Getting set up to trade property derivatives effectively necessitates company-wide competence, as Charles Ostroumoff reports
Volume in the property derivative market bounced back from its nadir in Q4 2010 to just under £500m (€554m) in Q1 2011. This coincided with two of the largest and most respected global real estate investment management firms announcing that they too were entering the market.
This property cycle is forcing fund managers to employ better risk-management techniques, and there could be a divergence in market performance between those houses that are able to use property derivatives as part of their investment strategy and those funds that do not yet have the capability to trade these products.
The reasons for using property derivatives are many and varied depending on what the goals of the fund are - whether it be for strategic asset allocation, sector rebalancing, cash drag avoidance or risk-management purposes.
Attaining the ability to trade property derivatives organically through the ‘gate-keeper' approach (an individual within the organisation primed to share knowledge and drive the growth and development of this internal work stream) has proven difficult in most cases because of the lack of management support and influence among those making the final investment decisions.
It is clear that getting set up to trade property derivatives is not an easy job. Moreover, fund managers will only trade these products when they have confidence in their companies' ability to execute these products and to manage all the associated risks successfully.
The two fund houses that have recently entered the market have employed an ‘holistic,' top-down, management-driven approach embedding the necessary systems and processes within the organisation and empowering the fund managers with the necessary training and skills to evaluate, appraise, execute and monitor trades.
The implementation process involves having each fund manager check mandates for approvals, educate their trustees about the products and strategies, go through a set-up checklist with procedures for compliance, legal, tax and accounting and ensure that all the risks are successfully managed and mitigated.
Not having the mandate to trade property derivatives in the Investment Management Agreement (IMA) is the key barrier in preventing a fund from trading and can take time to change. Typically, trustee meetings occur annually or bi-annually so the opportunity to even discuss mandate changes is relatively rare.
There are different set-up requirements for the various property derivative products: swaps, notes and futures.
For example, to trade swaps you need to have International Securities and Derivatives Association (ISDA) documentation in place. This is a two-part legal negotiation involving a master service agreement (MSA) and a credit support annexe (CSA).
The ISDA credit line process can take up to three months, although it is quicker if the fund has an existing credit line set up with a bank for other markets such as interest rates, inflation and or foreign exchange, as in some cases these credit lines can be extended to cover property derivatives.
Such formalities are not necessary when trading futures on-exchange. Once a relationship with a clearing bank and broker is established the client is able to trade the UK all property total return index in lot sizes of £50,000.
When sector and sub-sector products launch on Eurex in Q3 2011, this will give fund managers the granularity they need to rebalance their portfolios and buy/sell synthetic real estate when they are having difficulties accessing the physical market, without counterparty risk.
Once the capability to trade property derivatives has been implemented using the holistic approach, the fund manager will have the competitive edge when assessing a property derivative trade with other investments.
As part of best practice, prior to trading the fund manager must go through a thorough checklist to ensure that all the business, operational and trading risks associated with any trade they execute have been assessed and mitigated - for example, counterparty risk, liquidity risk, basis risk and volatility risk.
Fundamental mind shift
If you have spent your working career buying and selling bricks and mortar it is not easy to make the transition to trading paper whose returns are linked to the performance of a property index.
While it may be quicker, easier and cheaper to execute property derivatives compared with buying or selling a building, the fund manager needs to feel completely confident prior to trading, and know that the various departments within the organisation (tax, legal, accounting and compliance) are ready and able to support these products.
Educational toolkits and cash flow models have been developed to empower fund managers with the ability to identify and appraise trading opportunities and to track and monitor the market effectively.
As the market matures more customer-centric products are being created to enable pension funds and other market participants to use property derivatives as risk-management tools to manage their portfolios efficiently by rebalancing sector/sub-sector weightings, hedging downside risk and even protecting rental values.
In conclusion, when establishing a presence in this market it is clear that those companies that avoid the gate-keeper approach and implement from a holistic company-wide point of view will be most successful and able to take advantage of strategic trades and pricing, with the full knowledge that the end-to-end trade lifecycle is being successfully managed internally from a legal, compliance, risk management, tax and accounting point of view.
Charles Ostroumoff is a property derivatives broker with BGC Partners