Earlier this week, Legal & General Investment Management (LGIM), which houses the sector’s largest Property Authorised Investment Fund (PAIF) at £1.3bn, proposed transitioning the fund towards a hybrid investment approach, opting to hold up to just 45% in direct property and 45% in Real Estate Investment Trusts (REITs) to hedge against illiquidity risk. The remaining 10% will be held in cash.

James Crossley, LGIM’s UK head of wholesale, said the transition would be “in the best interest of investors” and recommends that they vote in favour, ahead of a shareholder meeting in April. He added: “As a property sector leader for over 16 years, we are well positioned to continue providing balanced property exposure to investors.”

“Relative to other asset classes, we feel that the UK property sector remains an attractive diversifier in any balanced portfolio, and is well positioned for investors with long-term horizons.”

The changes were first openly discussed in November last year, weeks after M&G announced it will wind up its £565m open-ended property portfolio due to “declining interest in open-ended daily dealing property strategies” from UK retail investors. Just one day later, Canada Life shuttered its PAIF after assets under management (AUM) more than halved from £254m to £102m, leaving it “no longer commercially viable”.

Direct property funds have suffered a torrid time over recent years, having been forced to temporarily close after the UK’s EU referendum and during the pandemic to stem outflows, which would have otherwise overtaken the funds’ ability to sell assets and thereby return capital to investors. The number of PAIFs in the Investment Association have slowly dwindled, with Aegon and Aviva taking their offerings off the market in 2021, and Janus Henderson liquidating its strategy in 2022.

The struggles faced by the sector led to a consultation by the FCA on the “liquidity mismatch” of open-ended property funds in 2020, which resulted in the regulatory body creating the Long-Term Asset Fund (LTAF), which requires a notice period of between 90 and 180 days before an investment can be redeemed.

However, this has not fixed the sector’s problems, nor its reputation in the industry. According to data from FE Fundinfo, 10 out of 13 funds (including the soon-to-be-closed M&G Property Portfolio) in the IA Direct Property sector have shrunk in size over the last three years – by an average of 40%. Among these 10, falls in assets range from 7.8% for VT Redlands Property Portfolio, to an eye-watering 74% for M&G.

And, in order to combat liquidity risk, many funds in the sector hold significant cash weightings. This has come under fire from many investors, who argue that more of their cash should be put to work given the ongoing charges they pay.

Could the future of direct property funds be a hybrid model, and is LGIM paving the way for other existing PAIFs to restructure their portfolios?

Oliver Creasey, head of property research at Quilter Cheviot, says he is a “long-term fan, buyer and advocate” of hybrid property funds, holding positions in CT Property Growth & Income and TIME:Property Long Income & Growth.

The former, which is co-managed by Marcus Phayre-Mudge, Alban Lhonneur and George Gay, was launched as an OEIC in 2015, although Phayre-Mudge has been running the strategy since 2011. The latter, which is run by Roger Skeldon and Andrew Gill, was launched in September 2021.

“Both of these funds have approximately a 60:40 ratio to REITs,” Creasey explains. “So, in principle, [switching to a hybrid portfolio] is a good idea from our perspective – it is good to see a firm willing to innovate and look for a solution to the regulatory issue being faced, rather than throwing in the towel.”

But of course, a consideration for existing funds is whether those invested in them will welcome such a significant change to their investment proposition.

“The specifics are a little more complicated; we also have investments in LGIM’s property fund, and because of the diverse nature of our clients, not all will wish, or be able, to hold a hybrid fund – depending on how it looks once the idea is solidified,” Creasey explains. “We will have to wait and see exactly what changes are proposed before we can definitively say it’s a good idea, and whether it is suitable for a particular client or service. But it is a sensible move in principle.”

Darius McDermott, managing director of FundCalibre, also holds Legal & General UK Property and says “it appears to be a sensible option”.

“LGIM always have had a strong property team and offering. Shifting to a hybrid solution will ensure greater liquidity than historical norms, appealing to investors and regulators and potentially incentivising continued open-ended access to the asset class,” he reasons.

Meanwhile, Ben Yearsley, director of Fairview Investing, says he has been buying hybrid property funds for “six or seven years”.

“It gives you the best of both worlds – full property exposure alongside liquidity”.

AUM difference

However, the difference in assets under management between direct property funds and their hybrid counterparts is significant. Despite having a track record of more than 10 years, CT Property Growth & Income is £319m in size, while TIME:Property Long Income & Growth is just £15.8m. This is materially less AUM combined than the LGIM fund, alone.

Rob Morgan, chief analyst at Charles Stanley Direct, says the mandates are less popular among investors because they “potentially falls between two stools for some fund buyers”.

