Suspensions of open-ended property funds show the current fund structure is not fit for purpose.
One of the big lessons for fund investors over recent years has been that open-ended property funds are not fit for purpose, points out Tom Becket, chief investment officer at Punter Southall Wealth.
In the podcast below, Becket explains why he would never invest in an open-ended property fund, on the grounds that the structure is not suitable for retail investors.
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He is not alone. The Bank of England has taken aim at open-ended funds with liquidity issues as posing a “systemic risk”. In its Financial Stability Report for 2019, the Bank argued that the mismatch between daily liquidity and the ability of some funds to sell their assets quickly means “there is an advantage to investors who redeem ahead of others, particularly in a stress.”
To combat this the Bank of England report proposed a combination of longer redemption periods and a system to force those leaving the fund in times of market stress to accept a discounted price for their units.
The Investment Association (IA), the trade body for open-ended funds, has published its own idea for a new long-term assets fund structure, which is very similar to what the Bank of England came up with.
Becket comments that the current structure of open-ended property funds providing daily liquidity is a “recipe for disaster”.
He says: “It is obviously a dangerous structure – we have now seen the funds suspend three times in my career, and we will see it happen again in the future unless radical steps are taken to prevent these sorts of funds being offered to retail investors. I just don’t think they are suitable.”
“Mixing short-term retail investor cashflow with long-term illiquid assets is a recipe for disaster. I am amazed the lessons of the great financial crisis (when open-ended property funds first suspended) have been so quickly forgotten by investors.”
He adds it is not just the illiquid nature of the assets he is concerned about. He also points out that high cash levels (in order to boost liquidity of the fund) act as a drag on performance. As Money Observer has previously reported, since the Brexit vote (shortly after which over half of the assets in the IA UK property sector were frozen due to a raft of fund suspensions) cash levels have increased from around 10-15% to around 20% or higher in some cases.
Becket explains: “The other thing that does not compensate investors is the paltry yield on offer because of the liquidity buffer these funds feel they need to hold. That undoubtedly holds back returns, because if you have 20% of the portfolio doing nothing and still having fees charged on top, then you are getting a significantly negative return from that part of the portfolio. These investments do not make sense, and we do not invest in them on behalf of our clients.”
Investment trusts, due to their closed-ended structure, are not under the same pressure to react defensively when investors take fright. Trusts have a fixed level of capital, so they do not need to sell the properties they own.
Rob Murphy, an analyst at Edison Group, points out that the inappropriate nature of the open-ended fund structure for illiquid assets will continue to boost demand for investment trusts.
He adds: “There’s been a big shift towards alternative income, and real estate investment trusts (REITs) have been a part of that. This has been driven by investors looking for ‘bond substitutes’, given the unusual backdrop of some bond yields being negative, and also the attractiveness of the closed-ended structure, which allows the fund manager not to be a forced seller of assets.”
Such a one-sided narrative…
Such a one-sided narrative. Why do these articles never look at the 'cons' of investment trusts too? I agree that the open-ended funds would be enhanced by having notice periods for redemptions but certainly wouldn't go as far as saying they're 'not fit for purpose'. That's just harrumphing. The offer very valuable diversification that REITs simply do not.