Many investors are locked into frozen funds but have the option of selling on the secondary market at significant discounts. Michael Stein examines the implications for investment performance

The recent financial market crisis and the urgent need for liquidity spurred a run on the German open-ended real estate funds (GOEFs). The funds that were not integrated into distribution networks were most affected. Several had to suspend redemptions because their liquidity ratios dropped below critical and/or regulatory minimum levels. A number of funds managed to re-open for redemptions, at least for some time, but had to gate their products again.

Others have yet to re-open, while some are already in liquidation or are expected to face termination soon. With more than €60bn in assets under management, the fate of the industry is under question, as is the viability of GOEFs in a financial market that is faster and more dynamic than it was when the fund structure was first established.

GOEFs have often been used (or misused) as money market substitutes in the past, but under the new regulation that was passed by the German Upper House of Parliament (Bundesrat) and became effective on 8 April 2011, they underwent a decisive change of structure.

Protecting the retail investor
The new law aims to prevent further redemption suspensions, is clearly protecting the retail investor base and legally underpins the long-term investment nature of GOEFs. It introduces minimum holding periods of 24 months and announcement periods of 12 months for redemptions above €30,000 per half-year. While the holding restriction is applicable to new investors only, the notice period is applicable to all investors following adoption of the law by the respective fund companies.

Although investors can redeem shares after 24 months (as long as they made an announcement at least 12 months in advance), the new regulation makes investments into GOEFs considerably difficult for institutional investors. This applies especially to those exposed to fluctuations within their own investment volumes - such as funds of funds, wealth management entities, and discretionary mandate managers - and to outflows in particular.

Since the new rules make it impossible to redeem at short notice, the selling of shares will only be possible via pre-announced redemptions or on the secondary market. A secondary market for funds already exists in the form of the fund exchange, but it is still far from becoming mature and highly liquid, as block sales of €1m, for example, result in observably large spreads and often lower prices.

Figure 1 contains the premiums/discounts against the net asset value (NAV) as calculated by the fund companies (and therefore against the price obtained when buying/redeeming with the fund company, if possible). The chart includes a sample of funds frozen for redemption.

Clearly, large negative performance effects may have to be incurred when shares of closed funds are sold on the secondary market. Discounts might reduce once the law is implemented and the fear of further terminations - coupled with anxiety about large devaluations of property as seen in some funds - diminishes among investors, but share prices below the NAV might still be expected.

This is due to the fact that, according to the new law, shares can be issued at any time but are only taken back after a two-year delay and therefore an illiquidity discount may still be demanded. In addition, real estate market movements might affect the secondary market prices, depending, of course, on the direction the market is taking.

The severity of the effects of the discounts be can easily be visualised with a hypothetical portfolio. Consider a GOEF portfolio on an equal weight basis, which might be part of a larger portfolio or mandate, or represents a fund of GOEFs. Portfolio performance effects during recent years would have been as depicted in Figure 2, for selling of up to 100% of capital invested in GOEFs. Accordingly, the discounts that would have been incurred are considerably large and would have distorted the portfolio performance as depicted.

While this represents average discounts in an equal-weight setting, effects may vary based on actual allocations. These discount effects add up to the reduction in performance achieved by the funds during recent years, with the average year-over-year total return of the included funds being -3.2%, as at the end of July 2011 (following the three previous year-on-year total returns of 4.4%, 2.9%, and -1.4%). However, the majority of funds delivered positive returns, with the negative average being the result of five funds severely dropping in NAV following strong property devaluations.

While it is unclear how large the discounts on secondary markets will be, even smaller discounts of up to 3% or 5% in combination with the new law may have a prohibitive effect for investors. This applies especially to investors exposed to (short-term and/or short-notice) fluctuations in assets under management, since they might be locked into the funds when they exceed the €30,000 threshold and therefore can only resort to the secondary market to sell shares in the need for liquidity - given that they do not get an exit possibility when funds will open before implementing the new law.

Furthermore, funds already in liquidation, or likely to announce liquidation, will continue to exhibit large discounts, as the staggered pay-outs over time will, in some cases, take several years, due to the necessity of selling large blocks of property. What this means for portfolio performances of existing investors looking for divestment has been laid out above, and the magnitude of the effects depends on the respective composition and the quota of total capital invested in GOEFs, as well as individual investors' need for liquidity in an inherently illiquid market environment.

Michael Stein is professor for financial market econometrics at University of Duisburg-Essen, and a portfolio adviser