tipping point, where advertising dollars will start shifting away from traditional linear television to other platforms.

Broadcast networks should remain a solid venue for advertisers given live sports, news, and first-run programs; however, non-differentiated cable networks will likely struggle. Those left on cable/linear television in the coming years will likely be older viewers who are typically less technology savvy—not the ideal demographic for advertisers.

As a result, advertising dollars will have to find a new home, with possible beneficiaries being live programming (news and sports), digital, and streaming services.

The views expressed herein do not constitute research, investment advice or trade recommendations, do not necessarily represent the views of William Blair nor TEXPERS, and are subject to revision over time. 

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Investment Insights

Understanding the problem with 

fixed fees in efficient asset classes

By Philip S. DeSantis/Westwood Holdings Group

Fees should reflect the market rate for beta, the alpha potential of the asset class, unique manager/product attributes and the overall probability of a favorable outcome.

Institutional Strategies 10-Yr Annualized Excess Returns (%)

Top & Bottom Quartile Levels, Net of Fees

Click image to enlarge chart. Source: eVestment

We believe the largest misalignment between client advantage and active manager compensation occurs most often in U.S. Large Cap.

Mutual Funds 10-Yr Annualized Excess Returns (%)

Top & Bottom Quartile Levels, Net of Fees

Click image to enlarge chart. Source: Morningstar Direct.

Without the proper fee symmetry between the asset manager and asset owner, the relative value proposition during periods of outperformance may not be enough to offset periods of underperformance when you consider a high fixed fee in the context of the asset class — further adversely skewing the probability of winning for active investors.

Applying sound reasoning, investors could potentially improve the probability of winning by aligning with a sensible fee structure that offers symmetry with a favorable outcome, combined with a high active share strategy, understanding that these are the two corollaries that truly impact the odds for investors.

While an extremely limited number of asset managers have experimented with Fulcrum Fees, we affirm that traditional Fulcrum Fees and other fee structures may not be best aligned for a traditional efficient asset class like U.S. Large Cap where beta is priced like a commodity and the true value of active management needs to be measured in relative risk-adjusted terms.

Learn more about fee structure aligned for asset managers at Westwood Sensible Fees™.

A performance-based fee generally introduces the following risks: (i) performance-based fee arrangements may cause Westwood to make investments that are more risky or speculative than otherwise; (ii) Westwood may receive increased compensation (compared to a fixed fee) based on unrealized appreciation as well as realized gains on assets in the client’s account, (iii) clients may pay a performance fee even if an account declines in value, and (iv) no compensation or refund is paid if Westwood underperforms the benchmark. Sensible Fees are only available to those investors which are “qualified clients,” as defined in Rule 205-3 of the Investment Advisers Act of 1940.

The views expressed herein do not constitute research, investment advice or trade recommendations, do not necessarily represent the views of Westwood Holdings Group nor TEXPERS, and are subject to revision over time. 

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Investment Insights

The U.S. leveraged loan market: risk or rhetoric?

By Nick Gray and David H. Lerner/Shenkman Capital Management

With recent media focus on the leveraged loan market, misconceptions have surfaced surrounding the asset class. 

Politicians and pundits have raised concerns over this market’s size and growth, structural features and perceived similarities between CLOs and CDOs. These claims deserve further analysis.

Press coverage of the loan market has increased in lockstep with its growth, as loans outstanding more than doubled since the end of 2012. The loan market has gained steam on the $1.7 trillion US high yield bond market, after being less than half its size 10 years ago. While this growth is substantial, loans comprise less than 5% of the total fixed income markets and are a fraction of the size of the $5 trillion investment grade bond market, and the loan market has grown by 7% annually from 2008 to 2018, versus 17% for the BBB corporate bond market. 

Click image to enlarge chart. As of December 31, 2018. Annual Update. Source: J.P. Morgan Research.

