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Are open-ended property funds facing an extinction event? – Analysis from AJ Bell’s Laith Khalaf

An online survey of DIY investors with AJ Bell Youinvest suggests most would sell their open-ended property funds if the FCA brings in 90 to 180 day notice periods.

 

  • 54% of property fund investors said they would sell their holdings if a 3 to 6 month notice period was introduced
  • 76% of potential property fund investors said a 3 to 6 month notice period would put them off investing
  • The FCA could announce new rules as early as Q3 this year (i.e. from now on)
  • Closure of the Aviva Property fund formally begins next Monday, 19th July

 

Laith Khalaf, financial analyst at AJ Bell, comments:

“Our survey suggests the majority of DIY property fund investors will fly the coop if notice periods are introduced, which the FCA is currently considering as a way of reducing the frequency of trading suspensions. Property funds aren’t likely to get bailed out by fresh investors making up the difference either- three quarters of those we surveyed who were potentially interested in property said they would be put off investing by notice periods.

“These numbers suggest the open-ended property sector could find itself facing an existential threat if the FCA imposes mandatory notice periods on these funds. As well as retail investors, multi-asset funds, multi-manager funds and discretionary portfolio managers might also think twice before investing in open-ended property funds, if they felt a notice period would reduce their own ability to rebalance portfolios, and provide liquidity to their own investors. There’s also the issue that under current legislation, notice periods of 90 days or more would make property funds ineligible for inclusion in an ISA, where rules state an investor must be able to encash investments withing 30 days. HMRC is currently consulting on whether it can somehow work around these rules, if the FCA does introduce notice periods on property funds.

“The commercial property sector has already been rocked by long term fund suspensions, and the heightened uncertainty surrounding both office and retail space, as a result of the pandemic. The doomsday scenario is that the introduction of long notice periods prompts a wave of further withdrawals, which proves to be an extinction event for the open-ended property sector. Hence why the FCA is taking its time in formulating the rules to avoid such dramatic consequences. It does at least seem likely that any introduction of notice periods would mean the number of open-ended funds on the market shrinks, with assets congealing around a few big funds.

“Indeed, Aviva and Kames have recently decided to call it a day after redemption requests have stacked up so high that their funds became unviable. The high level of withdrawal requests could simply be a reflection of pent up activity after long trading suspensions. But ahead of any FCA announcement, there could also be some early movers selling up, to beat any possible stampede for the exits. The FCA has said it will allow 18 months to two years after announcing any policy for changes to take place, but some may feel it’s better to get their cash back sooner rather than later, just in case. Of course, many may have already done so, and the remaining money held in open-ended property funds may ultimately prove to be sticky. While the majority of our survey respondents did say they would sell existing property funds in the event of notice periods being introduced, it was fairly evenly split, with 46% saying they would retain their holdings.

“The fundamental problem with open-ended property funds is they are a square peg in a round hole. The underlying assets these funds hold take a long time to sell, while the funds themselves offer daily liquidity. This has resulted in funds holding high levels of cash, and suspending trading for long periods, which clearly isn’t a good thing for investors, and why the FCA wishes to take action to minimise the chance of this happening going forward. Notice periods are probably the least worst option, but they’re still not ideal for investors, and our survey suggests many will simply vote with their feet.

“Some may move out of property altogether, others may opt for investment trusts which offer property exposure, but whose closed-ended structure means they can be traded throughout the day. There is a price for this liquidity however, which is reflected in the discounts placed on many of these trusts, and which may effectively also act as a barrier to investors encashing, if they don’t wish to take a price so far below the deemed value of the underlying assets. The one thing that open-ended property funds do offer investors, in normal trading conditions, is the ability to buy and sell property holdings at somewhere near the market value of the underlying portfolio. That’s valuable not just to retail investors, but also to many advisers and institutional investors who want exposure to property, but don’t wish to take a position on whether a discount is warranted or not. Institutional investors also often want to hold property as diversification from stock market investments, and the equity-like volatility of investment trusts reduces that appeal. So, there is still, in theory, demand for open-ended property funds, even though that is likely to be dented by long notice periods.

“The FCA has said it will take a final decision on the property sector in Q3 2021 at the earliest, in order to also take into account feedback from its Long Term Asset Fund consultation, which is seeking views on the regulatory framework for open-ended funds that invest in illiquid assets including real estate, private equity and infrastructure. Last November, the Chancellor pledged in Parliament that the first Long Term Asset fund would be up and running within a year, so the clock is ticking for a policy decision, and the future of open-ended property funds hangs in the balance.”

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