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Watching brief: The way forward for gated property funds saga

Watching brief property 620

Property fund giants with assets of over £18bn have moved to stem the outflows sparked by fears over falling property values in the wake of the Brexit vote.

Standard Life Investments, M&G, Columbia Threadneedle, Aberdeen Asset Management, Henderson and Aviva Investors are among those who have imposed temporary “gates” on exiting investors.

As a result, the FCA and the Bank of England are examining ways to restructure property funds to prevent market panic.

But investment professionals have poured scorn on moves to change the fundamental structure of property funds.

They have also challenged the assumption that the raft of trading suspensions was caused by, rather than exacerbated by, the EU vote.

So how can managers and policymakers avoid risks of contagion and work to solve liquidity issues? What of advisers’ exposure, and the fallout for multi-asset funds? And how does what we are seeing now compare with the financial crisis of 2007/2008?

The domino effect

Among the fund groups who have limited investment into or out of property funds some, such as F&C, Kames Capital and Legal & General have stopped short of suspending trading. Instead, they have chosen to apply a fair value adjustment on the fund’s price reflecting the uncertainty around property valuations.

Aberdeen has taken a different approach, applying a downward adjustment of 17 per cent to pricing for those seeking to redeem cash from its £3.4bn UK Property fund.

Chelsea Financial Services managing director Darius McDermott says: “The situation we have now is investors can’t get money out of [these funds] and if they do it is at a much higher price. It is possible these funds will be closed for a while -my guess is we are looking at a minimum of six months.”

Rating agency Fitch has warned the developments we have seen over recent weeks will be difficult to move on from.

Fitch says: “Gating helps mitigate the inherent risk in open-ended funds that invest in illiquid assets by preventing value-destroying fire sales. But once introduced, gates can be challenging to reverse.

“Experience in the UK and in Germany during the global financial crisis shows responses varied from fund to fund. The majority of German open-ended real-estate funds that gated were unable to reopen to redemptions and eventually entered a liquidation process that is still ongoing.”

Investment firm SCM Direct claims major property funds could also been forced to inject around £140m into their funds to compensate them for allowing exiting investors to sell their holdings at materially inflated prices post-Brexit.

Chief investment officer Alan Miller says: “We looked at the price of some property funds after the vote and most of them were overvalued. If fund groups really had the interest of their clients they should have suspended trading right on the day after the vote.

“Individual fund groups should now calculate how much they have to compensate the funds after redemptions as they have allowed exiting investors to gain at the expenses of remaining investors.”

‘Unrealistic’ changes

Following the en masse fund suspensions and price adjustments, new FCA chief executive Andrew Bailey said the regulator is in “very close touch” with firms in the sector.

The FCA plans to look into the structure of open-ended property funds which may need a formal review. It has asked fund managers to consult the regulator before deciding to stop trading in their funds, to properly guide investors on what to do when these events occur as well as giving them enough time to seek appropriate advice.

Meanwhile, the Bank of England said it is looking at emergency measures to stem the outflows from property funds.

In particular, the BoE is “actively working” with firms to tackle any “second order effect” gating property funds might have on multi-asset funds and any others holding those property funds, Money Marketing understands.

Seneca Diversified Income fund manager Richard Parfect says: “There are clear ramifications for any multi-asset fund holding such vehicles. But then there may also be ramifications for other asset classes such as equities and bonds if these multi-asset funds receive redemptions and are forced to fund them from areas other than their gated property funds.”

Hargreaves Lansdown senior analyst Laith Khalaf says holding commercial property funds in multi-asset vehicles will affect their value but contagion is unlikely as these funds “have plenty of assets they can liquidate” and normally they do not have a huge amount invested in property in the first place.

Other measures from the BoE would include enforced notice periods before redemptions, cutting the price for investors looking to sell out, or increasing liquidity requirements for the vehicles by holding more property-related shares and bonds, which can be more easily sold off than physical offices or retail parks.

