Open-ended funds have a future but market players must adhere to some important rules if trust in the product is to be -restored

For a long time, open-ended real estate funds were generally deemed a sound and, above all, a safe and stable investment in Germany. On top of that, the liberalisation of the German Investment Act and the expansion of the investment universe with regard to usage types and location quality have seriously boosted the earnings prospects of many funds over the past 10 years or so. The brightened prospects, though, have tended to coincide with heightened risk.

Unlike private investors, institutional investors have rarely had to pay upfront fees because they required no sales consultancy services. With this is mind, it is clear why major institutional investors warmed to open-ended real estate funds as a money market substitute. They were lured by returns far above the money market level combined with on-demand availability.

The problem was this: whenever rates of return for a conservative investment product become less than competitive or indeed turn negative, investors will withdraw their capital. So when the market environment abruptly deteriorated in the autumn of 2008, institutional investors pulled vast amounts of money out of these funds. In particular, the liquidity management of funds whose portfolios showed a high percentage of cluster risks arising from shares held by institutional or semi-institutional players was permanently destabilised. The massive cash drain inevitably led to the closure, and in some cases even to the wind-up, of the affected funds.

At this time, we can draw two significant conclusions from the experiences of recent months. For one thing, it has become apparent that the ability of this fund type to survive is greatest when it has a large asset volume, is widely diversified, and has been on the market for a long time, during which it has pursued a responsible and circumspect investment and sales strategy. The ramifications of changes in valuation or temporary market shifts are unlikely to have more than a moderate impact on funds of this type. Having moreover a high-powered sales background - preferably of the classic type targeting private investors - will no doubt contribute to a successful performance.

Other funds, by contrast, often acquired their portfolios of property at peak prices during boom cycles, prompting drastic adjustments to valuations and plunging returns when the financial and economic crisis struck. Moreover, the selection of volatile global markets was often at odds with the requirements of the predominantly safety-oriented investor clientele. So investor interest began to flag, especially for those funds with a largely global orientation. The trend increasingly limited the structuring options available for purposes of portfolio control and property acquisitions. The result of this is that the future success of an open-ended real estate fund will hinge on a shift in focus toward Western European markets with an add-on role for opportunity-driven commitments outside the core markets of Western Europe. Furthermore advisers and investors will scrutinise funds beyond the yield aspect, paying much closer attention to characteristics such as fund volume, diversification, and sales structure.

The other key aspect is that Germany's governing coalition has, in the meantime, pushed the reform of open-ended real estate funds through the Lower House (Bundestag) and the Upper House (Bundesrat) in conjunction with the new Investor Protection Act. The essential components of the legislation include the provision that investors may return their shares on any trading day up to a total of €30,000 per semester, notwithstanding a one-year notice period that applies to all investors. This preserves the fungibility of the asset class in the best interest of private investors. Once ratified, the reform of open-ended real estate funds is likely to enhance stability in the fund industry. Institutional investors will most likely have lost interest in the funds once the new legislation is in place, but leaving them in a position to keep benefiting from the advantages of open-ended real estate funds is nonetheless desirable.

This presupposes that the rules of the game are more clearly defined. Unless they wish to see them written into law, investment companies managing such funds must - in their own interests and those of countless private investors - define these rules in their own right. The divergence of the investment profiles of private and professional investors suggests that investment companies need to do a better job aligning their fund products with their target clientele. Institutional funds are the vehicle of choice for institutional investors; we believe, however, that smallish institutional investors such as foundations or family offices can only be targeted via so-called business funds, meaning public funds for institutional investors that are characterised by high minimum stakes and strict redemption rules.

What matters more than anything is that a permanently stable investment environment evolves for everyone who continues to believe in the positive qualities of open-ended real estate funds or real estate funds that favour long-term and safety-oriented commitments. Revising the competitive and statutory parameters is one thing; creating trust in the product quite another. To facilitate the latter many market players could make a definitive contribution - opinion leaders by conducting differentiated analyses, and fund providers by showing a high level of integrity in the way they conduct their sales and portfolio management.