Fund Selector: Victims of their success?

Largely, one suspects, at the expense of fixed income.

While the move in asset allocation is one that I wholeheartedly agree with, I do have reservations over the direction of the flow of assets.

In particular, it appears that the net beneficiaries are the behemoths of the sector, which for the most part have very capable and able fund managers.

So what is the problem?

These funds have become a victim of their own success, due to historic performance and the inflow of assets through various platforms.

Ultimately, the already large funds continue to grow rapidly and as a result their choice of available stock diminishes and competition for assets increases.

While this should support asset prices in the shorter term, in the medium term it may lead to increased structural cash weightings – which the manager cannot be blamed for – and as a consequence less exposure to the intended underlying asset.

This is a common complaint levelled at the managers of open-ended property funds.

Meanwhile, although closed-ended fund managers do not face this same issue, they are instead challenged with claims of “unfair pricing”, or a discount or premium to manage.

So what can be done?

In short, focusing upon the smaller and more nimble funds within the sector may be advantageous.

While they may face cash weight issues, it is not to the same absolute monetary level. Moreover, they benefit from a less competitive marketplace as the property lot sizes they are interested in are too small to be of interest to the larger funds.

They can also expand their geographical reach much further across the UK due to the same property lot size reasons.

Small funds are also more nimble in terms of moving sector preferences quickly and a more specialist mandate may also be accessed. For example, secondary market opportunities are able to be targeted with higher yields.

Indeed, the secondary market provides greater opportunities for asset management – for instance, a change of use could lead to strong capital and yield uplift.

The downside is that investors may be exposed to a nominally higher level of risk, although one could argue that they are more geared into a domestic recovery play.

I am far from calling the top of the UK direct property market. But I do believe that investors should be cognisant that when larger funds are faced with a liquidity call, and are forced to sell down their portfolios, they may suffer relatively more than smaller funds.

For our own part, I would much rather be six months early on the property call than six days too late.

That day is, by its very nature, closer each day, but I do get the sense of history repeating when I see European direct property funds climbing on to the launch pad.

James Calder is research director at City Asset Management