Flaws in the design of UK property funds

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Worry for now about the return of your money, not the return on it. That warning of pain ahead comes from Bill Gross, the veteran bond fund manager. It will be keenly felt by investors in UK commercial property, who have rushed to make withdrawals from real estate funds since the shock of the Brexit vote, prompting several large funds to suspend redemptions.

This shuttering of open-ended funds, while it carries echoes of similar “gatings” in the early stages of the global financial crisis, should not present a general threat to financial stability. UK banks are not as exposed to commercial property as they were in 2007, and it seems unlikely that the assets in question would become entirely unsaleable, at a time when global fund managers are struggling to find any source of reasonable returns.

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However, the suspensions will still be damaging. They will hit confidence in the residential market and they are having an unnerving effect on general sentiment towards UK assets, visible in the ever-shakier performance of sterling. Moreover, open-ended funds have assets of about £35bn under management, some 7 per cent of total investment in the sector. If they have to sell assets swiftly, they will exacerbate the slump that seems likely in UK commercial property prices.

It is increasingly apparent that regulators need to look closely at the poor design of supposedly open-ended funds that are widely marketed to UK savers, but where the promise of swift redemption is at odds with the illiquid nature of the underlying assets.

Unlike conventional listed property companies, which simply take investors’ money and put it into property, these open-ended funds promise to hand back capital at a fixed price (based on a historic net asset value) should the holders demand it.

This might seem an attractive offer to retail savers but it creates an inherent mismatch: in contrast with securities, property cannot be sold within hours or days should investors ask for their money back. To meet their guarantee, the funds therefore hold cash reserves. They also retain the right to clip the net asset value by some 5 per cent, to deter a flood of redemptions. If these defences fail, they are able to suspend trading for a specified period, which they can extend if necessary.

The funds that have been first to announce trading suspensions — including those run by Standard Life, Aviva and M&G — had far lower cash buffers than rivals. Many open-ended funds had written down the value of assets and increased their cash holdings in the run-up to the referendum.

Yet this is unlikely to proof them against a broader loss of confidence in a flawed structure that creates deeply perverse incentives. The commitment to repay funds at a fixed price will encourage investors to demand their money back when they see property values falling elsewhere. They have an interest in getting out swiftly, before the fund faces demands it cannot meet and slams the door.

Worse, when a fund comes under this kind of pressure, the structure obliges managers to act against the interests of at least some of their investors. Either they dump their best properties to keep paying out redemptions, hitting long-term investors, or they pull down the shutters, locking out investors with a nearer term outlook.

Andrew Bailey, head of the Financial Conduct Authority, has underlined the need to look at open-ended property funds “from the point of view of conduct and systemic stability”. Promising instant redemption of illiquid assets is dangerous. At minimum, regulators should impose far tougher standards.

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