Property – safe as houses?
The announcement that M&G has suspended withdrawals from its property fund seems to have caught many unawares, but it was clear the risks were increasing throughout the year – particularly as the deadline for leaving the EU approached. It was this risk that resulted in us not holding any physical property funds in our portfolios, and prompted us to remove any physical property funds from our Favourite Funds list earlier this year. We wrote about this in February when we sensed the risks increasing.
The asset class certainly has a role to play in portfolios and it’s important to find a way of allowing retail investors to access commercial property, but the broader question for discussion is – after the second suspension in less than four years – are open-ended property funds suitable for daily trading?
In the FCA’s recent update to the rules in September, after it had spent a couple of years digesting the 2016 suspensions and latterly the Woodford debacle, it laid down a clear marker that it judges property (and other illiquid assets) to be suitable for daily trading. All the FCA looked to do was take away the stigma of suspension and ensure that asset managers give clearer information to investors that a risk of suspension exists.
I said at the time, and I repeat it now, that this seems a missed opportunity to make it clear that the mismatch between liquidity and daily trading is just too great a risk for investors to bear. While I understand the desire to preserve daily trading and to force the industry to put in place more and more warnings to ensure investors understand the risk, the reality is that each time a fund has to suspend due to illiquidity, telling investors they can’t have their own money back when they want it will never be a message that is well received. If anything, it will chip away at investors’ confidence in the asset management industry.
As I write this piece, there are rumblings that the Bank of England will step in to override the FCA and enforce that illiquid assets in open-ended funds must be moved away from daily trading. This comes as little surprise given Governor of the Bank of England Mark Carney’s comments over the summer when, in the light of the Woodford debacle, he suggested that funds that had a mismatch between the underlying assets and the trading frequency were “built on a lie”. Events of the last few days with M&G will surely only reinforce this view and remind investors of the reality that you can’t expect to invest in illiquid assets and have perfect liquidity when you want it. The two are just not compatible in all market conditions.
Currently, property funds employ different approaches to try and mitigate the liquidity risk, from charging investors an upfront fee (thus ensuring that only committed long-term investors invest in the fund), to running high levels of cash to keep a constant cash buffer. The former seems like a sensible approach regardless of market conditions, given the trading costs that come with buying and selling commercial property, and we saw Janus Henderson introduce this approach in the spring; as yet, no other property funds that didn’t already do this have followed suit. Time will tell whether this has a positive effect on keeping those short-term investors out of the fund.
More common is funds keeping high cash buffers for liquidity purposes. However, this results in investors only having between 70% and 85% actually invested in property, causing high levels of cash drag on returns and meaning investors pay fees on a portion of their money that will never actually be invested. While this mitigates a large part of the liquidity problem, is this really the right approach for investors? Ultimately, investors want property exposure and therefore the industry needs to find a solution that gives investors the exposure they are paying for with the access that is appropriate. Moving the dealing frequency to monthly would allow fund managers to operate with lower cash levels and again would dissuade those investors who are not committed to the long-term nature of property investment from investing in the fund.
Implementing a solution such as this is difficult as currently there is no first-mover advantage – any manager that shifts pricing frequency is likely to be hit by a wave of outflows. As a result, any change will have to be led by the regulator to move the entire property fund universe en masse.
One option could be to implement a flexible-pricing approach where all funds are either daily traded in normal conditions or monthly traded in challenging conditions; however, this feels like it would penalise those managers who manage their liquidity well and would again have to be regulator led. Alternatively, rules could be changed to allow property funds to make extended use of borrowing powers, allowing the funds to run overdrafts for longer in order to give managers time to sell the underlying assets. However, this means that costs would be borne by the remaining investors in the fund.
Ultimately, whichever way you look at using commercial property in an open-ended daily-traded fund, it looks to be forcing a square peg in a round hole. Unsurprisingly, a compromise has to come from somewhere when a liquidity mismatch arrives and it’s important to ensure that retail investors understand this. The FCA has looked to keep the current market shape but with added disclosures to make investors more aware of the suspension risks. However, I can’t get away from the fact that every suspension will inevitably knock the confidence of investors in the asset management industry and as a result, the only long-term solution is for the FCA to look again at the rules it announced in September and stop illiquid assets being allowed for daily-traded funds. If the rumours are correct, the Bank of England may just do it for them.