“It is neither purely physical property nor purely listed real estate equities – although the hybrid approach does offer an interesting middle ground, and a pragmatic way forward for LGIM,” he reasons.

“Generally buyers have taken the view to allocate to one or the other – direct property or through REITs or funds of REITs, or to mix and match according to allocation policies.”

If funds opt for the hybrid model but don’t stick to set REIT and direct property allocations, however, he warns this could “create some uncertainty around how performance and risk might vary over time”.

Ryan Hughes, investments director at AJ Bell concurs, explaining that cash and REIT weightings could fall if a fund experiences significant outflows and no set proportions are put in place.

“What L&G seem to be proposing is to ensure this liquidity buffer is significant in size so to reduce the risk of it drying up,” he says. “While this makes sense, it still isn’t addressing the underlying problem of holding illiquid assets in a daily traded fund.”

McDermott believes hybrid funds are less popular because they have a less established track record, while Creasey says: “I like to think it is an awareness issue, but L&G will have to spend some time educating existing and future investors as to what this idea means in practice and why it makes sense.”

Classification

The other issue that arises is based on sector classification. In 2018, the Investment Association divided its Property sector into two: IA UK Direct Property, where included funds must hold at least 60% in physical UK property over rolling five-year periods; and IA Property Other, which includes funds which invest in property company shares, or property funds and investment trusts.

And, as it stands, the IA’s Sector Committee considers 10 funds to be the minimum constituents in any one sector in order to make it viable.

A spokesperson for the IA says: “The IA seeks to review existing sector(s) from time to time. This is typically due to factors that suggest that something may have changed in the market, impacting on the number of funds that are like for like and could be usefully classified into a new sector to aid comparisons for end investors.

“Sometimes it is necessary to sub divide or close existing sectors, and on other occasions new sectors are created.”

The sector could continue to shrink by default, with a number of its constituents already falling below the 60% minimum direct property threshold. Aside from funds which are only available to institutional investors, this could leave just two retail-friendly PAIFs standing: Abrdn UK Real Estate and CT UK Commercial Property.

Charles Stanley’s Morgan says: “It feels like the property sectors should probably be merged at this juncture as a sector average comparison here is increasingly meaningless.”

FundCalibre’s McDermott adds that an “IA sector comprised of only two funds is not viable”.

“It is likely that Columbia Threadneedle and Abrdn will face challenges in maintaining their property funds in their current PAIF format. If they do, they will potentially encounter stricter liquidity requirements, making them less appealing to investors seeking daily liquidity.”

Columbia Threadneedle and Abrdn were approached for comment.

The future of PAIFs

Looking over the medium-to-long term, some fund buyers believe the longevity of traditional PAIFs is in jeopardy.

Quilter Cheviot’s Creasey says: “I feel that there is still a market for daily-dealt direct property, but it doesn’t suit all investors/circumstances. The lack of choice, plus the regulatory issues overhanging the sector do limit the appeal.

“I think the sector can survive, but whether it will or not is a different matter. It certainly requires regulatory certainty, but we are a long way away from a new daily-dealt fund being launched. Some investors will hope the remaining funds stick around, but few would blame them if they don’t.”

Both Fairview’s Yearsley and AJ Bell’s Hughes stopped using pure direct property funds some time ago.

“Why would you own them with the threat of suspension and only holding approximately 70% in physical property?” Yearsley questions. “Physical property and daily dealing don’t mix. One of those two variables has to change – it doesn’t look like the platforms will allow monthly dealing, therefore it has to be the funds changing.”

Hughes says there “has to be trade-off between illiquidity and access” and “investors have to accept this fact”.

“Given what has happened to the open-ended property space, it is clear investors prefer liquidity over access and therefore we have seen an increase in investor demand for listed property assets,” he says.

“This trend seems to have momentum, with only a few lone voices fighting against it. In our investment team, we stopped using illiquid, open-ended property in 2019 as we saw the risk of suspension as too great and moved solely to investing in listed property securities.

“With the open-ended space almost shrinking to nothing, I suspect the vast majority of investors either have or will follow suit.”

That being said, AREF – The Association of Real Estate Funds – believes the headwinds facing the sector have been overstated.

During an online presentation at the end of last year, its managing director Paul Richards acknowledged previous difficulties with funds being forced to shutter, but argued that these were rare occurrences relative to the lifecycle of open-ended property funds. He added that PAIFs offer other benefits, including low correlation with other asset classes and differentiated income streams.

On hybrid funds, Richards says: “ It’s a fascinating move that will provide those investors who want daily liquidity with continued access to the underlying real estate assets. The benefit of the open-ended property funds holding direct real estate, be they daily-, monthly- or quarterly-traded, is that they provide lower volatility than listed shares and a level of diversification against the wider listed equity market. This is especially useful if you’re a large institution with little interest in daily liquidity.

