Are open-ended property funds unsuitable for retirement?

Many fund houses responded by suspending dealing on daily dealt property funds or applying temporary pricing adjustments, in order to meet demand for redemptions. 

Gradually, the funds began re-opening and trading again but the incident served to highlight the liquidity issues surrounding these types of funds.

The suspensions also caught the attention of the Financial Conduct Authority (FCA), which issued the findings of its review into open-ended property funds in July this year.

The regulator’s key findings were: “In general, authorised fund managers (AFMs) did not adequately plan, or have clear policies and procedures, for valuing their property portfolios under stressed market conditions.

“Some AFMs did not adequately consider the implications of their distribution model in their liquidity monitoring and management of funds.

“AFMs could improve their communications to platform providers, to enable platforms to communicate more effectively in turn with advisers and end-customers.”

Open-ended property funds can provide diversification benefits in a portfolio due to their historical low correlation to equities.Alex Moore

But the FCA did acknowledge the use of suspensions, deferrals and other liquidity management tools “were effective in preventing market uncertainty from escalating further” following the Brexit vote in June 2016.

As the FCA revealed, UK-domiciled open-ended authorised funds have approximately £35bn invested in UK commercial real estate, so the implications should a similar situation arise again are potentially significant.

Diversification benefits

All of which begs the question, does this make commercial property funds unsuitable for a retirement portfolio?

There are certainly some diversification and income benefits of an open-ended property fund which in the past has appealed to those preparing for retirement.

Alex Moore, research analyst at Rathbones, notes: “Open-ended property funds can provide diversification benefits in a portfolio due to their historical low correlation to equities. 

“For a long-term investor, open-ended funds provide exposure to the asset class without the gyrations of stockmarket price movements that a property share or Reit [real estate investment trust] can experience.”

It is also useful to consider how commercial property funds have recovered since the numerous suspensions last summer.

Guy Glover is manager of the F&C UK Property fund – a daily-dealing UK property fund that did not close post-referendum.

The funds which were more sensitive to the referendum reaction were those exposed to the retail and Central London office markets, as well as those more heavily weighted to development activity.Kenneth MacKenzie

He explains: “Actually apart from a few funds which suffered from short-term liquidity issues, commercial property at an asset level has been remarkably resilient over the past 12 months, delivering an income return of above 5 per cent.”

In addition, he observes capital values - which dipped by a “modest” 2.8 per cent - have bounced back to recover the lost ground, with values up 2.6 per cent. 

“Importantly, capital growth is continuing in 2017 and we expect strong returns in the second half of the year, with total returns being 6-7 per cent,” he forecasts.

“So if an investor is looking for long-term steady income at over four times the gilt yield and twice the income from corporate bonds, together with a low level of volatility even in challenging times, property seems to fit the bill nicely.”

Suitability for later life

But then a property fund manager would say that, wouldn’t they?

Kenneth MacKenzie, managing partner at Target Advisers, suggests: “As always, investors should seek the advice of a financial adviser when considering suitability for a given aim.”

But he agrees as part of a balanced portfolio, commercial property can deliver returns appropriate to the risk. 

“The funds which were more sensitive to the referendum reaction were those exposed to the retail and Central London office markets, as well as those more heavily weighted to development activity,” he adds.

Ultimately though, Mr Glover believes these types of funds are still suitable for those saving for later life.

As he notes: “Many of the underlying investors in the F&C UK Property fund are retirees, as their advisers know and appreciate the benefit of a core property holding which invests in quality assets throughout the country. Secure long-term income with steady growth is what we seek to achieve from a balanced and diversified portfolio, spread throughout the UK.

“An allocation to property would seem to work for retirees as it provides diversification away from the low income return of some other asset classes and less volatility than the equity markets.”

As the FCA points out in its review of property funds and liquidity risks, advisers did manage to shield their clients from much of the impact of the suspensions.

It states: “Wealth managers and financial advisers were well prepared for the suspensions. Given the diversified nature of their portfolios, the suspensions had little impact on clients.”

Cash is king?

There is still the issue of liquidity though, with Ian Sayers, chief executive at the Association of Investment Companies, noting, “many open-ended funds are holding substantial amounts of cash to provide protection against redemptions, sometimes as high as 25 per cent or more”. 

He points out this is particularly relevant for income seekers, as such balances will be earning very low returns.

This may not be of too much concern to longer term investors though. As Mr Moore points out, managers of open-ended property funds hold high levels of cash for a reason.

“While holders of daily dealing open-ended funds typically receive redemption proceeds within a week of selling their units, it can take a property manager months to sell an asset due to the amount of due diligence involved. Given the mismatch, most funds will hold large amounts of cash to meet client outflows,” he says. 

“In times like the surprise Brexit vote, when there are large outflows, transactions can be suspended to prevent the fund being a forced seller of an asset to the detriment of current fund holders.”

Mr MacKenzie also acknowledges the need for large cash holdings in property funds.

The problems experienced by some open-ended property funds in the wake of last year’s referendum underscores why we are generally wary of the asset class for accessing property.Alex Scott

“Inevitably for open-ended funds such as unit trusts or Oeics, where investors have the right to redeem units for cash, some on a daily basis, fund managers need to maintain large cash balances to meet such demands. 

“And if these aren’t adequate redemptions may be restricted or available at a substantial discount.”

But for some, despite the sector’s recovery, they are still not reassured enough.

For example, Alex Scott, deputy chief investment officer at Seven Investment Management (7IM) says: “The problems experienced by some open-ended property funds in the wake of last year’s referendum underscores why we are generally wary of the asset class for accessing property.”

Darren Cooke, chartered financial planner at Red Circle Financial Planning, is equally dubious about being exposed to property funds.

“Certainly I wouldn’t advise anybody to put all their eggs into a property fund in any way, shape or form, particularly after what we had happen last year post-Brexit where a number of property funds were closing their doors and not letting you out, or if you did come out it was with massive penalties. Admittedly, it was a relatively short lived thing but I remember that happening before. 

“By all means hold a property fund, but only as a diversifier within a portfolio, never on its own,” he suggests.

eleanor.duncan@ft.com