SACRAMENTO, CA—Last week the California Public Employees' Retirement System revealed it had decided to divest its entire allocation in hedge funds. The reason, it said, was not due to performance issues but rather one of scale: their $4 billion allocation in the asset class was not large enough to provide cost-effective diversification.

At the same time the fund has increased its allocation in a number of commercial real estate investments: it is adding $400 million to an existing partnership with Invesco Real Estate and $200 million to an existing partnership with Pacific Urban Residential. Another $600 million went to a real estate partnership with Bentall Kennedy and $700 million to two real estate partnerships with GI Partners.

With assets totaling $300.3 billion as of June 30, 2014, CalPERS has about $25.9 billion in real estate. Clearly it is not the pension fund's main asset class allocation [see chart for more details on that] but it is also not its smallest. Rather it sits somewhere in the middle of a plethora of approaches that range from growth to liquidity to infrastructure to absolute return to income.

Of course with CalPERS' size, any shift in strategy, no matter how small for the fund, is significant to investors. Why did CalPERS decided to increase its allocation to CRE? Certainly for the typical reasons of diversification and yield and the strong growth in valuations. But, we wondered, could other factors been at play as well. Here are some theories.

It's business as usual.

It was just real estate' turn, says Stephen Culhane, who heads the investment management practice at the law firm Kaye Scholer.

Institutional investors are always assessing and reassessing their allocations," he tells GlobeSt.com. "Commercial real estate valuations are strong and it is perceived as a bit as a safe haven particularly for non US and long-term investors."

It's a better match against assets and liabilities.

Commercial real estate is better for a fund like CalPERS, whose liabilities are better suited for longer-term assets than those of shorter durations, Culhane also says. Interestingly, this shift can also be seen in the growing numbers of corporate pension plans that are realigning their portfolios away from stocks and into corporate bonds, a trend recently highlighted by Citigroup Global Markets.

It's a safe way to get exposure to untraded securities.

Typically institutional investors like to have a certain allocation of untraded securities. They will hold a higher percentage of those than the average retail investor, Jeff Edison, co-founder and principal at Phillips Edison & Co. tells GlobeSt.com. The hedge fund holdings fell in that category so when CalPERS moved out of its hedge fund holdings they wanted an alternative that didn't fall in the category of daily traded assets – CalPERS has enough of those – and that could provide stable, longer-term returns.

It's a shift in investment philosophy – and not just a change in asset allocation.

CalPERS handles over $300 billion for over 1 million current and former state employees. Their investing philosophy is transitioning from a classic hedge fund, 60/40 model, to more of an endowment model, says Jeff Sica, founder and CIO of Circle Squared Alternative Investments.

"CalPERS is aiming to reduce volatility and obtain a more predictable annual return across their portfolio," Sica tells GlobeSt.com. "Their move into real estate provides them with stability and a quantifiable income stream. With reduced volatility and a stabilized annual return, it will be more beneficial to them in the long run instead of fluctuating with the equity market," he says.

Hedge funds have lost their appeal.

Despite CalPERS careful explanations, this is the theory of Bill Militello, co-founder and CEO of Militello Capital.

"The increasing trend of moving away from hedge funds is due in part to their lack of transparency and a lack of understanding of the investments—they are intangible," he tells GlobeSt.com. "Hedge funds are simply public securities in a different wrapper, they are not an asset class, they are a compensation scheme."

There is also evidence that hedge funds on an overall basis have actually underperformed versus passively managed funds, Chauncey M. Swalwell, partner with Stroock & Stroock & Lavan LLP, tells GlobeSt.com—"making the relatively high fees typically paid to hedge fund managers untenable at CalPERS."

It is an inflation hedge…

This is the flip side of fund's decision, Militello adds. "Properly purchased real estate in supply constrained markets with built in demand drivers provides access to well-insulated investments that protect against rising interest rates."

…and a growth driver.

"Although in major markets like New York City, prices are reaching all-time highs, we believe that the values will be sustained over the long term and we will continue to see attractive opportunities nationwide, particularly those with patient capital," Avi Benamu, managing partner of Winchester Equities, tells GlobeSt.com.

"The right allocation to real estate can generate superior yields as well as tax benefits which in by themselves are of value to institutional investors."

Certainly the general recovery of the real estate market, particularly commercial real estate, has made greater allocations into that sector--always a staple for CalPERS and other pension funds—much more viable independent of what is happening with hedge funds, Swalwell says.

"CalPERS and other pension funds seem also to be focusing less of their investments in more risky speculative development investments than perhaps was the case during the pre-recession boom, which also would be consistent with getting away from hedge funds, and provide (at least theoretically) a more stable asset base and consistent return for the fund," Swalwell also says.

Instant Insights /

7 Reasons Why CalPERS May Have Increased Its Exposure to Real Estate

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