Why investors should tread carefully with this fund sector

With this sector, the investment trust structure is better suited, argues Kyle Caldwell. 

More than a year after barring investors from accessing their cash, most open-ended property funds have now re-opened, with M&G being the latest firm to announce that its M&G Property Portfolio will resume dealing on 10 May.

Most funds in the sector put suspensions in place last March in response to the Covid-19 pandemic, which caused uncertainty over the valuation of UK commercial property.

However, the M&G fund was an exception, suspending in December 2019 before coronavirus started to spread across the world. Its suspension was down to Brexit-related uncertainty.

The fund suspensions highlight that in times of market stress there’s a clear mismatch between the daily liquidity that open-ended funds offer and the inability of property funds to sell their assets quickly. Following the EU referendum vote and during the global financial crisis, the same thing occurred and fund suspensions were put in place, stopping investors from accessing their money.

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Below, we explain why property fund suspensions happen and other reasons why investors should tread carefully with the sector.

Why property fund suspensions occur

Commercial property is a bellwether for the wider economy, so it is an economically sensitive asset class. The commercial property market is made up primarily of shops and offices, as well as industrial buildings, such as warehouses.

In normal market conditions, although it takes months for these funds to buy and sell the shops and offices that are held in the portfolios, it is usually not a problem for investors to withdraw their cash on a daily basis, as a portion of the portfolio remains in cash.

But, during times of heavy selling, it is a different story as the cash buffer is depleted, which makes it difficult for open-ended commercial property funds to meet withdrawals on a day-to-day basis. This is because property sales are not quickly or easily arranged, particularly in times of market uncertainty. It is very difficult to raise money quickly.

Therefore, to halt the outflows and avoid a ‘fire sale’ of assets, which would negatively impact the investors who remain, fund management firms temporarily restrict or bar investors from accessing their cash. 

Rules introduced by the Financial Conduct Authority (FCA) in 2019 require property funds to automatically suspend when their valuers find material uncertainty over the pricing of 20% or more of their assets.

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Will history repeat itself again?

Yes, unless the structure changes. But the good news is that the FCA is considering changing the rules. New rules proposed last August (which were put to a consultation) would require investors to give notice – potentially of up to 180 days – before their investment is redeemed.

In response to the consultation, interactive investor called for fixed redemption periods that are long enough to be effective, as well as clearer disclosure for investors. interactive investor also called for investors to receive regular communication disclosing how much, in percentage terms, the fund has invested in illiquid assets. 

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Other reasons to tread carefully

In response to fund suspensions that took place following the EU referendum, property funds raised cash levels in an attempt to avoid future fund suspensions at times of market stress. With the benefit of hindsight, higher cash weightings (with cash positions typically ranging from 15% to 30%) did not have the desired effect.

Higher cash weightings are a drag on a property fund's performance and lower its dividend yield. In addition, most funds have not reduced their fund charges to take into account the higher cash weightings. 

The investment trust structure is a better fit for illiquid assets

Investment trusts, due to their closed-ended structure, are not under the same pressure to react defensively when investors take fright. Trusts have a fixed level of capital, so they do not need to sell the properties they own. Instead, investors who wish to sell simply dispose of their shares.

As a result of this, property trusts offer greater liquidity and can be fully invested without concerns over liquidity.

Bear in mind, however, that selling during a period of market stress may mean selling at a lower level than desired if there is a rush to the exits. Indeed, during the first quarter of last year investment trust discounts and share prices slumped notably.  

Therefore, while the upshot with open-ended commercial property funds is the prospect of investors not being able to access their money, panic-selling is a comparable problem for investment trusts. Managers of trusts are not forced to sell property to redeem investors, but the market can take a dim view of the outlook and force down share prices. However, the widening of trust discounts at such times may be viewed as opportunity by some investors.