Brexit was just the tipping point

Actions taken by fund managers in the first week of July were far more severe than we saw during the last property downturn, which started the year before the global financial crisis. None of the open-ended funds that have suspended trading recently suspended during that earlier period. Fair value adjustments were not necessary, and dilution adjustments were not heard of. While those working in the sector operated under the constant fear that suspensions were imminent, the only mainstream daily dealing fund that closed was the New Star International Property fund, though many life and pension funds ceased trading during the crisis. @Image-c048c943-b231-4294-93a6-ef22a296996c@

Therefore, until about two weeks ago, the probability of suspension was seen as very low given how well these funds were able to manage a two-year bear market and substantial outflows in 2007-2009, and their seemingly cautious cash positions of about 15 per cent to 20 per cent. Most property fund managers had been expressing in investor updates since the start of this year that they expected flows to moderate in 2016, therefore were building up liquidity reserves and dialling back acquisition programmes. They will also have been well aware that suspension of trading would send a strong message to the market about the liquidity mismatch of offering daily dealing of an asset that typically takes months to trade.

The probability of suspension was seen as very low given how well these funds were able to manage a two-year bear market and substantial outflows in 2007-2009

This incongruity has long been recognised by the industry and is the reason investors had been so accepting of fund performance that lags the main market index, the IPD UK Property index series. The IA Property sector has produced an annualised return of 6.3 per cent over the past 20 years to the end of May, while the IPD UK All Property Index has delivered 9.0 per cent a year.

Investors understood that funds needed to hold about 20 per cent of assets in cash and other liquid instruments such as Reits. So what is so different now that has caused fund managers to cross the liquidity line?

Valuations within the UK commercial property sector have looked a little expensive since the start of the year. In January the yield on the IPD Monthly All Property index fell below 5 per cent (to 4.99 per cent). While this was only just below 5 per cent, it is an absolute level of yield that a lot of investors, and fund managers, consider to imply overheating in the property market. It was no surprise therefore that many wealth managers, financial advisers and fund managers expressed a desire to reduce allocations to property amid expectations of weaker returns and uncertainty leading up to the EU referendum.

Net retail flows for the IA Property sector reflected this change of mood and January 2016 saw the first month of outflows for more than three years. Historically, flows have been strongly correlated to returns for the sector, so this change of direction indicated that more muted returns should be expected in the future. In all it seemed in the first quarter of this year that we were experiencing a steady decline in the popularity of the asset class, but most investors agreed that the underlying fundamentals were still fairly strong and the financial health of both tenants and other property investors was much better than when we entered the last property downturn.

What appears to be different about this turn of the cycle compared to that of 2007 is the concentration of investment influences on the underlying investors. Since the financial crisis regulation has become much more focused on clients’ risk profiles and consistency of outcomes. Financial advisers and wealth managers are spending much more time and/or resource on in depth research to support investment decisions, both on an asset class and fund basis.

While some advisers and investment managers will undertake this independently there is also a huge swing towards outsourcing. There are now independent firms consulting on risk profiling, asset allocation or fund selection, or even all of these. Across wealth management companies, prescriptive ‘buy lists’ are becoming more common, as well as model portfolios. So when it became clear that property market returns were not likely to be as appealing as they had been for the previous three years it is no surprise that it turned out to be a consensus trade to reduce allocations to the sector. Outflows for May were the highest on record for the sector and it is expected that numbers for June were as bad, or even worse.

We can only assume that fund managers have sight of much larger outflows waiting on the sidelines and expected their current cash weightings to be depleted before they could arrange sensible sales of underlying property assets. This is a concerning development within the fund management universe and makes us worry about the potential problems building up in other asset classes, or even specific funds. In particular the fixed income sectors look vulnerable. While the economic backdrop is still supportive of ‘lower for longer’ interest rates the sector is exposed to default risk of companies as well. The shrinkage of inventory of fixed income trading desks at investment banks has had a negative impact on the ability of bond holders to trade. Therefore a shock to the credit market could bring about price adjustments in these funds and, at the worst, more fund suspensions.

So while it is clear that investors are going to have to weigh up the potential risks of investing in open-ended property funds in the future, they should also consider the risks of investing in any asset class through a daily dealing open-ended fund.

Louise Babin is a portfolio manager at Charles Stanley