One of the best ways to avoid spikes in redemptions of open-ended funds is to diversify the investor base. Richard Lowe reports
Open-ended real estate funds in the UK aimed at retail investors have had a torrid time in the past nine months. The situation, which has been covered widely by the financial and mainstream press, can be summarised thus: droves of individual investors attempted to redeem their shares all at the same time from property funds, resulting in redemption freezes, angry investors and claims of mis-selling.
This sort of scenario was always a risk for open-ended vehicles that invest in an inherently illiquid asset class but at the same time offer a certain amount of liquidity to retail investors - investors known for their herd-like behaviour, not least when markets enter into a major correction, as was the case with UK property.
Of course, institutional investors have longer-term horizons and are less sentiment-driven than their retail counterparts. As Robert-Jan Tel, head of real estate investments at TKP Investments, says: "That is really retail behaviour - getting all your money out of real estate and selling it before something happens. In general, the institutional investors don't move like that."
TKP Investments, which manages fund of funds structures for the TKP pension fund and other Dutch institutions, invests in underlying funds that are both open-ended and closed-ended. Tel says he has not seen any of the problems witnessed in the UK retail funds emerge in any of the institutional funds TKP Investments invests in.
However, it is wrong to assume that only retail property funds in the UK have suffered significant redemptions in recent months. As Simon Redman, head of business development at Invesco Real Estate, says: "Both the retail and the institutional funds have suffered in that there have been redemptions on both counts, which has certainly caused some issues in terms of being able to provide sufficient capital to meet those redemptions."
In some cases there is a queue of institutional investors waiting to exit. Fortunately, most UK institutional funds have a three-month or 90-day notice period for redemptions, rather than a daily provision like retail funds.
But Redman still does not believe this gives fund managers enough time to satisfy redemptions, especially in the current market environment where transaction levels are at a low and most potential buyers are waiting for the market to bottom out further.
"The institutional funds still only have a three-month window and that is not long enough to be able to transact and sell assets if you do not have enough cash. In most cases, if you want to extend that you have to effectively close the fund or suspend redemptions, which has happened."
The last situation that is comparable with the recent UK fund redemption crisis is the situation that emerged among German open-ended funds between 2005 and 2006. Again, funds were suspended as redemptions became unmanageable. This occured for various reasons, including doubts surrounding valuations in funds being significantly higher than market values. This led institutional investors to exit the funds. They were in turn followed by retail investors swayed by newspaper reports.
"Ironically, in Germany the first to run away from the open-ended funds were the institutional investors," says Ulrich Kaluscha, managing director of Sal, Oppenheim's indirect real estate investment platform 4IP. While the management of liquidity in open-ended funds is perhaps more problematic for vehicles marketed to retail investors, Kaluscha believes it is very much a pressing issue for institutional funds as well.
"At the end of the day," he says, "I don't think the question about open-ended funds and the liquidity problems is related to just retail or institutional funds. It is an inherent matching problem between liquidity of the fund and an underlying asset whose liquidity and value realisation depend on cyclical transaction markets."
If institutional investors have longer-term objectives and are not swayed by the same factors as retail investors, why do they find the need to redeem from open-ended funds?
An obvious reason is changing an investor's overall strategic allocation to real estate or the denominator effect of having to scale down real estate investments to stay in line with other asset classes, such as equities, that may have had significant falls in value.
Another would be a need to overweight or underweight specific countries in a pan-European or global portfolio. Tel recalls how TKP Investments sought to gain greater exposure to Scandinavia and central and eastern Europe in recent years. Since the assets under management in the fund of funds has grown during that time, TKP has been able to direct this new capital to both regions without having to remove capital from other markets.
If the assets under management had remained static, Tel says, "we would have extracted some money from western Europe to get it into those areas. We didn't have to, but if we had we would have needed a redemption facility."
Redman agrees that institutional redemptions tend to be for "much more fund or investor-specific strategic reasons. So for the most part it is actually quite easy to manage in terms of matching subscriptions and redemptions."
However, he also admits that the phenomenon of ‘herd mentality' can arise among institutional investors and this certainly has been in the case recently regarding UK pension funds, which are driven by a relatively small number of investment consultants.
There are a large number of UK pension funds that have made the first move to replace their UK-only property portfolios with pan-European or global mandates. This is driven foremost by the fundamental benefits of global diversification. But with the high returns that characterised UK property in recent years now no longer the case, the argument to go global has become more persuasive than ever from a UK-domiciled perspective.
"Many UK institutions are coming at it quite late in the game in terms of moving from a fairly domestic portfolio to an international one," Redman says. "Quite a lot of the changes in allocation have not been necessarily away from real estate, but actually wanting to diversify into international real estate.
"If you look at the timing for this, it probably makes sense. Pension funds have had a good run in the UK, so why would they move outside of that? But from early 2007, investors were seeing the warning signs and wanting to become more international and diversify into other markets where there is less valuation risk. The problem we have seen is that being able to execute that quite so quickly has been difficult."
