3 months ago the UK voter rebelled against the EU, putting pencil to paper in favour of the UK leaving the shaking union…
Thankfully this isn’t another collection of thoughts relating to whether this was in the best/worst interest of the UK, my kids or their kids futures – it’s too early to tell and it is impossible to say what would have happened had more voters ticked the remain box!
On hearing the result, our attention shifted quickly to investments and in particular UK commercial property. This is an asset class that typically shows strong correlation with the strength of the economy and in some market conditions can see investors locked into funds. Over the past 12 months our outlook for property had weakened, unrelated to referendum may I add, so we had already been reducing property for a number of months. The referendum result was the catalyst for us to sell down the remaining property. We were not alone!
In the days following the referendum it was apparent that investors, like the UK voter, were looking for the exit doors.
The below chart shows the net flows to the IA property sector over the past 3 years. When you have more redemptions (investor sales) than you do purchases, the capital flows away from the fund. Up to the turn of the year, property had been experiencing consistently strong inflows, with this trend turning and the sector seeing outflows each month this year.
To meet investor redemptions, funds must use cash within the fund or sell assets to realise cash. This is all well and good when there are only a limited number of redemptions, whereas when there are more buyers than sellers of the fund, or if the fund is invested in liquid assets such as large cap equity or government bonds, for instance.
For property funds invested in physical buildings there is disconnect between the liquidity of the investment vehicle (the fund) and the underlying asset (the buildings). To realise cash the fund must sell the buildings which can take months - but the sellers of the fund will expect to be paid within days. Add this liquidity disconnect to the scale of the redemptions and it is no wonder that something had to give.
The sector was haemorrhaging capital at an unsustainable rate – nearly £1.5bn through June. Patients going through unsustainable trauma are routinely placed in induced coma to allow the problem to be treated and their internal body to adjust before being awoken. In much the same way, property funds that could not cope with the shock of investor redemptions were temporarily shut down, allowing the managers to adjust the fund positioning and the trauma to pass.
This soft close, where redemptions and purchases are not permitted (or ‘gating’ process) has come under criticism with many calling for a review of the ‘bricks and mortar’ property fund approach. Many investors already prefer to invest in closed ended property funds that avoid the forced sales detailed above. The issue with these is that they trade more like shares, can be very volatile and are more correlated to the stockmarket.
The past week or so has seen a number of the property funds reopen and others give indication that they will open sooner rather than later. As with waking a patient from a coma, this is a delicate time with fund managers taking into consideration how the funds investors will react to re-entry to the market. Will there remain a strong desire to leave? Has the fund recovered cash positions sufficiently to meet possible further redemptions?
Recently it has been interesting to hear feedback from property managers regarding the period out of market and their thought process around when to reopen the funds.
One of the funds we sold and which was subsequently ‘gated’ is managed by Fiona Rowley who defended the approach which allowed an orderly disposal of assets rather than a fire sale that would “destroy investor value”. Whilst capital values did fall, the asset class did receive a boost from the weak sterling with foreign investors creating demand in the market. Fiona confirmed nearly £200m has been traded by the fund during the period, some of which admittedly was sold at a discount to previous valuations as the market has become more risk averse. However, the capital falls of around 3.5% were perhaps less than many had feared. The fund is likely to reopen soon as it is nearing the 15% cash target they set.
Whilst the ‘gating’ mechanism employed by the funds is not ideal it is in the best interest of investors and something that investors should be aware of before purchasing the funds. For us the diversification benefits of these funds when held within a multi asset portfolio are very attractive, particularly when we are in an environment that is seeing increasing correlation between the major asset classes.
As investors, having the ability to trade in and out of funds is important but understanding the risks of any investment we make is also very important. We have sympathy for investors who have had their investment locked into the funds, but for us it is key that you should not invest in something if you do not fully understand it.
If there is a criticism, it is perhaps that this needs to be made clearer for non-professional investors. In fact, might it actually be better not to allow retail investors to purchase such funds unless via an adviser or wealth manager?
The content contained in this blog represents the opinions of Equilibrium investment management team. The commentary in this blog in no way constitutes a solicitation of investment advice. It should not be relied upon in making investment decisions and is intended solely for the entertainment of the reader.