This piece by Con Keating was first published in Professional Pensions
In early 2020, in order to explore the potential for Collective Defined Contribution (CDC) pensions, I began an extensive project to investigate the investment performance of the major asset classes, products and investment strategies. This has involved wading through a quagmire of marketing hype, greenwashing, and outright misrepresentation. The Competition and Markets Authority’s new strictures on greenwashing seem overdue.
It appears that many commonly held attributes (and marketing staples) of these portfolios do not bear close scrutiny – for example, private equity is replicable as highly-leveraged small-cap listed equity at far lower management cost. Environmental, Social and Governance (ESG) outperformance, such as it is, is entirely explained by the huge recent inflows of capital into these products, which has driven up their price and speculative content.
Investment performance consistency or persistence is problematic. Past performance is no guide with respect to strong performers, but it is a good guide among the poor performers. The best do not remain the best, but the poorest do tend to remain the poorest. Why or how these dogs can continue to exist is a challenge for believers in efficient markets.
On average, passive management outperforms active, though the marketing departments of the active asset managers are quick to promote their ‘stars’ based on a few years success. As the life span of CDC schemes can be expected to far exceed the working lifetime of a ‘star’, these active funds really have no place. Their use would be speculation, not investment.
Measures of Speculation
Of course, speculation is always present to some degree or other in any financial market and it affects the returns realised over a period. This is obscured in standard performance analysis by the focus on total return and benchmarking, as it is present in both.
Fortunately, there is a simple measure of the degree to which speculation has increased or decreased; it is the return due to revaluation over the period under consideration[i]. Following the work of John Woods (New exercises in decomposition analysis[ii]), we may decompose the total real return[iii] into its components: Income Yield, Income Growth and the Revaluation Effect. Table 1 reproduces the calculations by Woods of the ten-year average total real return and its revaluation component for selected dates.
Table 1: Ten-year average real returns at selected dates
| 2000 | 2008 | 2018 | ||
| Equity | Total Return | 12.2 | -1.4 | 5.9 |
| Revaluation | 9.4 | -5.7 | 0.1 | |
| Gilts | Total Return | 10.4 | 2.6 | 3.9 |
| Revaluation | 5.7 | 3.3 | 4.6 | |
| ILG | Total Return | 6.0 | 2.8 | 4.6 |
| Revaluation | 1.8 | 1.7 | 13.3 |
Source: J. E. Woods (2020)
This decomposition carries information about the decade past and may be used to inform estimates of the period ahead, but most importantly it indicates current value. For example: the revaluation effect for UK equities was maximal in the year 2000 at the height of the Dot.Com bubble, when it accounted for 9.4% of the 12.2% total real return realised. This was indicating a highly valued market. By contrast in the decade to 2008, the revaluation effect was at its nadir at -5.7% and the total realised real return -1.4%. Here, the market could be considered cheap. These are wild variations of the revaluation effect, speculative boom and bust, which has typically been in the range 0.1% – 0.2%.
By contrast, the revaluation effect for conventional gilts has been relatively tame reflecting, in large part only, the decline in interest rates over the past forty years.
Index-linked Gilts
However, this is not true of index-linked gilts. Since 2006, the revaluation effect for index-linked gilts has climbed inexorably, reaching 13.3% in 2018 and dwarfing the overall total real return of 4.6%. Of course, this has been the period in which UK DB pension schemes have been the dominant, apparently price-insensitive, buyer of index-linked gilts – they now account for over 80% of the stock outstanding. The level of speculative interest in index-linked gilts is currently far greater than the speculative interest in equities was at the height of the Dot.com bubble.
With speculative interest this high, it seems wise for CDC trustees to look for other instruments which may provide inflation protection, particularly so given the uncertainty over the path of inflation post-pandemic. However, with nominal conventional yields close to all-time lows, there is little incentive for CPI/RPI linked debt issuance by the corporate sector, even for those whose revenues are CPI-linked.
Residential Housing
The one sector of the UK financial system that is large enough to generate inflation-related returns on the scale needed for private pension savings is residential housing. The ONS reported that net property wealth was £5.1 trillion of total aggregate wealth of £14.6 trillion – and private pensions wealth was £6.1 trillion.