But Axa Wealth head of investing Adrian Lowcock says: “Daily liquidity just doesn’t work for commercial property investing and that leads to unrealistic expectations among investors who will expect liquidity. The challenge is putting the right controls in place, while not making the market unpopular among investors.

“Having a higher cash buffer will have detrimental impact on fund performance as they will lag in a rising market.  At the same time investors are paying fees, which end up going into cash, so I am not convinced investors will appreciate a higher cash buffer.”

Khalaf says holding more shares in property funds means runs counter to what investing in the property sector is all about.

He says: “You can sell shares quickly but a lot of investors hold property as a diversification away from shares. Property shares are more correlated with the equity market so you are undermining the very reason for these funds being in existence by asking them to invest in cash and property shares.”

Lowcock adds removing daily dealing “solves the issue” but says if the timescale between requesting money back and getting it is too long that will deter many investors.

He says: “It is hard enough to switch from a sector at the right time but to try and judge it six months in advance will be near impossible for many investors.”

Not 2008

Experts are also keen to stress the current turmoil in the property sector should not be compared with the aftermath of 2008, when UK property funds saw £1bn net redemptions.

Heartwood Investment Management investment manager Charu Lahiri says: “Open-ended property funds have greater levels of cash in portfolios today than in 2007 with cash holdings of between 15 and 20 per cent partly due to regulatory pressure post-financial crisis.”

Lahiri says in 2007 cash levels were “very tight”, with many open-ended funds holding “cash proxies” such as investment trusts and shares in developers which compounded selling pressure in the sector as a whole.

Meanwhile, other point out that outflows in property funds started way before the EU vote.

Property funds saw net sales of close to £1bn in the first quarter of 2015, but yet saw their largest outflows since 2008 in February this year at £120m before going negative £360m in May, according to the Investment Association.

Fund selectors and fund managers agree investing in close-ended funds, such as real estate investment trusts, are a valid alternative to maintain a higher level of liquidity making it easier for investors to sell.

Parfect says investing in a large amount of illiquid assets in an open-ended fund is “inefficient even in good times”.

He says: “When we have times like now, although we are not exposed to physical property, we think about contagion as when redemptions are restricted it has a bearing on the property market. We’ve been aware of this risk for some time and we’ve avoided the south-east area and prime office sector too.

“We invest in Reits, it is a much smaller sector-focused space with no yield compression and has a regional outlook. We invest in five Reits such as LondonMetric and Custodian. These trusts offer high dividend yields ranging from 5 to 9 per cent and dividends are covered by rental income rather than profit sales.”

Architas senior investment manager Nathan Sweeney has been reducing exposure to the UK commercial property sector since the start of the year given concerns about future returns. The manager has instead increased exposure to more specialist property investments, such as retirement homes and healthcare facilities, which are much less correlated to capital market sentiment and offer stable long-term cashflows.

Seven Investment Management also says it tends not to use property funds in its model portfolios as it is much more difficult to liquidate them.

Co-founder Justin Urquhart Stewart says:”We are going to go into a period of increasing illiquidity so we look at the ability to liquidate any portfolios in 24 hours.

“Running discretionary models without effective liquidity shows a level of naivety from certain operators.”

Platforms including FundsNetwork, Aegon, Nucleus, Aviva and AJ Bell are in contact with investors and advisers to how they have responded to suspended fund dealing.

Aegon says any payments currently allocated to suspended funds will be allocated to cash or redirected to another fund where advised. Aviva has removed suspended funds from model portfolios and replaced affected funds with cash. Nucleus will not accept dealing instructions for any suspended fund but will hold in cash any regular investments and new business destined for property. AJ Bell says it “will not touch” the suspended funds.

Adviser views

Jonathan Davis

Managing director

Jonathan Davis Wealth Management

Fund managers know these funds are very illiquid, so there is nothing to change in the structure of the fund. If they are all going to sell their property to create liquidity to pay back investors it could be one of these moments when they have to sell very cheaply. The idea this could not have been foreseen is nonsense, we just do npt know when it is going to happen.

Tom Kean

Director

Thameside Financial Planning

We have had more calls on commercial property than on Brexit itself.