With this context, we do not believe this growth is cause for concern, and in fact see certain benefits including more diversified issuance, improved liquidity, and better access to the capital markets for more companies.

Worries over declining covenant quality are perhaps the most prevalent. Although cov-lite issuance has risen to 80% from less than 20% pre-crisis[1], we believe these concerns may be misunderstood as cov-lite refers to the absence of maintenance covenants, not no covenants. In fact, like corporate bonds, loans possess other significant incurrence covenant protections. Ironically, a new issue loan with maintenance covenants in today’s market typically conveys greater issuer risk. Additionally, senior bank loans typically enjoy a priority claim over other debt in the capital structure while often being secured by the issuer’s collateral.

Fixed Income Market Composition

Click image to enlarge chart. As of July 10, 2019. Source: Barclays

The rising popularity of CLOs has also landed this asset class in the media’s crosshairs. CLOs are long-term vehicles that provide stable capital to the loan market and have long been its primary funding source, currently owning more than 60% of issuance. Now a $700 billion market, CLOs have drawn comparisons to CDOs despite meaningful differences whereas CDOs comprised of static portfolios of securitized mortgages which played a material role in the Great Financial Crisis, “CLO structures are much sounder than the structures that were in use during the mortgage credit bubble,” according to Jerome Powell.[2] 

Institutional New Issue Cov-Lite Loans

Click image to enlarge chart. As of February 28, 2019. Source: Morgan Stanley, LCD.

CLOs have many distinguishing features, including their composition of actively managed, continually monitored, and well-diversified pools of loans. In stark contrast to CDOs, CLO debt tranches have performed extremely well from a principal loss perspective. While the cumulative default rate of all U.S. CLO tranches rated by S&P since 1994 is only 0.38%, and AAA CLO investors have never experienced a default, the estimated 10-year cumulative loss rate of AAA global CDOs over roughly the same period was nearly 29%.

Standard & Poor's Rated U.S. CLO Tranches 1994-2018

Click image to enlarge chart. Source: Standard & Poor's Research. Includes all U.S. cash flow CLO tranches have ever been rated as of 7/31/2018. Default rate = number of ratings that had ratings lowered to D/total number of ratings.

Each of these CLO defaults was from pre-crisis issues, whereas post-crisis CLO structures are more conservative as they feature additional credit support and less leverage, restrict purchases of certain assets including structured finance issues, and have shorter reinvestment periods.

Estimated 10 Year Cumulative Loss Rates by Original Rating, 1993-2016

Click image to enlarge chart. Source: Moody's, Wells Fargo Securities.

Additionally, first-loss risk is more likely to be provided by non-bank investors, which should limit the potential for systemic risks.[3] Because CLOs are funded by long-term, locked-up capital, they may act as a “shock absorber” in times of loan market stress, as managers are not forced sellers and may be incentivized to purchase discounted loans to enhance equity returns.

2006 Median Structure BS CLO

Click image to enlarge chart. As of 12/31/2018. Source: LCD, Wells Fargo.

Regulators’ primary concern appears to be the potential for the leveraged loan market to cause systemic risk to the financial system, but many experienced financial leaders think this is unlikely and regulators have, for the most part, prudently distinguished credit risk from systemic risk.

2014-2018 Median Structure BSL ClO

Click image to enlarge chart. As of 12/31/2018. Source: LCD, Wells Fargo.

We concur, that the financial system as a whole looks markedly different today than it did in 2007 with respect to the leveraged finance markets, and do not believe it will cause broader financial market instability. In our view, loans and CLOs are proven asset classes that warrant consideration in a prudent investor’s portfolio. We believe a benign default environment should persist, but macroeconomic and political concerns are present. As such, active management is paramount, and a deep dive into credit is essential. We remain highly selective and cautious with respect to our portfolio construction and aim to avoid pockets of excessive risk in the credit market.