Demand for new housing in England is conservatively estimated to increase at some 340,000 dwellings annually until 2031[iv] and production has never reached these levels (243,770 dwellings were built between April 2019 and March 2020). The housing shortfall is estimated as an eye-watering 3.9 million dwellings. The decisions by John Lewis and Lloyds Bank to build large portfolios of rental properties are welcome – but, totalling a mere 60,000 units, these will not make much impression.
The result has been completely predictable. Figure 1 shows the Land Registry house price index from 1990 together with the retail price and consumer price indices. The figure also shows fitted exponential trend lines for house prices and the consumer price index (and the descriptive statistics for these). House prices have increased at almost twice the rate of consumer price inflation (0.41 versus 0.21) since 1990. This implies that structures which share house price gains between tenant and investor should be viable. It should be borne in mind that house prices, though rising faster, are approximately three times as volatile as consumer prices.
Figure 1 also throws light on the highly contentious decision by government to switch the basis, in 2030, of index-linked gilts from RPI to CPI. RPI has produced 123.7% of the returns of CPI over the period since 1990 – an annual loss of 73 basis points.
Just over 4.4 million households live in the private rented sector in England, ie 19% of all households. By comparison, 17% (4.0 million) live in the social rented sector and 65% (15.4 million) are owner occupiers. The number and proportion of private rented households has declined from 20% (4.7 million) in the period 2016 to 2017.
Younger private renters are more likely than older private renters to expect to own a home in the future. More than three quarters of private renters aged 16 to 24 (78%) and those aged 25 to 34 (77%) say they expect to buy a home in the future[v]. These groups account for 41% of all private renters. The expectation to buy tapers off in older age cohorts – just under two thirds of those aged 35 to 44 (65%), two fifths of those aged 45 to 64 (41%) and just over a tenth of those aged 65 to 74 (12%) eventually expect to buy.
Figure 1: House Prices and Consumer and Retail Price Indices
Source: ONS
These aspirations suggest strongly that rent-to-buy based investment structures would serve a considerable social purpose, and be attractive to younger cohorts, provided, of course, that they could be created on commercially attractive investment terms.
The essential elements of rent-to-buy are inflation-linked rents and the sharing of house price performance, with many variations in the detail of those terms being possible. While rent-to-buy schemes have been known since at least the early 1980s, they have until recently been small scale, ad-hoc arrangements. However, in August, the new Allianz-Wayhome partnership, combining their financial and property expertise, began buying properties and writing rent-to-buy contracts on an institutional scale. The investment structure is a limited partnership, which has institutional support from several pension funds. The expected returns of this partnership fund are estimated, conservatively, to be of the order of 5% pa nominal.
The reception has been good from both investors and aspiring homeowners:
Conrad Holmboe, CIO at Wayhome commented:
“We wanted to prove that having a positive societal impact doesn’t have to come at the cost of lower returns or higher risk. Being responsible isn’t an opportunity cost. Home-ownership is no longer a pipe dream for aspiring home-owners, including key workers, such as teachers and NHS staff.”
Jason Allan of Allianz Global Investors added:
“Pension schemes have been impressed by the genuine innovation and that this provides access to the residential market efficiently at scale.”
Doubtless, with success evident, many competitors will spring up and, with that, a new capital market, with financial and social purpose embedded within its DNA, will emerge.
[i] There are nuances to the speculation interpretation – see Woods op. cit.
[ii] J. E. Woods (2020) New exercises in decomposition analysis, Journal of Post Keynesian Economics, 43:1, 36-60
[iii] The figures quoted in this article are all rolling real ten-year geometric returns.
[iv] See Heriot Watt University in Commons Briefing Paper 07671, Tackling the undersupply of housing in England, January 2021
[v] English Housing Survey, Private Rented Sector, 2019 – 2020
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I no longer subscribe to Linked-In (I find its security appalling) but I have been told that Eddie Truell posted the following comment on this blog cross-posted there.
