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Econometric Advisors' blog

Denominator Effect Takes Hold as Pension Funds’ Real Estate Target-to-Allocation Gap Falls to Just 0.5%

Oct 13, 2022, 13:47 PM by Michael Leahy
Public pension plans are formidable participants in U.S. financial markets with roughly $4.5 trillion in assets under management. Diversification is an important element of these plans’ strategies and they set strict targets for the percentage of their investment portfolio they can allocate to each asset class. If allocations approach or exceed the target, the plans have no choice but to stop investing – or even trim their holdings – in an asset class.

This phenomenon is called the denominator effect and it’s come into play this year given the dreadful performance of stocks and bonds. These strategies can be detrimental to real estate investment at a time when publicly traded assets, such as equities and fixed income, dramatically underperform private market assets.

Using a representative sample of public plans, Figure 1 shows that many are still under invested in commercial real estate, but just barely.  (Each bar represents the fund’s target investment in real estate, less its current allocation.) At the end of 2021, funds were under allocated (compared with their target) to real estate by an average of 1.3 percentage points. Resetting allocations in light of the S&P 500’s decline this year, the allocation-to-target gap fell to just 0.5 percentage points, leaving most funds little headroom for making additional real estate investments.

With many public pension funds on the sidelines, investors who are not fettered by stringent target allocation requirements can move quickly to capitalize on opportunities created by market dislocations. Of course, stocks don’t decline forever, and a share-price rebound can quickly reverse the denominator effect, restoring pension funds’ capacity to invest in real estate.

COTW Image 10.12.2022

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