[1] S&P LCD
[2] Federal Reserve
[3] LSTA

The views expressed herein do not constitute research, investment advice or trade recommendations, do not necessarily represent the views of Shenkman Capital Management nor TEXPERS, and are subject to revision over time. 

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Investment Insights

Investment grade private credit provides long-term fixed income investors diversification within fixed income, downside covenant protection and improved total returns

By Chris Gudmastad/Securian Asset Management Inc.

Investment grade private credit, a.k.a. private placements, combines the duration of fixed-rate public corporate bonds with the legal protections and covenants that are contained in most bank loans. 

Relative to investment grade public bonds, investment grade private credit offers:
  • Covenants, which provide downside protection and potential for additional fee income
  • Diversification through exposure to borrowers and assets that are typically not found in the public debt markets
  • Yield enhancement, compensating investors for illiquidity and structural complexity
The asset class has proven to be durable in a variety of market conditions and is best suited for investment managers with strong legal and credit underwriting skill sets, along with long-standing market relationships.

Investment grade private credit 

IG private credit bonds are unregistered debt securities that are sold to accredited investors via investment banks. Typical use of proceeds is similar to those of public bonds: refinancing debt, expansion, acquisitions, dividends, and stock buyback and recapitalization programs. Transactions range in size from less than $100 million to in excess of $1 billion.

The total outstanding market for IG private credit is approximately $800-$900 billion. Annual insurance topped $100 billion in 2018 and an established secondary market trades approximately $2-3 billion per year. Maturities typically range from five to 30 years and are able to be customized, making it an attractive market for foreign, privately owned companies and small public companies to issue term debt.

Click image to enlarge chart.

Why issuers access the private market

For decades, the U.S. investment grade private credit market has provided borrowers across the globe with consistent access to term funding. This was especially apparent during the 2008-2009 global financial crisis when major debt capital markets became disrupted, yet the IG private credit market remained a viable place for companies to issue term debt. In the years following the financial crisis, the U.S. IG private credit market experienced increased cross-border issuance as a number of European banks curbed lending.

Issuers value the ability to have a diversified source of funding beyond bank loans or public bonds to meet a particular funding need. In other cases, the small size of an issue, appetite for non-standard maturities (e.g., nine or 11 years) and amortizing structures, or the absence of a credit rating may rule out the public market.

A company without a long credit history may also view the private markets as a path to building a good reputation in preparation for an entry into the public bond market. In return for this access, their notes must carry strong covenants to provide investors comfort regarding the issuer’s willingness to maintain an investment grade rating profile

Some issuers prefer keeping financial and company information private – this may be for trade purposes or to preserve confidentiality for family-owned companies.

How investment grade private credit bonds compare 

Strengths and considerations for investors

IG private credit provides investors an opportunity to generate higher total returns, versus holding a basket of similarly rated public bonds. This can be achieved by several factors:

Structural protection. Covenant protections, a key differentiator between public and private bonds, provide downside protection to investors from financial and event risk. Covenants also ensure seniority in the capital structure, which, in the case of default, typically results in higher recoveries for IG private credit investors. (70-80%) vs. public unsecured bonds (40-50%).

Covenants legally compel management to maintain key financial metrics. Examples include limits on leverage (e.g., debt/EBITDA), restrictions on asset sales and requirements to maintain minimum coverage ratios. Covenants result in an early seat at the table, limiting event risk, resulting in compensation to bond holders through waiver or amendment fees, coupon step-ups and prepayment premiums that can add 10-20 basis points of additional fee income per year.

Yield enhancement. Upfront, IG private credit provides 15 – 50 basis points of additional spread relative to public bonds. The incremental yield for IG private credit compensates investors for the perceived lack of liquidity relative to public bonds, as well as compensation from structural complexity.

Diversification. A large number of IG private credit issuers do not issue debt in the public debt markets, thus providing investors additional portfolio diversification. Types of issuers accessing the U.S. IG private credit market range from utilities, industrials, infrastructure and project finance to professional sports leagues and stadiums/arenas.

