Open-ended property sector in a 'state of paralysis'

Earlier this month Janus Henderson sold the book of properties in its open-ended property fund after exploring various options against the backdrop of uncertainty for the vehicles.

The sale is the latest in a string of closures, suspensions and resulting volatility in the open-ended property fund sector.

The problem faced is the mismatch between the daily trading of open-ended property funds, and the illiquid nature of property, which cannot be sold quickly in the case of high redemption requests.

Open-ended property fund sizes

Source: Morningstar

Since April 2017, £5bn has flowed out of the sector, according to data from Morningstar.

Former Bank of England governor Mark Carney famously said funds which invest in illiquid assets but offer daily dealing were "built on a lie".

Waves of redemptions

The issues began after the Brexit vote in 2016, when the funds rushed to gate for redemptions amid concerns over valuations.

The whole concept was flawed from the startNick Britton, head of intermediary communications, AIC

Then again in 2020 the pandemic left the fund managers with no choice but to suspend the funds again, after most independent valuers said the market conditions left it impossible to value the makeup of the portfolios.

In May last year Aviva Investors closed its UK property fund over concerns that it had become increasingly challenging to generate positive returns while also retaining enough liquidity to re-open the fund, which remained gated since the start of the pandemic.

The next month Aegon also closed its property fund, citing similar issues.

Open vs closed ended

Nick Britton, head of intermediary communications at the Association of Investment Companies said he was surprised open-ended property funds were successful in gathering assets for so long.

“Putting illiquid assets into a daily-dealing, open-ended structure was always bound to lead to widespread suspensions whenever markets wobbled.”

Britton said in other countries, such as the US and Japan, real estate investment trusts (Reits) have long been accepted as the standard way for retail investors to gain property exposure. 

Some even have regulations that effectively ban daily-dealing open-ended funds from holding assets like property, he said.

“In the UK, however, with our famed obsession with bricks and mortar, we embraced the promise of exposure to an illiquid asset in a fund you could cash in any time you liked.”

He said it is clear investors are voting with their feet and highlighted how closed-ended property funds have seen ten-year total returns of 226 per cent for the UK commercial property sector versus 161 per cent for open-ended equivalents.

Managing director at Tilney, Jason Hollands, said the closures of these funds during times of market stress are a reminder that the open-ended structure is not optimal for holding an illiquid asset.

“Investors either need to be prepared for those funds to be gated at times of market stress, or the funds end up having to hold very large liquidity buffers which dilute some of the return potential.”

Regulator hold up

The FCA opened a consultation into the future of open-ended property funds, however last May it said it would not confirm specific property fund rules until a consultation on the long-term asset fund had been completed.

This was concluded in October, and the regulator has not outlined any further details to date. 

A spokesperson from the FCA said they were unable to give a date when the new rules would be released.

One of the solutions touted by the regulator in the consultation was the introduction of notice periods for redemptions, either on certain days throughout the year, or a set time after a withdrawal request has been given.

However, this presents a headache for platform providers who currently do not have the functionality to adhere to notice periods for redemptions.

Head of investment research at AJ Bell, Ryan Hughes, said the open-ended property fund sector is in a state of paralysis until the FCA comes out with its review.

“They’re not part of [AJ Bell’s] investable universe while there’s such uncertainty hanging over them,” he said.

The delay also means the fund managers cannot really market the funds, and they will not really want to actively manage the portfolio as it will be hard for them to buy and sell property without knowing what is going to happen, he said.

“I think they really are in a state of paralysis.”

The case for real estate

Hollands said putting all the fund structure issues to one side, there is still a case for investing in real estate.

“Over the long run property can bring some important diversification benefits to the portfolio and it can be very good for income and there is an element of inflation-proofing as well.”

Although his view was that the best fund structure for investing in bricks and mortar assets is closed-ended, they are not a panacea.

“If you’re investing in the listed property investment company, you can sell at times of market stress but do bear in mind that you're likely to be doing so at a big discount to net asset value.”

When picking a real estate investment trust, Hollands said, it is important to consider the quality of the tenants and the length of unexpired leases.

“When the economy hits a rough patch, you want to be in portfolios where the tenants have locked in on long leases.”

Britton summed up the plight of open-ended property funds.

“So what went wrong? 

“Nothing, really – the whole concept was flawed from the start.”

sally.hickey@ft.com