“Thank you – an interesting read. Particularly interested in residential housing as an asset class.
However, Con ignores political risk where left wing governments impose rent controls every other generation ( when they have forgotten the pernicious effect ).
I do take issue with his canard that Private Equity can be replicated by leveraging small cap equities. Totally ignores the long series data sets that show that PE has far better Risk adjusted returns. A diversified PE portfolio demonstrates real Alpha and resilience.”
I did not mention rent controls though they dominated the UK residential rental market throughout my student and early career years. Indeed, they are quite common in both state and municipal form in overseas markets to this day. They are also not solely the domain of left-wing governments – though concerns with social or subsidised housing do tend to be. Clearly this would have had to have been considered extensively (and no doubt expensively) by the various institutions proposing to enter the rental market at scale. These institutions will also tend alter the nature of the UK private rental market which is dominated by small scale landlords – they may even go far in closing the inefficiency gap between gross and net rental returns, which at around 30% -35% are far larger than their European equivalents where institutional ownership is far higher. Institutional landlords are also through their lobbying power likely to lower the possibility of rent controls being imposed. I have not come across any explicit form of regulation of rent to buy – a somewhat convoluted case can be made that they are a form of hire-purchase and clearly these contracts are subject to oversight by the FCA and subject to the principle of treating customers fairly. It does seem likely that private landlords will attract the attentions of HMT and new taxes imposed – perhaps alongside variation of the treatment of carried interest in private equity / venture capital.
My principal reason for not mentioning the possibility of rent controls was that these contracts can easily be recharacterized as partial purchases rather than rentals.
The point left/right division is less obvious in policy terms. Home ownership is supported by all parties in the UK. The population at large is in favour of building more houses and this is evident regardless of gender or political leanings, just not in my back yard. It may surprise but polling also finds that the population would like to see lower house prices, but again presumably not mine. I was absent overseas for the majority of the last great decline in houses in 1990 -1994 but discussion of negative equity and impoverished over-mortgaged house buyers were a staple of both tabloids and broadsheets and reached overseas.
We are currently at something of a turning point in Conservative housing policy – the build 300,000 units annually ambition has been quietly dropped. Brown-fill rather than green-fill is now the planning requirement. The once mooted relaxations of planning procedures are not happening. Now the irony of this about-turn is that the ‘academic’ cover for it, such as it is, is a paper produced by Ian Mulheirn, who is Chief Economist of Renewing the Centre at the Tony Blair Institute for Global Change. This paper “Tackling the UK housing crisis: is supply the answer?” challenges the consensus that the problem is one of supply.
Moving to the question of private equity performance, my earliest discussion of this took place in 1980 in the bar of the Intercontinental Hotel in New York and when I left NYC for London in 1984 my P.A. joined one the major PE houses and made a very substantial fortune before retiring. For the purpose at hand I reviewed as many publications as I could find – going back as far as the late 1980s – and I spoke with a number of their authors. The results were mixed – the trade and sponsor literature was boosterish and universally positive – the academic publications shifted emphasis over the decades growing increasingly sceptical. The quality and rigour of these studies has increased over time – problems such as the conceptual value of assets held, liquidity and the proportion of committed funds deployed have been largely (but not completely) overcome. I would recommend reading the publications of the Private Equity Institute at Oxford’s Said Business School and the work of Ludovic Phallipou in particular.
There have been periods when PE has produced strong performance – this appears to have driven the development of the market is its early days – but there have also been sustained periods of underperformance. The business model of the PE managers could, unkindly, be described as heads I win, tails you lose. With this in mind I decided to do my own analysis – a process which took over a year – that work led to my conclusion that I could reproduce market average performance using leveraged listed small cap – which of course would carry a massive cost advantage.
I was also concerned by the present state of the PE market – dry powder is at an all-time high and the prices now being paid appear to be at a premium to listed equity of the order of 70%. This does not make for an attractive vintage. I wonder and worry about the development of ‘continuation funds’.
I will end by saying that I have been impressed by the power of the PE lobby – notably over performance fees for DC and DB funds, but also in other areas such as the LTAF.