Open-ended retail funds took a battering after last year’s EU referendum as investors looked to cash out. Property Week asks whether it could happen again and if yes, what can be done to mitigate the damage.
Few London buildings better epitomise the impact that the Brexit vote has had on the market than 10 Hammersmith Grove, London.
In the aftermath of the referendum, Aberdeen Asset Management’s retail funds, Aberdeen UK Property Fund and Aberdeen UK Property Feeder Unit Trust, experienced a flood of redemption requests from investors and it was forced to suspend trading.
It then needed to recoup cash quickly and provide liquidity so it sold the 122,744 sq ft office scheme to Brockton subsidiary Leon Property Holdings for a price rumoured to be around £89m. Last November, Leon sold the scheme to Hong Kong-listed company Tai United for £103m. Then this September, Tai sold it to Blue Horizon Investors for a rumoured £112m. In a little over a year, the building had been sold no fewer than three times.
Aberdeen wasn’t the only fund to sell off assets or suspend trading. Within days last July, six funds shut up shop and seven eventually closed before gradually re-opening in the second half of 2016, the last being Aviva Investors in December.
The defensive move to suspend trading prompted many to argue that the open-ended retail fund model was broken and reforms were needed. So what has actually happened since the funds resumed trading. Have the calls for the model to be overhauled come to anything – or have the old ways been resumed?
The mood immediately following the UK’s decision to leave the EU in June last year bore many of the hallmarks of the mood after the 2008 financial crisis. Investors were spooked as the pound crashed against the dollar and the euro.
Analysts were making dire projections about the UK economy. And Property Week was full of stories about deals collapsing thanks to ‘Brexit clauses’ being invoked. The fear was that we were on the brink of another property market collapse.
The situation wasn’t helped by stories coming out of the open-ended retail funds. On Friday 24 June – the day the vote’s result was declared – Henderson introduced a fair market value adjustment just ahead of the weekend. This effectively made it more expensive for investors to cash out.
Come Monday, Standard Life Investments announced it was doing the same thing and the following day Legal & General, Kames and Aberdeen also announced fair market value adjustments. Three days later, M&G followed suit. On 4 July, things took a turn for the worse, with Standard Life suspending trading in its retail fund. Within two more days, Aviva, M&G, Henderson, Columbia Threadneedle and Aberdeen did the same.
John Forbes from John Forbes Consulting – who wrote a post-mortem on fund behaviour for the Association of Real Estate Funds (AREF) titled ‘A review of real estate fund behaviour following the EU referendum’ – recalls: “Once Standard Life and Aviva suspended, that put massive pressure on the other funds because it was all over the news. Suddenly there was a panic and that triggered a further round of redemptions.”
But the bigger effect was felt by discretionary fund managers making what Forbes describes as “some significant quarter-end relocation decisions” at the end of June, the unintended consequence of which was greater volatility in the market.
“Part of the untold story of last summer was that it was five multi-managers who sold out of the retail funds in a short period of time and that was what caused [the problems]. It wasn’t the retail investor on the street,” explains Guy Glover, fund director of F&C UK Property Fund at BMO Real Estate Partners.
It is worth pointing out that many of the retail funds had registered a decline in new capital inflows during the first half of 2016 that had started to turn into net outflows as many investors felt that the property market had peaked and they wanted to reduce their exposure.
It should also be stressed that none of the funds acted outside the regulatory boundaries by shutting up shop. Having experienced significantly higher-than-normal redemption levels, these funds merely used a mechanism built into them under the collective investment schemes regulations to protect investor interests. They were taking a defensive position as they dealt with assets, which by their nature are fairly illiquid.
Pulling up the drawbridge
Some funds fared worse than others. Some had problems because they had large-scale individual investor exposure or because sales that were going through prior to Brexit and that would have offered greater liquidity levels fell away following the vote. Others had portfolio-related issues.
“Standard Life had a stronger weighting to the London offices market, which has generally been a positive thing, but in the immediate panic after Brexit everyone thought London offices were going to be hammered the most,” says Forbes.
However, a number of open-ended funds managed to stay open, having managed to build up their cash holdings ahead of the vote. This was the strategy that Legal & General Investment Management (LGIM) took.
Michael Barrie, director of fund management at LGIM, says that prior to the referendum the fund had conducted scenario testing around the need to generate cash in a turbulent trading environment caused by a ‘leave’ vote and had built up a strong liquidity position.
“We got ourselves in a fairly defensive space ahead of the vote,” says Barrie. “Even though most people expected it to be a ‘remain’ vote, it was clear from our point of view that a vote to leave would have some immediate impact on sentiment around fixed assets like real estate and we were using experience from the Global Financial Crisis [GFC] in terms of what that might mean in terms of flows. Our fund stayed open during the GFC and we stayed open this time as well.”
Another that stayed open was Kames Capital. Its property investment director David Wise recalls that he decided to go “pretty long on cash” in the run-up to the referendum, taking its cash position to 33%. “That dropped within a short period of time to about 14% at its lowest point. If that had continued, we would have had to shut the fund to protect investors remaining in it, but things did slow down,” says Wise.