Most of the standard model portfolios on asset allocation recommend exposure to commercial property. Advisers are caught between a rock and a hard place: criticised when we do not follow these models, then criticised when we do.

Changing the structure of these funds does not seem viable. This a classic case of regulators tinkering with things they do not understand.

Expert view: Martin Gilbert

Aberdeen Gilbert Martin Gilbert 700x450

There has been much focus on the reaction of property fund managers following the referendum. We were well prepared ahead of the vote having ensured the Aberdeen UK Property Fund had around 25% in cash. Some investors had been taking profits in the months preceding the vote so property funds had been experiencing moderate outflows. But we did not envisage the rush to the door experienced by the sector in the past fortnight. The decision to suspend trading by other property funds intensified the focus on our Fund.

Rather than follow suit we wanted to continue to provide investors with liquidity but, given market conditions, they would need to take a reduced price. I liken it to selling a house. If the owner wants quick sale, compressing the sales process – an estate agent marketing the property, a buyer employing a surveyor and the legal paperwork – a discount to the value is to be expected.

Our focus was on treating all customers fairly throughout the decision-making process. That’s why we took an alternative approach and it has been well received by investors and advisers in the Fund. Intermediaries and platforms have worked tirelessly to contact all those investors who placed redemption trades last Wednesday.

The closure of various funds has prompted comparisons to be made with the Global Financial Crisis in 2008, when the commercial property market collapsed. But back then the catalyst was a credit squeeze due to banks withdrawing funding. The Brexit vote has been a shock to the system this time around but banks are not withdrawing funding. The low interest rate environment means property will continue to be considered as a source for income and the 10% decline in sterling vs the US dollar and Euro will attract overseas investors.

Hopefully market conditions will begin to settle down. The curtailment of the Conservative leadership contest with a new Prime Minister now in place should help. Now is the time for calm decision-making and leadership forging new relationships for the UK economy with the EU and the rest of the world.

Martin Gilbert is chief executive of Aberdeen Asset Management

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Comments

There are 4 comments at the moment, we would love to hear your opinion too.

  1. Closed-ended property funds were trading at discounts of 25-30% at one point last week.

    Open-ended property funds have been discounted but not by nearly this degree, and so far no evidence has been presented that significant numbers of investors are actually experiencing hardship as a result of gating. (Those that rigidly stick to model portfolios and find themselves unable to rebalance have created their own problems, not the property funds.)

    So the FCA proposes that O-E property funds should be forced to invest money in C-E funds. Which means that in the next crisis, they will experience steeper losses than they have in this one (thanks to the discounts on their C-E holdings) which will mean more investors panic and flood for the exits. They will then either be forced to sell C-E holdings at rock bottom discounts, or sell perfectly good bricks and mortar properties at low prices because investor sentiment has temporarily turned against C-E funds.

    You can see why it costs so much money to fund this kind of economic genius.

  2. With all the bad publicity surrounding commercial property OEICs/UT’s I am surprised that IT’s/REITS are not being mentioned as a genuine alternative.

    I have never been authorised as an investment/porfolio specialist – but given that we have been burnt twice in the last 10 years with liquidity issues, I would be very reluctant to place my clients money in these instruments.

  3. So many people keen to jump on the “illiquid assets don’t suit open ended funds” bandwagon. As long as the liquidity risk is understood and it’s only a proportion of a medium to long term portfolio I don’t see the big issue. Jumping into REITs with their typically high volatility, increased equity correlation and, as currently evidenced, higher potential losses doesn’t make sense to me.

    When people talk about contagion risk, self fulfilling prophecies and trying to draw parallels with unrelated past circumstances there’s value to be found.

  4. Jon, Liquidity risk is a big issue when it comes to Open Ended property investments. How many IFA’s genuinely spell out in plain English the real risks to their clients of what can happen with Commercial Property. The NAV discounts on IT’s that Sascha was quoting where only a blip, and probably highly correlated to what was going in the OEIC world. If anything it was an opportunity to buy at those levels.

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