Liquid assets can have a beneficial or negative impact on fund performance, depending on the direction of the market cycle. Tim Francis and Mark Long explain how investors can manage their real estate portfolios with this in mind and ask whether derivatives offer new solutions

Cash is king' is an often used phrase during times of falling asset values and rising economic uncertainty. In the property sector, ‘liquidity is king' might be a more accurate reflection of current sentiment, referring to the liquidity of property markets as measured by transaction volumes and the proportion of liquid assets held by individual funds.

To the extent that we are now in a period of asset price correction, putting pressure on market and fund liquidity, it is timely to consider the impact of liquid assets on portfolio performance.

Conventional wisdom would suggest that liquid assets can be held within property portfolios in three main forms: listed property shares, unlisted property shares and cash (or related money market instruments). Unlisted shares, in property unit trusts and limited partnerships for instance, which offer unitised exposure to diversified direct property performance, do not, in our view necessarily improve the liquidity characteristics of the overall property portfolio.

Anecdotal evidence suggests that over the past 10 years liquidity in the unlisted market has been highly correlated with the direct market, peaking in 2005 and 2006 and falling sharply ever since. However, while they may not be useful in improving liquidity in larger funds, they do have a valuable role to play in enabling smaller investors to gain diversified access to property market performance. 

We therefore focus our attention on listed property shares and cash as the principal choices of liquid assets for property funds - later, we consider the possibilities offered by the emerging market that is European property derivatives.

Over the past 18 months, a combination of falling property values and redemption requests from investors has called into question the appropriate proportion of liquid assets held within property portfolios. Some property fund managers have temporarily closed their funds due to a lack of available liquidity to meet these requests.

We estimate that average portfolio weightings to liquid assets have actually risen from around 5-10% at the end of 2006 to 10-15% at present, due primarily to falling property values. Over the course of 2009 they could rise further to 20%. How should we expect property portfolios to perform with these higher weightings to liquid assets?

For the purposes of our analysis we focus on the UK since it allows us to compare the performance of hypothetical portfolios incorporating varying weightings with direct property, listed property and cash since 1988. Figure 1 shows the long-term historical performance characteristics of three hypothetical property portfolios, each with a 20% weighting to liquid assets.

We also show 100% direct (unleveraged) property performance for reference. Over this period, average annual total returns were broadly similar in the hypothetical portfolios, ranging from 8.14% annually for "Listed 20%" to 8.2% annually for "Listed 10% & Cash 10%". However, all three portfolios underperform "Property 100%" at 8.58% annually.

By reducing the direct property weight from 100% to 80%, historical total returns on the three hypothetical portfolios fall by between 30 to 50 basis points per annum, a not insignificant amount. However, the effect on portfolio volatility is more mixed, whereby the introduction of cash assets has a beneficial impact, in contrast to listed property assets.

The portfolio risk-adjusted return (ie average annual total returns divided by standard deviation of returns) is therefore higher with a 20% weighting to cash, lower with a 20% listed property weighting, and broadly similar with a 10% listed and 10% cash weighting.

Figure 2 shows the difference between the hypothetical portfolios in terms of historical performance relative to 100% direct property. In general, the inclusion of high-beta listed property has a strongly positive effect on portfolio returns during periods of above-average direct property performance.

The opposite is generally true of cash performance. We can see this most vividly when we look at recent performance during 2007 and 2008, where the "Cash 20%" portfolio outperformed "Property 100%", while the "Listed 20%" portfolio underperformed. The middle-ground portfolio, which incorporates 10% listed and 10% cash, has historically tracked direct property performance very well, as the total return correlation since 1988 of 99% would attest.

Given the high-beta nature of listed property returns, is there a strong case to tactically switch the liquid element of the portfolio between listed property and cash, according to the market cycle? Assuming a hypothetical portfolio switches its liquid asset weighting each year into the best performing asset class (which assumes the benefit of perfect hindsight), total returns do indeed improve from 8.2% annually to 10.8% annually with no change in volatility.

So at a theoretical level at least, it is possible that funds do not need to suffer from underperformance by holding liquid assets, although as always timing the switch between cash and property shares is crucial.

The emergence of a flourishing property derivatives market in Europe has provided investors with new liquidity management tools. A fund that is fully invested in direct property can sell a property derivative in order to achieve a desired level of cash holdings.

Equally, a fund with a higher than desired level of cash can simply buy a property derivative that swaps the total return on its cash investments for total returns on property investments. In practice, there are a number of issues that investors should consider:

The derivatives market is still in its infancy, therefore large trades can have a significant impact on market pricing; Property derivative performance is mainly determined by the total returns or capital growth of a market index. Investors should consequently consider the tracking error that exists between assets in their own portfolio and in the index; Derivative contracts adjust quickly to changing expectations of asset performance. For instance, if the market expects property to outperform cash, the price of the derivative contract would normally increase.

If the derivatives market was correctly pricing in future performance expectations, the net effect of buying the derivative will be no different to holding cash. However, as we have seen over the last five years, the derivatives market does not have perfect foresight and so the opportunity for outperformance, while retaining liquidity, remains.

In summary, now is a good time for investors to reappraise their liquidity strategy and management, as falling property values are expected to have the effect of increasing liquid asset weightings.

Liquid assets can have a beneficial or negative impact on portfolio performance, as our simple analysis of hypothetical portfolios illustrates. New tools such as property derivatives can assist investors with liquidity management, but investors should be comfortable with the risks to derivative pricing.

Tim Francis and Mark Long are directors of research and strategy at Invista Real Estate Investment Management