The California Public Employees’ Retirement System (CalPERS) shocked the investing world in September when it announced that it was pulling its $4 billion investments in hedge funds.

The pension fund is the largest in the United States — nearly $300 billion in size. Many investors follow its lead when it comes to asset allocation.

The decision to sell out of 30 hedge fund and fund-of-funds investments was made by the board to reduce complexity and costs in the pension fund. Many hedge funds use complex algorithms to pick and pair stocks, and usually charge a 20% fee on profits, on top of a 2% administration fee.

The withdrawal of CalPERS is a recognition that the high costs may not be worth the hedge funds’ modest returns.

CalPERs made another disclosure that may be just as important, possibly even more so.

The Largest Asset Class In The World
On October 8, CalPERS announced that it will increase its allocation in real estate by $7 billion — to $33 billion, or 11% of the fund’s assets. The fund has already increased its allocation to 9.9%, but still has approximately $3.25 billion to invest before reaching its 2016 target.

#-ad_banner-#​CalPERS’ real estate investments, averaging a 14% annual return since 2011, have easily beaten its hedge fund investments which returned just 7.1% in the fiscal year ending June 30.

As an asset class, real estate is pretty hard to beat. The value of housing in the United States alone is $26 trillion and global real estate trumps all other assets for absolute size. It is the greatest source of wealth for most families and few investments have created as much legacy wealth. Along with the growth of exchange-traded funds, individual investors have access to a portfolio of properties with geographic and property-type diversification.

The Vanguard REIT ETF (NYSE: VNQ) outperformed the S&P 500 over the last ten years with an annualized return of 8.7%, against a return of 8.2% for the general market. This includes a dividend yield of 3.5%, nearly twice that of the S&P 500. Volatility is slightly higher but only as a result of the sector-specific selloff with the housing bust.

Where might the money go?
CalPERS is well-diversified across property types, according to its August 13F Securities & Exchange Commission filing. Much of its property investment is through private management firms, but it also holds more than $500 million in publicly-traded companies.

Simon Property Group, Inc. (NYSE: SPG) is CalPERS largest REIT holding with 950,708 shares worth $158 million. The REIT invests primarily in regional malls and outlets, which could give it a big upside opportunity if the recent drop in gas prices converts to higher consumer spending. Simon Property is geographically diversified as well with assets in North America, Europe and Asia.

Simon Property recently announced a bond program of up to $500 million that will guarantee liquidity over the near-term. The REIT pays a 3.1% yield and has provided investors an annualized return of 16% over the last three years.

American Tower Corp. (NYSE: AMT) is CalPERS second-largest REIT holding with 1,140,775 shares worth $105 million. The REIT is different because it invests in wireless and broadcast real estate around the world. The company’s U.S. assets provide stable cash flow to support the dividend while growth in emerging markets offers upside potential for the shares. The REIT pays a 1.5% yield and has provided investors an annualized return of 22% over the last three years.

The fund holds 782,352 shares worth $57 million in Starwood Hotels & Resorts Worldwide, Inc. (NYSE: HOT). Shares of Starwood have come down 12% since the beginning of October, but offer strong upside on best-in-class management. Dave Forest, strategist for Top-10 Stocks, recently highlighted Starwood as one of his favorite “Forever Stocks” for its ability to collect premium rates on luxury properties. The REIT pays a 1.75% yield and has provided investors an annualized return of 20% over the last three years.

In-line with my warning on October 13 on rate risk in REITs, Pension Consulting Alliance cautioned CalPERs in June that real estate asset values could be constrained as interest rates rise to normalized levels. Because of the interest rate risk next year, I prefer REITs that will be able to increase lease rates quickly due to shorter-term contracts, which includes apartments, self-storage and hotels.

Risks To Consider: REITs will likely come under pressure as interest rates rise and investors may see increased volatility in 2015 so be prepared for near-term weakness. These strong investments in real assets stand the test of time and should provide strong long-term returns.

Action To Take –> Follow the country’s largest pension fund into real estate for solid long-term profits through both cash dividends and price appreciation. I prefer property types that can increase rents quickly, like apartments, public storage and hotels.

Real estate investments trusts are regularly talked about in our premium newsletter High-Yield Investing. The real estate space is home to some of the highest yielders and we’ve got the latest insight and analysis of the industry. For more information about High-Yield Investing, click here.