Why on earth does anyone own open-ended property funds?

published 5 December 2019

Ah, liquidity. It sounds kind of complicated, doesn't it? The good news is that it's not. If an asset is liquid, it's easy to sell quickly without overly affecting the price. If an asset is illiquid, it's hard to sell quickly without overly affecting the price. Is an office block liquid or illiquid? Stupid question, isn't it? It's clearly illiquid. Takes a while to sell an office block, even if people are tearing down your door in the hunt for office space.

So, would it make any sense at all to get a load of people to chip in money to buy an office block, and then tell them that they could withdraw the value of their stake, in cash, any day of the week, with no notice? No, that'd be stupid. Who'd be stupid enough to do that? Take a wild guess...

Another open-ended fund chokes on illiquidity

Fund manager M&G has just been forced to close the doors ("gating") on its £2.5bn commercial property fund. It's the same story that we saw in 2016 following the Brexit vote. And it's the same thing as we saw with Neil Woodford's fund. Too many people have been pulling their money out too quickly, and the underlying assets are too illiquid to allow that to continue without badly impacting the remaining fund holders.

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The M&G Property Portfolio was put on hold yesterday. M&G said: "In recent months, unusually high and sustained outflows from the M&G Property Portfolio have coincided with a period where continued Brexit-related political uncertainty and ongoing structural shifts in the UK retail sector have made it difficult for us to sell commercial property." The fund has seen quite a slump this year. Net outflows, reports Morningstar (via the FT), came to £901m in the first ten months of the year, compared to just £299m for the whole of 2018. By the end of October, the fund had just 5% in cash. Rival property funds Aberdeen UK Property and SLI UK Real Estate were quick to highlight that they hold 12.7% in cash and 15.7% respectively, according to the FT.

So what's going on? You can see why these funds ended up being closed to withdrawals after the Brexit vote. Investors flooded out in a somewhat hysterical response, but the funds were able to open up relatively soon afterwards when it became clear that Brexit was a process rather than an event. (It is a mystery to me why people still own these funds after that happened, but we'll get to that a bit later.)

M&G is now arguing that ongoing Brexit uncertainty, combined with the battered state of the high street, has made it hard to sell property (ie, the underlying assets have become even more illiquid). But meanwhile, people have been pulling out much more rapidly than they were before. Why's that? I haven't spoken to anyone about this, but I suspect that Neil Woodford provided a valuable wake-up call to private investors and also to their advisors.

Suddenly, everyone cares about liquidity. And the most obviously illiquid funds around are open-ended commercial property funds. So, if I'm honest, I suspect this is not a Brexit or even a high street decay story, it's a Woodford story.

Don't own these funds. It's really, really simple

But what does it mean for you? Firstly, if you don't have money in this or in any other open-ended commercial property fund, then well done you. You've clearly been paying attention during the last three and a half years. Secondly, if you've got money in this fund, there's nothing you can do. So there's no point in worrying about it. I don't know how long it'll be closed for. M&G says the suspension will be reviewed every 29 days. We'll keep you informed. I mean, now they're in a position where they're under pressure to sell stuff. Being an under-pressure seller is never great and it's not going to help them to fetch a good price for their assets. So, don't expect great returns when the fund does open again. (Oh, and they're going to wave 30% of the annual charge. Big deal.) Finally, if you own assets in other open-ended commercial property funds, you have to think about what you're going to do. M&G was in the weakest position, no doubt about it. That's why it's the first to go.

But if you're going to panic, then you might as well panic early. Because others will. And if you decide to sit tight, then do give some thought to that process. Why do you own this stuff, in this specific manner? Even if you don't care about daily liquidity, do you think that having to manage the spectre of mass withdrawals helps or hinders the fund manager of an open-ended property fund, when they are trying to do their job every day?

Do you think that worrying that their fund will one day be gated helps them to choose the best properties? To find the hidden value in the market? To negotiate shrewdly? What's the benefit here for you, the end customer? Please write to me if you figure it out, because I can't see it.

One key benefit of investing in illiquid assets is that you earn an illiquidity premium. In other words, you get paid a bit extra because you know you'll have to wait to get your money out, and that getting your money out might also be a bit fraught, depending on when you try to do it.

If you buy an illiquid asset using a vehicle that promises constant liquidity, then you are missing the whole point. If the liquidity is managed so that the fund is genuinely liquid at all times, then the manager will always be sitting on so much cash that you'll erode your returns that way.

And if the liquidity isn't managed effectively enough, then you end up in a situation where the manager becomes a forced seller in any case. There is no way to look at this and think: "hmm, open-ended commercial property funds are a good idea". Now maybe the FCA should ban them, rather than just monitoring them more tightly (as it will from next year). Maybe the funds should have bigger warning signs on them. Maybe they should all be forced to convert into investment trusts. Whatever. That's a question for the boys and girls at that end of the business to fret about.

But as for you, you don't have to invest in these things. So, don't. If you own any open-ended commercial property funds, then I suggest you sell them at the next viable opportunity and reinvest your money in a similar real estate investment trust. You still get to own commercial property (assuming that's what you want to own), and the fund manager doesn't get overly distracted by liquidity management.

Lots of things in finance are quite complicated, but this really isn't one of them.

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John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.