With a distinct whiff of 2008 about them, recent events at UK property funds recall Sir Winston Churchill’s paraphrasing of Santayana’s admonition: "those who fail to learn from history are doomed to repeat it.”
The mismatch between daily-dealing direct property funds and the illiquid nature of their underlying investments is bad for investors
A number of open-ended UK commercial property funds suspended trading during the first week of July, thereby freezing investors’ rights to redeem their shares.
Last month, investors were hit with share price markdowns as funds including Henderson UK Property, M&G UK Property Portfolio, Standard Life UK Real Estate and Aviva Investors Property Trust, swung their prices down from offer to bid or mid pricing, thereby lowering the prices of the funds by around 5%-6.25%.
In addition to imposing those high exit charges, a number of funds have also undergone fair value adjustments, bringing their values down by an additional 4%-5%. Such action has come in response to redemptions which were triggered ahead of the UK referendum, and surged amidst the uncertainty of its aftermath.
Brexit to Blame
The near-term cause of all this is the uncertainty caused by the outcome of the Brexit referendum, but the root cause is much more significant. The funds in question are open-end funds providing daily liquidity to investors. That’s all fine and well when a fund owns assets which can be readily bought and sold to either put incoming cash to work or raise cash to meet investor redemptions. However, these funds invest the vast bulk of their assets directly in property. Their portfolios consist therefore of buildings and land, which can take months, if not years to buy and sell.
To combat this mismatch between the liquidity expectations of investors and the illiquid profile of their portfolio holdings, asset managers uses measure such as those above with the aim of restricting outflows and ensuring valuations are correct.
Swinging the pricing doesn’t necessarily deter investors from redeeming their shares though – if it did, we wouldn’t have seen funds close for redemptions in 2008 – however, it does help finance some of the transactions costs that are associated with redemptions. Otherwise, the remaining investors in the funds would have to bear the brunt of those costs.
Carrying Cash to Provide Liquidity
Managers also carry cash buffers to provide some balance in the portfolios in terms of liquidity, but this then means there is a restricted amount of redemptions that can be met through this buffer. M&G Property Portfolio, for example, held as little as 5.5% in cash in January 2014. Cash is also intended for new purchases and the costs associated with these, so it is not purely for redemptions. Further, in an upward trending market, that cash buffer becomes a drag on performance and is perhaps one of the reasons why those funds have struggled to outperform the IPD UK All Property Index over various time periods.
Indeed, over the last five years, the average fund in the Morningstar Property – Direct UK category has returned 5.7% on an annualised basis, compared with a far higher 10.4% return for the IPD UK All Property Index.
The mismatch between the open-ended structure of daily-dealing direct property funds and the illiquid nature of their underlying investments is bad for investors. Time and again investors are faced with making the difficult choice between withstanding the woes that strike when fear overshadows the property market, and paying a high price tag to liquidate their investments.
It also raises concerns about market stability: The Bank of England in its Financial Stability Report released July 5 2016 has stressed the importance of property funds in influencing the market: “The behaviour of open-ended funds investing in the UK CRE [commercial real estate] market could amplify any market adjustment. These funds offer investors the option of redeeming their investments at short notice.”
Property Should be Restricted to Closed-end Funds
This is not a new problem and it doesn’t extend only to the property sector—the 2015 closure of a distressed-debt US mutual fund from Third Avenue amid sharp outflows demonstrates this clearly. At the very least, the level of illiquid assets permitted to be held by vehicles providing daily liquidity to investors should be curtailed.
Those funds that cannot meet the hurdle should instead be converted to investment trusts, which do not offer investors the ability to redeem but instead offer liquidity by trading on the secondary market. Whilst this would re-introduce price volatility to the smoothed return profiles of direct-property funds, the portfolios themselves would be insulated from having to sell properties to meet liquidity demands. That seems preferable to the potentially destabilising liquidity issues we see now.