But Redman believes there are a number of lessons that can be learned from the recent redemption debacle in the UK, one of which applies very much to the issue of ‘herding' among institutional investors.
In short, open-ended funds should diversify their investor base, whereby they are not restricted, for example, to UK pension funds, but allow in institutional investors from other countries. Redman believes this is now a real possibility given the internationalisation of real estate.
"If you broaden the investor base, you could have UK, US, German, Dutch, and Swedish investors. They each have different return requirements and different expectations, and in my view that reduces significantly the risk of what has happened recently, where everyone has decided at one time they want to redeem."
Redman believes a mixture of investors from different domiciles would significantly reduce the volatility of redemptions and cites unprecedented level of cross-border investment in global real estate, whereby investors from different countries have separate views on markets at any one time.
"A good example is if you look at the markets," he says. "At this moment we have US money wanting to invest in Europe, because they see Europe as being a competitive place to invest. We also have a lot of German money wanting to go to the US, because they see it as compelling. That is a very good example of two different capital sources having a different view of different markets.
"It makes it much more efficient for managing a fund that is open-ended if you can mix capital together. There aren't that many funds that can do it, but it is possible, because there is enough investor demand internationally now to be able to do so."
Another possible lesson to be learned from the situation in the UK is to consider introducing longer notice periods for redemptions. "Having only three months in which to settle redemptions is a fairly short time if you are thinking about property, because buying and selling will take longer than that," says Redman.
He also points to the model in the US where institutional open-ended funds have a similar notice period, but are able to match redemptions on a "best endeavour" basis, meaning if the market conditions, for example, are not conducive to liquefying assets they are not constrained by the three-month time period.
But as a fund of funds manager with a defined investment horizon, Kaluscha prefers to see open-ended funds use other means to manage their liquidity over the best-endeavour model.
"It is always a big discussion when we analyse an open-ended structure," he says. "Our fund of funds has a closed-ended structure, so we need to liquidate our investment in an underlying fund at the end of our fund of funds' lifetime."
Given the finite investment period, it is always important for Kaluscha to know how any redemption mechanism will work in different environments.
"For the placement of our investment in a secondary market or to liquidate the underlying assets of the invested fund, the general partner usually has a six- or 12-month period," he says. "However, there is a wide range of redemption mechanisms, from having a duty to take the units back to relatively loose ‘best-efforts', as well as extensive lock-up periods and excessive redemption refusals to be considered.
"Institutional investors like insurance companies or pension funds might live with the threat that redemptions are being temporarily refused. But for a closed-ended fund of funds, as we are, it is a little bit more tricky, because we have a defined investment strategy where it is written that it is closed down after 12 years. As a fund of funds manager it is a big topic in all our due diligence work, before we invest in a fund to really understand how to exit our investment."
There are other methods of managing liquidity. One is holding cash, but this dilutes the performance of the underlying real estate. Another is to use more leverage in the fund to pay the outgoing investor. However, as Kaluscha points out, any new future capital from new investors will go towards repaying this debt - not a very appealing proposition for prospective investors.
It is not surprising then that Kaluscha generally prefers closed-ended funds to open-ended vehicles. "We rather like defined business cases where on a limited lifetime basis the manager has to realise the values," he says.
The same can be said for Guenther Schiendl, CIO and member of the board at the €4.5bn VBV pension fund in Austria, which does not invest in open-ended real estate funds at all.
"It has not been the history here in Austria to invest in open-ended real estate funds," he explains. "It makes sense to go for different vehicles than open funds, because it seems to be that at some stage those funds are either money market funds or they have to buy real estate at higher prices. It is probably very difficult for open-ended funds to follow a focused strategy and for this reason we don't use them."
Does this question the role of the open-ended fund in an institutional portfolio? Redman does not think so. He points to the fact that unlike closed-ended funds, which often exhibit a J-curve effect - an initial period of negative returns before value begins to be realised - open-ended vehicles can offer stable returns, which can be appealing to pension funds.
"Closed-ended funds have the J-curve effect - you put your money in, it is drawn down, you have a heavy degree of costs at the beginning, you hope you bring up some value and then you exit," Redman says.
Furthermore, investors can remain in open-ended structures for the long-term, while closed-ended vehicles,
by their very nature, require investors to exit at a set time, forcing them to reallocate capital.
"You don't have the uncertainty of having to come out of a fund and reallocate the money into another fund," says Andy Rofe, managing director (Europe) at Invesco Real Estate. "If you have an opportunistic strategy or a value-added strategy, then a closed-ended fund makes perfect sense. An open-ended fund can provide a more stable platform in which to invest a strategic allocation, particularly those operated from - and open to capital from - different countries, because people can invest over a long period of time.
"It's not however the question of whether funds should be either open-ended or closed-ended - that there is one better than the other - because they both fulfil different roles."
