The saga engulfing the Woodford Equity Income Fund, which left clients overexposed to small, illiquid companies, has dominated recent media attention. However, the problem of illiquid assets in UK open-ended funds runs far deeper than a few funds running risky strategies. In fact, it is hiding in plain sight within the widely popular UK direct property fund sector.
Lockups of daily-dealing open-ended funds investing directly in real estate—occurring in 2008, again in 2016, and still more in 2019—have exposed the inherent design flaw of relying on cash buffers to provide liquidity in times of market stress.
Liquidity is rarely an issue when times are good and the supply of capital is strong. But when there is a rush to exit, the liquid reserves built into direct property funds can quickly evaporate. This can force fund managers to close the gates on redemptions, giving them time to raise cash by selling properties, often in a deeply unfavourable market.
To reduce this risk, open-ended direct property funds have been increasing cash reserves. In fact, funds in the IA UK Direct Property sector have doubled average cash holdings this year to more than 20%. This additional liquidity is not free. It can cost investors in the form of lost return potential given the low yields on cash equivalents, not to mention the fact that investors are essentially paying fund managers to hold cash.
More importantly, higher cash buffers do nothing to address the structural mismatch of having daily liquidity in investment vehicles where the underlying assets can take months to sell. This flaw forces investors to compromise either liquidity or return potential. To us, it does not seem to follow the UK regulator's prime principle of ‘treating customers fairly'.
Now is the time for the UK Financial Conduct Authority (FCA) to act.
We believe the FCA should consider the example of the US, where open-ended ‘bricks and mortar' property vehicles only allow redemptions monthly or quarterly, while daily-dealing open-ended mutual funds have strict limitations on illiquid holdings. The result: of the many thousands of US mutual funds in existence since 1972, only six have suspended redemptions, according to the Investment Company Institute. The UK cannot say the same.
Germany has also taken action. The country's open-ended property fund market experienced its own existential threat during the global financial crisis, with many funds suspending redemptions. In fact, funds holding almost €20bn of real estate assets had to be wound down in the aftermath of the crisis. In response, the German authorities removed daily dealing and introduced a two-year initial holding period, with a one-year notice period for redemptions.
Investors in the UK do not need to wait for the FCA the act. A liquid solution for property investment is readily available in the form of listed real estate securities, which investors in most developed markets have embraced.
The adoption of real estate investment trusts (REITs)—now present in more than 30 countries—has driven significant growth of the global listed property market, currently valued at nearly £1.5 trillion. Yet many UK investors remain unfamiliar with REITs.
We believe it is only a matter of time before UK investors and the FCA accept that REITs and other real estate securities are more appropriate for open-ended daily liquidity vehicles.
REITs trade daily on stock exchanges, allowing REIT funds to offer daily liquidity without the need for large liquidity buffers. Typically, REITs are required to distribute nearly all net income to shareholders, meaning it is rare to find one sitting on 20% cash for any meaningful length of time. Daily liquidity can also give fund managers the flexibility to quickly shift assets to geographies and property sectors they believe are most attractive. Moreover, the global REIT market offers a diverse source of investment opportunities, including emerging property types—such as self-storage, cell towers, data centres and manufactured housing communities.
A downside to REITs is that short-term volatility may be similar to other listed stocks. But over time, REITs have historically behaved more like private real estate, which makes sense since capital appreciation and dividends are tied directly to underlying property cash flows. The upside is that REITs offer greater potential returns: In the decade from 2009 to 2018, European and global real estate securities each returned 11% per year, compared with 9% for the UK private real estate sector.
At a time of heightened economic uncertainty, we believe it is imperative investors consider the importance of liquidity in real estate allocations. The good news is they have a historically proven option right in front of them.
Bob Steers, CEO and co-founder of Cohen & Steers