While the IG private credit secondary market is considerably smaller than the public secondary market, and the potential for resale can be limited for smaller transactions, liquidity is stronger for performing, well-covenanted private bonds. This was evident during the global financial crisis, where some investors obtained liquidity by selling IG private credit bonds when they were unable to sell their public bonds.

Click image to enlarge chart. Source: Private Placement Monitor 
The views expressed herein do not constitute research, investment advice or trade recommendations, do not necessarily represent the views of Securian Asset Management Inc. nor TEXPERS, and are subject to revision over time. 

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Investment Insights

Pension Investing

Understanding the 'Death Spiral'

By Thomas Cassara/River and Mercantile Solutions

Many public sector pension plan sponsors face unique challenges which need to be reflected when establishing an appropriate asset allocation:

  • Funding ratios less than 100%;
  • High levels of annual cash outflows (benefit payments often over 5% of the plan’s market value); and
  • Limited ability/desire to materially vary cash contributions from year-to-year.

Given these challenges, Trustees should develop investment strategies that improve the funded status in a predictable manner and avoid having the plan become underfunded to the point where the plan falls into a “death spiral”.

The ‘Death Spiral’

At a high level, a death spiral can occur when an underfunded plan has negative cash flow. This is more common in mature plans where benefit payments plus expenses exceeds the investment income and contributions entering the plan. This negative cash flow typically causes the level of assets to fall and leave the plan with fewer assets to earn excess investment returns. This becomes especially pronounced in falling markets. Eventually, the decline in asset value and funded status becomes substantial and a severe action needs to occur in the form of higher cash contributions, lowering future benefit payments or a combination of both. The following two exhibits show this point.

Figure 1 illustrates the projected funded status over 10 years for a sample open pension plan that is currently 60% funded, with relatively high annual benefit payments, new contributions entering the plan and assumed to earn 6% a year.

Even though this plan is making contributions and is earning the assumed liability return it is projected to be less than 45% funded 10 years from now. While most plans are above 60% funded today, any material longer-term market correction could leave many pension plans at or below 60%.

What investment return is needed?

Figure 2 shows the approximate annual rate of investment return needed to maintain the current funded status for a similar pension plan to the one described above. As an example, the above plan needs to earn 9% per year to maintain its current 60% funded status, a full 3% above the assumed 6% return, even after taking into account the 3% contribution.

As the above illustration demonstrates, the worse funded the plan is, the higher the investment return needed to maintain the current funded status, let alone to improve upon it.

As a result, plan sponsors and Trustees who have poorly funded pension plans need to invest not just to earn these rates of return but also to “protect” the plan as best they can from falling into the death spiral. These spirals are especially painful because a fall in funded status will most likely occur during a recession when the ability to increase revenue from tax payers is likely to be limited.

An example of a “death spiral” was seen during the recent financial crisis, where the level of funded status for state public plans went from an average of 92% funded in 2007 to 61% in 2009 according to a study by Wilshire. These plans had to sell off assets during the crisis in order to raise cash to meet required benefit payments and as a result had fewer assets with which to participate in the subsequent market rebound.

Considerations in Setting the Investment Approach

Given the characteristics of these plans and the heightened risks they face due to less than optimal funding ratios, we believe Trustees need to consider these factors in defining their portfolio allocation. Consideration should be given to future results under a diverse set of economic scenarios, especially those that can most likely lead to a death spiral.


A vast number of pension plans rely on diversified portfolios dominated by global equity allocations and a significant percentage of alternative investments (hedge funds, private equity, private debt), yet funding ratios have remained stagnant even in the face of the longest equity bull market in history. We believe that an investment strategy which encompasses more predictable returns and increases protection against shocks to its funded ratio via a recession or economic downturn is most prudent for plans to consider on behalf of their participants.

