News analysis: Synthetics revisited
Will increased investor demand be enough to give derivatives depth? Shayla Walmsley investigates.
The announcement this week that FTSE adviser MSS is to create a closed-end fund to track the FTSE All UK Property index provides as useful an opportunity as any to revisit synthetic investing.
Synthetics such as derivatives have been around long enough to generate a level of clarity on their primarily tactical benefits. If investors want, say, to reduce their retail exposure, derivatives allow them to do so without selling the buildings (and incurring hefty sales costs).
They can also help keep capital within real estate when it might otherwise be diverted into other asset classes for want of immediate opportunities. Instead of holding 20% cash as they wait for asset prices to come down, investors could buy at an implied discount of -10% or -15%.
"Investors can short the market or gain exposure for one or two years or even months - short-term risk management is suddenly a possibility," said BGC derivatives trader Charles Ostroumoff. "That gives derivatives game-changing potential."
Moreover, derivatives have a certain appeal in a market where beta is the new alpha.
"We're looking to deliver property market beta returns - we just happen to use derivatives to do it," said Paul Ogden, partner at InProp, whose UK commercial property derivatives fund started with £30m (€37.4m) in capital 18 months ago and now has £180m. "We're trying to be the world's most boring property fund."
A couple of things are happening in the property derivatives market that worth noting.
The first is a switch in emphasis from swaps to futures. Over-the-counter (OTC) swaps, traditionally appealing to an interbank market because of their capital efficiency, look somewhat less efficient now that Dodd-Frank and EMIR require swaps to be listed in a central repository and cleared via a central counterparty (CCP).
In contrast, futures come with standardised contracts, minimal set-up costs and transparency on pricing and valuation. These characteristics potentially give them traction with pension funds that, with a few exceptions, never took to swaps, not least because of the significant back-office burden.
The second change will be the launch of property segment futures on Eurex in the third quarter. "That will give real estate investors the level of granularity they have in the direct market without the counterparty risk of swaps," said Ostroumoff.
Both changes will benefit investors. Yet a couple of caveats are in order. The first is that, except for French office swaps, this is a UK-specific market. For investors looking for exposure beyond the UK, derivatives will not help.
The second is that it is still an embryonic market with limited depth. A strong position by a large manager would move the market.
Even if the market can pull in the investors, it also needs banks to provide daily liquidity - and they aren't. "We've been trying to do deals - in fact, we're currently doing a deal - where banks are unwilling to trade," said LGP business development manager Phil Bayliss. "I've traded £100m so far this year - but I'd like to have done more."
Without sufficient deal flow, investors are likely to rethink their view of derivatives as an efficient market.
In any case, increased appetite is coming from some investors only. The lack of capital likely to come into derivatives from DC schemes might become a problem as they become more prevalent than their DB counterparts.
"Would the man or woman choosing funds within a DC scheme select a derivatives fund?" said Towers Watson senior investment consultant Douglas Crawshaw. (In fact, it could make more sense to do so within a DC scheme because it allows pension-holders to buy property piecemeal.)
Despite describing himself as passionate about property derivatives, Crawshaw reckons there is a way to go yet before pension funds take to them en masse. "I can see the benefits, but I can't see the demand yet," he said. "Building a track record takes time, that's the problem."