To counter new rules on gating amid concerns over illiquidity, funds are holding higher levels of cash. But does this really make sense?
As we edge towards a Brexit resolution (apologies if the big reveal has already happened by the time you read this), the institutional property investment sector is getting increasingly worried about the impact of political disruption on open-ended funds.
Redemptions from open-ended property funds – which hold around £21bn of UK assets – have been flowing steadily during the past few months, as investors have attempted to anticipate the kind of seismic disruption that we saw in the wake of the EU referendum in 2016.
Whether or not we see (or have seen by now) a sharp spike in redemptions, I believe that in times like these there is a simple tactic UK institutions could adopt to sidestep the twin evils of holding cash (a major drag on fund performance) or risking the kind of redemption flood that forced some funds to be gated in 2016. According to fund analysts at Morningstar, redemptions rose sharply in the summer to a level not seen since immediately after the Brexit vote. Concerns over the ‘liquidity challenge’ posed by redemptions have been heightened by the well-publicised collapse of the Equity Income Fund – the £3bn investment vehicle of erstwhile star stock-picker Neil Woodford. Meanwhile, Bank of England boss Mark Carney has said that funds which hold illiquid assets but offer daily redemptions are “built on a lie”.
The Financial Conduct Authority has introduced new regulations governing funds holding illiquid assets, but these are more about transparency and procedure than about actually solving the redemptions. Tellingly, they still envisage gating as a remedy when there is “material uncertainty regarding the value of more than 20% of the fund’s assets”.
To counter this problem, property funds generally now hold much higher levels of cash. But I think that instead of hoarding money as a rainy-day measure against redemptions, institutions could look to hold a higher volume of smaller property assets that can be easily acquired or disposed of through auctions. Before you shout: “He would say that, wouldn’t he?”, I should point out that day-to-day it’s pretty incontrovertible that holding a small property investment producing a running yield of, say, 6% is better than getting virtually nothing from a pile of cash.
Institutions could opt for ‘virtual liquidity’ (through owning some smaller assets) rather than the total liquidity offered by cash. The current alternative to cash is having to meet redemptions through selling prime, trophy assets. In times of extremity – the argument runs – these are the only properties guaranteed to attract purchasers. But is that always true? And is this a sensible strategy for all circumstances? By definition, if you are invariably selling into a disrupted – and softened – market where prices are not optimal, you’re effectively closing the stable door after having chased out some very expensive horses.
In this scenario, a second option is to sell a group of small assets that will readily find private investor buyers in today’s market. While demand in the UK prime sector has weakened in the run-up to the Brexit resolution, it has continued strongly in the auction room for the smaller institutional quality stock because private investors tend to move at different paces – and also this market did not get overheated through massive global capital inflows.
The auction room accounts for 50% of all private investor purchases in the year to date, and demand remains high. The timeframe involved in selling a large prime asset (and actually banking the proceeds) is usually not going to be quicker than disposing of a group of smaller assets at auction. Yes, holding smaller assets has property cost implications, but surely the kind of technological advances we’re seeing in portfolio and transaction management – plus the benefit of an enhanced yield – can defray those?
