January 08, 2007

Stephen D. CauleyLOS ANGELES - Real estate has long been considered an "alternative asset" among portfolio managers. Tagged by the industry as "illiquid" and thus undesirable, it's been sorely underutilized to date. But the landscape is changing and new opportunities to optimize asset allocation have appeared on the horizon, say leading scholars at the Richard S. Ziman Center for Real Estate.

Recent research out of the Ziman Center examines asset allocation and the significance of liquidity in fund management. Results reveal that an "illiquid asset, such as real estate, actually can be a viable asset class despite popular thinking by pension funds and insurance companies.

"These institutions have very little money invested in real estate, which seems strange to us as economists," says Professor Steve Cauley who explored the topic with Ziman Center Director Eduardo Schwartz and Andrey Pavlov (Ph.D. '99). "They perceive of it as a highly illiquid asset. What we decided to explore is, "How much illiquidity can your portfolio afford?"

More than fund managers initially realized, according to the study that emphasizes the relationship between fund contributions, distribution of benefits and asset allocation. The team explicitly incorporated the "illiquidity" of real estate investments in asset allocation decisions. And they explored, through the use of a numerical model, the optimal asset allocation for a defined benefits pension fund.

Liquid Hunch
It became very clear that you could have a great deal more illiquidity - and not just that you could - but that it would be optimal if you did," Cauley says of pension fund management. He emphasizes the interconnectedness and relational aspect of assets under one umbrella. "The key is to realize that the relevant measure of liquidity as an asset, such as real estate, is not its liquidity in isolation but its contribution to the "liquidity" of an entire portfolio."

Real estate responds to different types of economic conditions than other asset classes, Cauley points out. Inflation is bad for stocks and bonds, for example, but may not be so bad for real estate. And all assets don't go up and down together; they have different rates of return. Even within the real estate class, liquidity varies, depending on the size and type of asset, the location and market conditions.

The research suggests that fund managers would be wise to transform their thinking from a focus on asset liquidity to portfolio liquidity. The study contends that a portfolio can be very liquid even with substantial investments in illiquid assets.

"Allocations to real estate in excess of 15 percent appear to be desirable for a wide range of cases," Cauley says of recent findings.

While the bulk of research has focused on pension funds to date, the Ziman Center will turn its attention to life insurance and casualty companies. Cauley is confident that the group's thesis will bear out in this case, as well, even though liquidity is top of mind in that arena.

"Let's assume you're an insurance company and 50 percent of your portfolio is in U.S. Government Treasury securities that can instantly be turned into cash," Cauley says. "The other is in assets that you can't unlock for 10 years. If the largest claim you can have on an insurance policy represents 10 percent of your portfolio, that illiquidity doesn't matter very much."

Cauley says the team's main goal is to get institutions to think about asset allocation in a new way - for their own benefit and that of their constituents.

"If companies manage their funds better it should ultimately benefit the consumer," he says. "The ideal would be that consumers contribute less in the future - or even contribute the same - but get more benefits as a result."

About the Ziman Center
The Richard S. Ziman Center for Real Estate, a joint center of the UCLA Anderson School of Management and the UCLA School of Law, was formed with a mandate to create and administer UCLA’s activities surrounding the topic of real estate.

About UCLA Anderson School of Management
UCLA Anderson School of Management is ranked among the top-tier business schools in the world building the next generation of leaders for institutions across the globe. A faculty ranked #1 in “intellectual capital” by Businessweek and renowned for their research and teaching, highly selective admissions, successful alumni and world-class facilities combine to provide an extraordinary learning environment.

The mission of UCLA Anderson School of Management is to be a global leader in advancing management thought and practice through education, research and service. Established in 1935, UCLA Anderson provides management education to more than 1,600 students enrolled in MBA, Executive MBA, Fully-Employed MBA and doctoral programs, and more than 2,000 executives and managers enrolled annually in executive education programs. UCLA Anderson alumni number more than 35,000 graduates around the world dedicated to continued networking, professional development and educational activities.

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