The views expressed herein do not constitute research, investment advice or trade recommendations, do not necessarily represent the views of River and Mercantile Solutions nor TEXPERS, and are subject to revision over time.

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Investment Insights

Flights not Ferraris

By Amy Chamberlain/Newton Investment Management

One of the most distinct aspects of current consumer trends is the growing move by millennials to spend money on experiences, rather than things. This spending shift has a host of implications for companies and investors.

In the past, social status was driven far more by the ownership of impressive or expensive items. If you wanted to make your wealth known, you would buy a big house, a fancy new car or expensive clothes. However, the general social climate is changing for young people, with material possessions no longer conveying the social currency they once did. Now, experiences are the focus of millennial spending, with the ability to share experiences on social media amplifying this trend.

This change in consumer preferences will affect a number of different industries, most notably travel, restaurants, entertainment and companies in the wellness and fitness space.

In the US, all industries within the travel sector have exhibited strong growth this cycle. The standout performer has been the hotel industry, which has grown at 6% annually, while the cruise, car rental and airline industries are not far behind.[1] As flights around the world become cheaper and more accessible to many, the travel sector is likely to benefit from a greater emphasis on experiential spending. 

The Eating-Out Experience

Of course, international travel is still out of reach for the majority of the world’s citizens, and even domestic travel remains too expensive for many people around the globe. However, there are plenty of cheaper experiences that people are also spending money on at home. In the US, 49% of millennials are spending more on eating out each month than they are saving for retirement.[2]

Another well-publicized new trend is that young people are more interested in fitness. In the UK, the value of the fitness market is up 6.3% year on year, considerably exceeding overall economic growth.[3] There are also a host of other consumer sectors profiting alongside gyms and fitness equipment, with sales of athletic wear, health-conscious foods and sports nutrition products on the up.

Finally, entertainment is also benefiting from this consumer trend. Spending is rising across both the sports and audio-visual entertainment sectors, with the fastest growth rate of all being seen in eSports (competitions involving video games), a combination of the two. This market is predicted to grow at a 22% compound annual growth rate until 2022.[4] Music is also positively affected by these tailwinds. 

Click to enlarge chart. Source: Cashing in on the US Experience Economy, McKinsey, Dec 2017.

Keep It Social

With Facebook boasting 2.3 billion users and Instagram now having a billion active users every month, social media underpins the increased spending in all of these experience-related industries. In aggregate, Instagram users like 4.2 billion posts every day, with many of those posts sharing beautiful brunches, far-flung destinations, the latest workout or a weekend at a music festival.[5] The social sharing of purchases makes even the act of buying a tangible item more of an experience, by arguably merging the material and experiential world.

Of course, it is always important to be mindful of the risks that accompany any economic trend. So far, many of these spending preferences appear to be concentrated with millennials, so as Gen Z (those born between the mid-1990s and mid-2000s) become the bulk of the younger demographic, there is no guarantee they will spend in the same way. It is also possible that the shift from buying material things to preferring experiences is cyclical, and we may see a resurgence of spending on tangible items in the future.

While we always keep potential shifts in mind, for now it seems probable to us that greater spending on experiences is a trend that will continue to develop over the long term. We think this is likely to offer investment opportunities in the travel, fitness, entertainment and restaurants industries, and will be bolstered by increased usage of social media. Technology and millennials have united to drive a wallet share shift away from material possessions to experiences, and the consumer sectors – and investors – will, we believe, need to adjust accordingly.

The views expressed herein do not constitute research, investment advice or trade recommendations, do not necessarily represent the views of Newton Investment Management nor TEXPERS, and are subject to revision over time.

