Listed equity real estate investment trusts (REITs) were the best-performing asset class for pension plans between 1998 and 2014, according to a study by pension research firm CEM Benchmarking, sponsored by the National Association of Real Estate Investment Trusts (NAREIT).

Listed equity REITs outperformed all other 11 assets in the study, generating average annual net returns of 11.95%. Average annual investment costs of 0.51%, the lowest of any of the alternative or real estate asset groups, contributed to REITs’ net return performance.                 

Hedge funds, with average annual investment costs twice those of REITs, produced less than half the net returns at 5.50%, according to the study. The hedge fund average annual return was the second-lowest of all assets surveyed, outpacing only U.S. other fixed Income, a category that included cash. Excluding cash from U.S. other fixed income, hedge funds were the worst performing asset in the study, underperforming all other categories of stock, fixed income, real assets and alternative investments.

While private equity had a higher average annual gross return than REITs at 13.46%, its net return was lower at 11.37%, pulled down by management fees that were nearly four times higher than those of REITs. REITs also outperformed unlisted real estate, which delivered an average annual net return of 8.59% with more than twice the annual fees of REITs.

Pension funds made substantial changes to their capital allocation strategies over the course of the study period, especially their allocations to hedge funds and tactical asset allocation strategies. This asset category averaged 1.46% of pension fund portfolios at the start of the study period in 1998 and grew to 8.36% of portfolios in 2014—a nearly 500% increase. Private equity also grew from 1.97% of portfolios in 1998 to 5.93% in 2014. The portion of portfolios allocated to unlisted real estate also increased from 2.90% in 1998 to 4.46% in 2014. Listed equity REITs were an extremely small allocation in pension plans’ portfolios in 1998 at 0.36% and the smallest of all allocations in 2014 at 0.62%.

“The fact that listed equity REITs were the top performing asset class, but represented only 0.6% of total allocations, the lowest allocation in the study, and have only realized an increase in capital of 30 basis points since 1998, is a complete disconnect,” says Alexander Beath, senior research analyst at CEM Benchmarking and the author of the study.  “The combination of limited portfolio allocations and outsized returns of REITs led to a significant missed opportunity for pension funds and may point to a strategy for improving future returns.”

If the pension plans included in the CEM study had reversed their REIT and hedge fund allocations over the 1998 through 2014 period, at the end of 2014, they would have had plan asset balances that were 2% larger, the study report suggests. Applying the 2% additional assets to the approximately $3.2 trillion in private defined benefit plan assets in the U.S. would yield an additional $64 billion in assets—more than three times the estimated $20 billion in private pension underfunding. Applying the 2% additional assets to the $3.8 trillion in non-federal public defined benefit plan assets would yield an additional $76 billion in assets—nearly 6% of the estimated $1.3 trillion in underfunding in these plans.

The study provides a comprehensive review of investment allocations and actual investment performance across 12 asset groups. The analysis looks at fund performance over 17 years, the longest period for which CEM had data for some of the assets studied, and it utilizes a proprietary dataset covering more than 200 public and private-sector pension plans with more than $3 trillion in combined assets under management.

The study report, “Asset Allocation and Fund Performance of Defined Benefit Pension Funds in the United States Between 1998-2014,” may be downloaded from here.