“But if you need daily liquidity – perhaps because you’re a DC pension scheme whose platform can’t or won’t accommodate monthly or quarterly dealing, the daily-traded, open-ended funds remain. They provide daily liquidity without the significant volatility of REITs.”

Morgan concurs that REIT exposure is not necessarily the ultimate fix to the property fund conundrum, reasoning that he is “still wary of having a meaningful proportion of illiquid assets making up a daily dealing fund”.

“REITs themselves aren’t necessarily highly liquid, especially in times of market stress,” he points out.

However, McDermott expects to see more hybrid funds come to market, primarily from firms with existing property teams and “proven expertise”.

Yearsley adds: “I think hybrid property funds are great. I don’t know why other firms don’t launch them.”

Creasey, however, says it is “too early to say” whether this will become a reality. “Options have existed for a while and haven’t captured investor imaginations yet. The structure is very interesting to us, but it is slightly more complex and investor education will be key.”

This article was written for our sister title Portfolio Adviser

However, GSAM holds a more constructive look on one bond proxy: REITs.

“REITs could come under pressure, but we expect some offset as rising inflation leads to rising rents, in contrast to the negative effect that inflation could have on consumer staples via rising input costs,” the report noted.

Data from FE Analytics showed that FTSE ST All Share REITs Index has been underperforming key equity indices over the past three years, notably due to a sharp fall since September this year, as shown in the chart below.

However, “we believe investors should remain patient through the current volatility, which could also serve as an attractive entry point or opportunity to top-up existing positions,” the GSAM report said.

Lee, who co-leads the GS Global Real Estate Equity Portfolio, believes REITs offer both higher income and earnings per share (EPS) growth as compared to other defensive sectors such as utilities and consumer staples.

“In a short-term rising rate environment, markets often group these sectors into the same “bond proxy” category. However, over the long term, markets can realize the growth potential for REITs to exceed other defensive sectors,” he said.

A GSAM report cited that during the Federal Reserve tightening cycle in 1999 and 2005, global REITs index dropped at the beginning but rose to new highs afterwards.

He also sees that the asset class is supported by limited new supply and stable demand. “Unlike traditional fixed income, REITs have historically performed well in a rising rate environment because they have the ability to grow distributions over time and provide greater interest rate resiliency,” he said.

Another appeal of REITs is their fair valuations at the moment after the recent market corrections. “Compared to bonds, REITs look very attractive, and following the rally of the S&P 500 over the past quarter, REITs are now trading cheaper relative to equities as well,” Lee noted.

The biggest risk for REITs in the next 6-12 months could be the short-term uncertainty over the 10-year US Treasury yield, he said.

“That said, investors may want to take into consideration that an unusually high 10-year US Treasury yield would not only hurt REITs, but could also potentially dampen the US economy from both a consumer and a national debt perspective,” he continued.

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Performance of FTSE ST All Share REITs Index over S&P 500 and MSCI AC World Index in three-year and three-month horizon.

The document covers the management, operation and ownership of the funds.

The regulator defined Reits as a real estate investment fund that is publicly offered and the units of which can be traded on Saudi’s Tadawul stock-exchange.

It added that the main purpose of the fund is to invest in real estate construction in a bid to generate regular income.

This includes residential, commercial, industrial, agricultural and other types of real estates.

The CMA also set out rules where the fund must pay a percentage of the vehicle’s net profit in cash to unit holders at least once a year.

Fund managers must also appoint a regulated property management company to deal with the real estate held for investment.

However, the rules point out that the fund manager can sign a leasing contract to manage and maintain the property during the leasing contract period, said the report.

CMA said the move is part of the Kingdom’s National Transformation Plan to develop its capital markets and diversify investment opportunities in the country.

Announced earlier this year, the plan set out how Saudi Arabia will more than triple its non-oil revenue, cut state handouts and create more than 450,000 new jobs in the private sector over the next few years.

As part of the country’s economic overhaul, the CMA said it will continue to provide “new investment channels”, update relevant regulation and seek to raise the standards of asset management professionals by introducing new qualifications. 

According to data from the firm, US Reits gained 30.4% in 2014 and a modest 2.5% in 2015, thanks to rising real-estate values and declining capitalisation rates (the ratio between a property’s net operating income and its original capital cost). But that performance averaged over those two years may not sustainable.

“Dividend stocks may end up outperforming Reits,” he said. “Reits have enjoyed a great run, but it’s late in the cycle and the risks have increased.”

