Suspension of UK property funds highlights liquidity benefits of ETFs

Jul 5th, 2016 | By | Category: Fixed Income

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Investment houses Standard Life, Aviva Investments and M&G have frozen trading in their UK real estate funds following a rapid increase in redemption requests as a result of the Brexit vote. The move, which prevents investors withdrawing their money from the funds as managers seek to sell off parts of the portfolio to accommodate the backlog of redemption requests, serves to highlight the relative liquidity advantages of exchange-traded funds.

Suspension of UK Real Estate funds after Brexit highlights liquidity benefits of ETFs

The iShares UK Property UCITS ETF fell 13.9% following the result of Britain’s referendum on independence from the EU, highlighting the uncertainty that Brexit has brought to the sector.

Laith Khalaf, Senior Analyst, Hargreaves Lansdown, said in a statement: “Property funds are clearly under pressure as a result of the Brexit vote, and we could now see a new wave of investors being unable to liquidate their property funds quickly, which we last witnessed during the financial crisis.”

Khalaf added: “These managers [Standard Life, Aviva Investments and M&G] will now be adding to the supply of commercial properties on the market, which is likely to put downward pressure on prices. Foreign investors might be tempted in by the fall in Sterling, but equally they may decide to steer well clear of an economy in limbo.”

The freezing of the funds precipitated the Bank of England to state it was monitoring the behaviour of investors in open-ended commercial property funds, as one of the risks to financial stability in the UK.

The forced lock-up of investor wealth within the funds serves as a reminder of the potential issues with open-ended funds whose underlying assets are relatively illiquid. Khalaf notes: “This is part of the problem with investing in open-ended property funds, and one of the reasons we don’t recommend them to investors. Property does offer diversification, and a reasonable yield compared to government bonds, but investors must be willing to accept high costs, and a lack of liquidity when the market turns down.”

“Closed-end property funds at least provide investors the chance to sell out during market upheaval, though widespread selling serves to depress share prices and widen discounts in times of stress. Indeed there are currently a number of closed-ended property trusts trading at discount in excess of 10%. However, being closed-ended does at least means the manager does not have to liquidate properties at a time when everyone else is looking to do the same.”

ETFs differ to both traditional open-ended and closed-end funds. They combine the best features of an open-ended fund with the tradability of a listed closed-end fund. But whereas closed-end funds, such as property trusts, can trade at significant discounts to their Net Asset Value (NAV) during times of market stress, ETFs will trade much closer to their actual NAV thanks to their investment in listed real estate investment trusts (REITs) and securities, coupled with the unique creation/redemption process underpinning the ETF structure. When secondary market liquidity dries up, a closed-end trust would begin to trade at a discount to its NAV. By contrast, in this scenario an Authorised Participant would redeem units in the ETF in line with investor demand thus keeping it trading in sync with NAV. Of course, real estate ETFs are not immune to falls in property prices and it must be noted that their underlying holdings may trade at discounts. But, nevertheless, the two complimentary layers of liquidity – namely the primary and secondary markets – at least give investors the ability to trade out of a position whenever they want in most conceivable scenarios. In stressed environments, such as now, this is a highly valued feature.

The largest UK property ETF is the £640m iShares UK Property UCITS ETF (LSE: IUKP)which invests in UK REITs and real estate companies in the UK by tracking the FTSE EPRA/NAREIT UK Property Index. The ETF fell 13.9% on Friday 24 June 2016 following the Brexit vote and as of 4 July 2016 is down 19.4% from its value immediately prior to the referendum. Importantly, however, the fund has not halted trading and is available to be ought and sold with ease.  The ETF, launched in March 2007, was stress tested during the 2008 financial crisis when its value fell by 77.3% up to March 2009, but at no point was trading suspended, meaning investors had the freedom to withdraw their investment if they chose.

While the property market in the UK may remain volatile as investors attempt to discern the long-term impact of Brexit, real estate remains an important portfolio component due to its historically low correlation with other asset classes and its ability to offer significant income in the current low yield environment.

Khalaf said: “Investors in property funds need to focus on the reasons they bought commercial property in the first place, and consider whether they are still intact, because there may be challenging times ahead. Diversification and income are both legitimate reasons for investing in the commercial property funds, but high costs and poor liquidity are two drawbacks which investors need to be willing to shoulder before investing in the sector.”

Investors may be able to avoid these pitfalls through the use of ETFs as their chosen property investment vehicles. ETFs possess many of the same beneficial characteristics as closed-ended funds, such as smaller minimum investments and continuous tradability on exchange, which protect investors from sudden lock-ups due to liquidity issues.

As of 4 July 2016, the iShares UK Property UCITS ETF has significant exposure to industrial & office REITs (35.6%), retail REITs (31.3%), real estate holding & development (16.1%) and speciality REITs (9.9%). Speciality REITs are equity REITs that don’t fit within the major REIT sectors and may include properties such as movie theatres and outdoor advertising.

There are 33 holdings in the fund of which the largest constituents are Land Securities Group (16.3%), British Land Co (12.2%), Hammerson REIT (8.4%), Segro REIT (6.5%) and INTU Properties REIT (5.5%). The ETF has a total expense ratio of 0.40%.

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