Within weeks, funds that stayed open for trading like Kames and LGIM experienced net inflows as investor sentiment improved and the market settled down. The funds that closed started to re-open over the latter part of 2016 and since then the majority have seen inflow return to pre-Brexit levels.
The latest inflow figures, coupled with a recent IFA Survey conducted by AREF, suggest there has been little lasting damage caused. According to the association, which represents the interests of the real estate funds industry, financial advisers continue to recommend an allocation of around 7% on average to property, with UK authorised property funds dominating that allocation. This is the same level as in the first quarter of 2016.
“Furthermore, only 8% of advisers favour asset fire sales to resolve short-term liquidity issues in the event of shock events and indeed liquidity ranks lowest in the qualities sought from allocating to property,” says an AREF spokesperson.
“So while there is no room for complacency among our members, investors looking for exposure that reflects the experience of directly investing in UK property assets should expect them to continue to provide the returns and diversification they seek from the asset class.
“As with most investments, however, the key for these investors will be a long-term investment horizon, particularly given the inherent illiquidity of a physical asset.”
While the actions of the open-ended funds that suspended trading may not have damaged investor sentiment towards the sector, financial analysts say that those funds that stayed open have benefited more in the 12 months or so since the closures.
This view is borne out by the funds themselves. Despite some initial pain, Wise says that net inflows at Kames have been positive over the past year, which he thinks is mainly because his fund carried on trading. “At the time, if anything we were penalised,” he says. “A lot of wealth managers, who one might argue were late to the party and who decided to take down their property weightings [after the vote], couldn’t do it in the funds that were shut so they took money from funds like ourselves that were still open. As a result, we did see quite a lot of redemptions by virtue of us staying open.”
Open for business
Wise’s comments are echoed by LGIM’s Barrie, who says his fund has had positive flows for every month since October last year.
“Investor flows have headed in the direction of those that stayed open,” he says. “We were the largest one to stay open and we certainly feel our investors were very complimentary about how we operated through that phase. They praised the openness of our communication and the clarity in terms of what we were doing.
“Liquidity is valuable to this investor group and while suspending is one of the options for a retail fund, the investors struggle to see that as a positive reaction, so certainly the feedback we’ve had has been very positive and we’ve seen the flows rebound strongly after the Brexit period.”
F&C also fared well thanks to its decision to stay open. The fund announced it was on an acquisition drive earlier this month after experiencing inflows of £100m since the referendum.
While it may currently be business as usual for many of the open-ended retail funds, the fact remains that some of the inherent problems that were highlighted in the wake of the Brexit vote have not been addressed. Should there be another dramatic financial episode, these shortcomings will flare up again as they did during the 2008 crash, when forced sales from open-ended funds and highly geared investors caused capital values to slump.
Although there were dire predictions that funds would be forced to take similar drastic action in the wake of the referendum – Jefferies retail analyst Mike Prew predicted disposals of between £3bn and £5bn – fortunately this scenario didn’t come to pass.
However, that danger has not gone away. According to some estimates, the retail fund sector accounts for as much as 7% of the UK commercial property market, so forced sales by these funds could drag down market pricing.
The situation could quickly spiral out of control as these forced sales would have a negative impact on the value of other assets in a fund. This in turn could trigger more redemptions, which would heighten liquidity issues, initiating a vicious cycle.
“When you’ve got a fund that is £3bn, £4bn or £5bn and you have assets that are £100m-plus, those are innately less liquid and there is a bit of a mismatch between having a fund of that size and providing daily liquidity,” says Wise. He believes some changes will be made to how open-ended funds operate in the the future, but he doesn’t anticipate a dramatic overhaul.
Nor does BMO Real Estate Partners’ Glover, who agrees that changes to the existing operating model are needed.
“I’d prefer the platforms to provide a queueing mechanism, but that’s not going to happen any time soon,” he says. “The need for daily liquidity is overstated – people are putting away money for the long term for their pension.”
He thinks it would take five to 10 years to reform the wealth management platforms, which currently require daily liquidity. If this were to occur, Glover believes that performance would improve because the funds would not have to hold so much cash, which acts as a drag on returns. “Instead of having 15% to 20% cash, they could hold 5% so they could deliver a higher return,” he explains.
Forbes also believes that changes are needed to the “architecture of platforms” in addition to relatively minor changes to regulation so that new investment products can be developed that allow funds to take daily subscriptions, but not to allow daily redemptions.
“The period following the previous crisis saw a period of product development for funds for institutional investors,” Forbes writes in the conclusion to his report for AREF. “There would appear to be an opportunity following the post-EU referendum liquidity event for product development for retail investors.”
But what are the chances of such changes happening? The Financial Conduct Authority (FCA) issued a consultation document about the funds this February and the industry submitted its response in early May. Now it is a case of waiting for the FCA, which has a lot on its plate at the moment, to publish its findings.
“It is difficult for the industry to do much by way of product development until the broad direction of travel of regulatory change is known,” says Forbes. “My own hope is that deficiencies in the regulations are addressed and that changes are made to investment platforms to allow products that give investors the choice of less liquid investment funds – funds with some of the characteristics of institutional funds.”
Until the FCA provides greater clarity on the issue, the threat of open-ended funds shutting up shop every time the market experiences a financial tremor remains.
Source: “Property Week”