[1] https://marketrealist.com/2017/03/what-you-need-to-know-about-the-us-hotel-industry-performance/

[2] https://www.cnbc.com/2018/08/20/how-much-millennials-spend-at-restaurants-each-month.html
[3] http://www.leisuredb.com/blog/2017/5/5/2017-state-of-the-uk-fitness-industry-report-out-now
[4] https://blog.usejournal.com/esports-has-grown-up-fast-but-this-is-just-the-beginning-da5a45c59ed3
[5] https://blog.hootsuite.com/instagram-statistics/

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Monday, August 26, 2019

Investment Insights

What pension fund trustees should know 

about investing in real estate 

By Meredith Despins/Nareit

As a pension trustee you have a lot on your plate. Ensuring that your systems’ assets are diversified, in order to minimize risk of loss, is a core responsibility.

Diversification is primarily achieved by investing the plan’s assets in different types of investments or “asset classes.” Commercial real estate is the third largest asset class within the $97 trillion investment opportunity set in the United States. 

Click to enlarge chart. See footnote 1.

There are many factors that go into determining the appropriate allocation to any asset class, including real estate within an investment portfolio, and these factors are unique and specific to each pension fund. One very simple approach is the “market portfolio,” which invests in each asset weighted in proportion to its total presence in the market. This would suggest that pension funds should be allocating about 17% of their investments to real estate.

More detailed asset allocation methods that include a broad mix of asset classes and consider returns, correlations, and volatilities consistently, demonstrate that a meaningful allocation to real estate, somewhere in the 15 to 20% range, is appropriate.

Click to enlarge chart. See footnote 2.

Real estate is a mature asset class, and like equity and fixed income investments, exposure to real estate can be achieved through public market investments as well as through private market investment. In real estate, when we say “public market” investment, generally we mean investment in real estate through REITs (real estate investment trusts). “Private market” investments are investments in real estate through private transactions and vehicles.

For investors who are considering adding a real estate allocation or are beginning to build their real estate portfolio, REITs generally provide the most cost-effective and efficient way to gain exposure to the asset class.

For investors who have only private real estate investments in their portfolio, there are specific benefits of adding a meaningful allocation to REITs. REITs and private real estate are complementary investments within a portfolio. 

To see how this might work in your portfolio, visit www.pensionsandrealestate.com.

Click to enlarge chart. See footnote 3.

Today, most pension funds, on an asset weighted basis, invest in both REITs and private real estate. Including REIT strategies in combination with private market real estate investments helps pension funds to address several issues that have become critically important over the last decade, and which are difficult to achieve by investing solely through private real estate investment.

Access. The ability to efficiently invest fully in the real estate asset class, including “new economy” real estate.

Click to enlarge chart. See footnote 4.

Governance. Commercial real estate is a physical “bricks and mortar” asset and traditionally has been relatively illiquid. Because REITs are real estate companies traded on stock exchanges, they provide real estate investors with real estate returns in a vehicle that also provides effective governance and market liquidity.

Performance. Investing in real estate through REITs has provided not only asset class diversification, but also historically has enhanced investment performance. REITs' track record of delivering reliable and growing dividends, combined with long-term capital appreciation, has historically provided investors with total returns that outpace private real estate returns by 2.5% to 3% per year.

Cost Management. REITs provide investors with access to real estate, and because they are public market investments and listed on the stock exchange, are highly transparent. Real estate investment through REITs is often the most cost-effective and highest total return way for pension funds to invest in the asset class.

Click to enlarge chart. See footnote 5.

Risk Management. Diversification of your plan’s assets is among the most powerful risk management tools available to investors; and having real estate in the pension’s portfolio is one arrow in the risk management quiver. Diversification within the pension’s real estate portfolio is another important risk management tool.

Click to enlarge chart. See footnote 6.

Nareit hopes this information has provided “food for thought” as you consider your pension fund’s real estate investments. We invite you to visit www.pensionsandrealestate.com, a new website that has been designed especially with pension trustees in mind, and is intended to provide information to help trustees and pension fund investors think critically about their plan’s real estate investments. 