Among those is new supply. Construction of new properties was initially slow in the aftermath of the 2008 global financial crisis and tight supply boosted valuations. That has recently changed across many parts of the real-estate world, including apartments, hotels and self-storage. While rents are still growing, that growth is decelerating. The firm describes US Reits as “fair value”.

McAllister’s team invests in what he describes as income with a value focus. There are three components: Reits, dividend stocks and listed energy infrastructure. All of them face risks, but so far in aggregate they continue to deliver a premium of 100-150 basis points when compared to the Dow Jones US Select Dividend Index, he said.

Dividend stocks did well in 2013 and 2014, McAllister said. In yield terms, he said pharmaceutical and fast-moving consumer goods stocks that pay dividends return around 3%, versus 2% for the S&P500 and – more importantly – versus 1.75% for a 10-year US Treasury bond and nothing, or negative yields, for many European government bonds.

Since then, these stocks have been eclipsed by big Silicon Valley names, but McAllister said institutional investors will continue to seek dividend stocks so long as interest rates are low.

The biggest and most obvious risks have been in the energy area. The biggest factor behind energy stock performance is the price of oil and gas, which has fallen precipitously over the past two years. Price volatility in turn creates uncertainty over production.

But energy infrastructure is the asset class with the greatest likelihood of outperforming, he said, as it is a play on US energy production, which survived a Saudi-inspired price war and will continue to grow.

In the case of David Coombs, the seasoned lead manager at Rathbone Multi-Asset Portfolios, he made changes to his investment strategy in June last year.

“I felt Brexit was a risk once we had the general election. We added US treasuries, for example, and towards the end of the year we increased exposure to global large and mega-cap earners. We have very little exposure to domestic UK companies; BT, ITV and Next are the only three we hold.”

Coombs says that if by 20 June he feels the odds are stacked in favour of remaining in the EU, he will adjust his currency positions.

“At the moment, it suits me to have a lot of non-sterling currency in the portfolios,” he says. “I think we’ll ‘remain’, but there are so many ‘don’t knows’ at the moment. I do worry there are quite a lot of shy Brexiters who are reticent to say they want to leave because they will be seen as little Englanders.”

He has not done any number-crunching on a Brexit scenario because it has never happened, though from a currency perspective he has referenced the European exchange rate mechanism crisis in 1992.

“In theory, this could happen again. Other than that, it is very, very difficult. All we do is always check where our revenues are in the portfolio and make sure we are not overly exposed to the UK; our European content is largely Scandinavian and Swiss. We think the contagion effect of Brexit into the eurozone is quite high as well,” he says.

Wealth of experience

Coombs’ career has involved running multi-currency, multi-asset portfolios over many years, working at Hambros and Barings before joining Rathbone to launch a series of Jersey-based funds. Three of these funds are about to be launched in a Luxembourg Sicav, namely Total Returns, Strategic Growth and Enhanced Growth.

“There is inflation, plus objective for the growth funds and cash plus for the low-risk fund, and then the really important point is that we have a return target and a risk target. It stops me from taking too much risk to chase returns because I’m constantly aware that I’ve got to hit my risk target as well.”

He says liquidity risk is the most important to keep under control, because if it is not possible to trade then the price moves more, creating volatility, bigger drawdowns and correlations changes.

Liquidity requirements

“My parents are in the Strategic Growth Fund and I think about what their liquidity requirements are. So I am trying to think about underlying investors and mapping liquidity, and what that also ensures is that the volatility of my funds is lower.” 

He breaks asset classes in the three distinct groups, one of which he highlights as “liquid but not necessarily low volatility”, including long-dated and index-linked gilts and long-dated US treasuries.

“What they will have is low correlation to equities but, importantly, they are highly liquid. I have got a lot of liquidity in my funds.”

So could these investments withstand an event such as the collapse of Lehmans in 2008? “Yes, that’s exactly it. On the morning after Lehmans went bust, they would all be tradable; they’ve probably gone up so they are negatively correlated to a stress risk.” 

The next bucket, the biggest position in the Strategic Growth Fund, is labelled “equity risk”, which includes everything from corporate bonds below AA-rated, emerging debt, property Reits, commodities such as copper, and currencies like the Australian dollar. Coombs says that a lot of multi-asset funds have got diversification of returns but not diversification of risk.

The final bucket covers what he calls diversifiers, which are not liquid and can be highly volatile. “I don’t care how volatile the investment is, but I do care about volatility on my fund. This is about correlation.”

For example, he says he owns a CTA, or managed futures strategy, which has a higher risk and higher volatility than the equity market, but it is negatively correlated.

Gold also sits in this bucket, along with long/short funds, which are market-neutral, and infrastructure, though he does not hold any infrastructure currently. 

Long-term views are established through quarterly asset allocation committee meetings, while there are also weekly portfolio construction meetings with the team.