The Pitfalls of Open-Ended Property Funds

Investors with long memories may have been spooked by the recent activity in the Investment Association’s property sector. A number of fund providers, including Aberdeen, Henderson, M&G and Standard Life Investments, have switched from their normal offer price to the lower bid or mid price. This has reduced the value of these holdings by as much as 5% or 6%.

The affected funds have all been hit by a wave of client redemptions as investors look to exit their positions ahead of the EU referendum. A vote in favour of the Leave campaign on June 23^rd could have significant negative connotations for the sector and many people are uncomfortable leaving themselves exposed to the risk.

Property funds have delivered strong returns in recent years and even over the last 12 months they have produced an average gain of 6.4%, which makes it one of the best performing sectors of the market. The problem is that the slowdown in the economy and risk of Brexit have prompted significant client withdrawals.

This wouldn’t be an issue for most asset classes, but funds that invest in actual bricks and mortar are incredibly illiquid. The managers get round this by maintaining significant cash balances of typically 10% to 15% that are sufficient for normal market conditions, so the switch in pricing suggests that they are getting short and need to raise additional liquidity.

Each property fund calculates a daily bid and offer price that reflects how much it would receive per share if all the assets were sold and how much new shares would cost to buy given the value of the underlying portfolio. The difference between them – the spread – is typically 5% or 6%. This is largely due to the costs of buying and selling the various properties and is much higher than for most other funds.

Under the normal pricing arrangement when client inflows exceed the outflows, the dealing prices are based on the higher offer price. This ensures that buyers contribute to the transaction costs incurred when the fund invests their money in new properties.

In unusual conditions when the sellers outnumber the buyers the funds can switch to the lower mid or bid price so that those who decide to sell their shares bear some of the cost of the property sales rather than leaving it all to the investors who remain in the fund.

The process is intended to ensure the fair treatment of all the investors, but it is confusing as the funds monitor the situation on an ongoing basis and can switch one way or another according to the inflows and outflows. This has meant that the M&G Property Portfolio has switched three times in the last few weeks.

The last time property funds resorted to these sorts of measures on any significant scale was after the 2008 financial crisis. Things got so bad that some of them had to temporarily suspend all redemptions until they were able to sell enough properties to raise the required cash.

If you are uncomfortable about these unusual and extreme risks you could buy a fund that holds property securities rather than the actual bricks and mortar. These are able to buy and sell the underlying shares whenever they need to and don’t incur high transaction costs so they should be able to handle large client redemptions without resorting to draconian measures.

The other option would be to invest in a closed-ended fund whose shares are traded on the stock exchange. When there are more sellers than buyers it will drive the share price lower – even to the point that they trade below their net asset value – but it will not have any impact on the underlying property portfolio.