  1. Stock and bond data from Board of Governors of the Federal Reserve, Financial Accounts of the United States, 2018Q4; commercial real estate market size data based on Nareit analysis of CoStar property data and CoStar estimates of Commercial Real Estate Market Size, 2018Q4
  2. The Role of REITs and Listed Real Estate Equities in Target Date Fund Allocations, Wilshire Funds Management, 2019 https://www.reit.com/data-research/research/nareit-research/reits-critical-retirement-portfolios; Global Listed Real Estate Investment: Asset Allocation in a Non-Normal World, Morningstar December 2010; Commercial Real Estate Investment Through Global Public Markets, Morningstar, November 2011; The Role of REITs and Listed Real Estate Equities in Target Date Fund Asset Allocations, Wilshire Funds Management, January 2013; Real Estate Investment In Liability-Driven Portfolios, Morningstar Inc., July 2011; Real Estate Investment Through REITs, Morningstar Inc., September 2008.
  3. Nareit analysis of quarterly net total returns for NCREIF Fund Index – Open-End Diversified Core Equity (ODCE) and FTSE Nareit All Equity REITs Index, 1978Q1-2018Q4, after subtracting assumed fees of 12.5 bps/qtr for REITs.
  4. Source: FactSet, Nareit New Sectors incudes cell tower, data center, self storage, timberlands, single family home, and farmland REITs. All Other includes all other sectors in the FTSE Nareit All Equity REITs index. Data as of June 30, 2019.
  5. Source: CEM Benchmarking, 2018 available, at https://www.reit.com/sites/default/files/media/PDFs/Research/NAREITCEMESupdate2018Oct24.pdf
  6. Source: Nareit analysis of property data from S&P Global Market Intelligence.
The views expressed herein do not constitute research, investment advice or trade recommendations, do not necessarily represent the views of NAREIT nor TEXPERS, and are subject to revision over time.

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Investment Insights

Lessons learned from the Wells Fargo 

RMBS trustee litigation

Since the financial crisis of 2007-2008, we have seen a flurry of securities class actions settlements involving residential mortgage-back securities, also known as RMBS. Most recently, Financial Recovery Technologies filed over 1,600 claims for the Wells Fargo RMBS Trustee Litigation on behalf of some of the largest asset managers and hedge funds in the world.

For context, in the aftermath of the financial crisis, the investment world responded by implementing additional oversight and regulation to the management of RMBS, and as a result we have seen fewer settlements related to these securities in recent times. That being said, such cases have not been entirely eliminated. Even today, in the event of alleged misconduct by the trustees overseeing residential mortgage-back securities, substantial settlements can still arise.

Most importantly, settlements relating to the security involve additional complexity in terms of successfully producing and filing acceptable claims. That’s why firms are turning to companies like Financial Recovery Technology to assist in the recovery process. Here are a couple lessons learned that may be relevant for future residential mortgage-backed security cases: 

  • Investors were overwhelmed with the volume of securities included in the case: There were over 4,500 unique securities that were relevant to this settlement, each of which was associated with multiple security identifiers (e.g. CUSIPs, ISINs, and SEDOLs).
    • Unlike most securities litigation where the class includes holders of relatively few equities or debt instruments, RMBS cases tend to include hundreds or even thousands of securities. Financial Recovery Technologies developed scalable, specialized software designed to identify eligibility across many securities to efficiently assemble claims. 
  • Data for the claim was not standard: Over the past several years, claims administrators have refined the specifications defining what they need from each claimant to determine the value of the claims they receive for RMBS cases. However, there is still some variability in terms of how historical transactions in residential mortgage-backed securities need to be presented to claims administrators to submit a claim that will be understood and accepted. 
    • Financial Recovery Technologies queries for (or assist clients in querying) the transactions required to file for the Wells Fargo Trustee Litigation (or any RMBS cases). For the Wells Fargo Trustee Litigation, Financial Recovery Technologies leveraged previously-developed proprietary software to handle the conversions between original and current face values, enabling easy and successful claim filing. We complement the technology with an operational team, trained to understand the necessary cash flows patterns from residential mortgage-backed securities, and capable of identifying and rectifying gaps. Members of this team are available for consultation with clients about best-practices for obtaining data, and possess the know-how required to successfully file RMBS claims. 

The views expressed herein do not constitute research, investment advice or trade recommendations, do not necessarily represent the views of Financial Recovery Technologies nor TEXPERS, and are subject to revision over time.

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Investment Insights

The performance of late-cycle premiums

By Marlena Lee & Wes Crill/Dimensional Fund Advisors

The media has recently sharpened its focus on business cycles. A common refrain from the industry is that the performance of certain groups of stocks is tied to the business cycle. For example, it has been argued that some factors or investment strategies are “defensive” because they perform well late in the cycle when economic growth begins to slow, while other premiums should be avoided because historically they have underperformed during this phase. Investors who are pessimistic about the direction of the economy may be tempted to wonder if it’s time to reevaluate how their portfolios are positioned. 

It is important to be cautious when interpreting research conducted on a small number of observations. The National Bureau of Economic Research (NBER) has identified 15 recessions in the US since the start of stock market data coverage in 1926. Small sample sizes can be especially susceptible to the effect of a handful of outliers. 

We assessed the behavior of stock market premiums—size, value, and profitability1—and found no reliable evidence that their performance fares differently deep into an economic expansion. Our results suggest that pinpointing where we are in the business cycle is unlikely to yield useful inputs for one’s asset allocation. 

Late to the Party?

The NBER retrospectively classifies the US economy through time by identifying peaks and troughs that define recessions. The last trough was determined to be June 2009, marking the end of a recession beginning December 2007. 

While the NBER effectively provides a binary historical classification of the economy (recession or not), many in the industry describe fluctuations in the economy as business cycles with four phases: expansion, peak, contraction, and trough. The nearly 10 years that have elapsed since the last NBER trough have prompted many to suggest we are nearing the end of the current expansion prior to the next recession, a stretch some refer to as “late-cycle.” 

For the purposes of our study, we define late-cycle using the chronological midpoint between NBER trough and peak dates, as shown in the illustrative example of the business cycle in Exhibit 1. Late-cycle months therefore compose the second half of each expansion period. 

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How have size, value, and profitability premiums fared during the oft-discussed late-cycle periods? As we see in Exhibit 2, the premiums in late-cycle months were positive on average and similar in size to their full-sample historical averages. The average monthly return difference between small caps and large caps in late-cycle months was 0.23%, compared to 0.28% in all months from June 1927 through December 2018. Value and profitability premiums were both slightly higher than their overall historical averages. And all three premiums were positive at least 50% of the time in late-cycle months, with similar frequencies to their full history. It appears that, despite the fanfare over late-cycle investing, there is no evidence that the size, value, and profitability premiums perform any differently late in the business cycle. 

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While the average premiums are similar between the late-cycle months and all months, an investor may be wondering how the range of outcomes compares. Specifically, are the premiums more prone to especially bad outcomes late in the business cycle? The distributions illustrated in Exhibit 3 suggest not. The distributions of premiums in late-cycle months are quite similar to the overall distribution in all months. In other words, there is no reason to expect different size, value, or profitability premiums just because we are many years into the current economic expansion. 

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Click to enlarge graph.

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Breaking the Cycle

What we know is that the US expansion is in its 10th year. What we don’t know is how much longer this cycle will last. With historical US expansions lasting an average of about four years, many in the industry would agree we are late in the cycle. What does that imply about the distribution of size, value, and profitability premiums? 

Not much, according to the historical evidence. While the premiums are not assured over any time frame, research suggests the most reliable way to capture them is through a disciplined approach that maintains consistency through time.

The views expressed herein do not constitute research, investment advice or trade recommendations, do not necessarily represent the views of Dimensional Fund Advisors nor TEXPERS, and are subject to revision over time.