December 7, 2023
Open-ended funds still have their place in the real estate investment arsenal
Open-ended property funds have suffered their fair share of scrutiny this year. Recent closures have fed the critics. The winding up of M&G’s Property Portfolio fund on account of “declining retail investor interest” is the latest to reinforce the view that to be open-ended in a relatively illiquid sector is a contradiction.
However, does this assertion miss the elephant in the room? Is it not the case that dampening investor confidence is more a function of strategy than structure?
Contrary to the view that open-ended funds are in a state of paralysis, increasing asset outflows from some fund strategies speak more to the changing dynamics that dictate investment allocation. Western economies are preparing for a protracted era of financial repression and, consequently, sustained higher rates of inflation. A higher risk-free rate also means that many investment managers are adapting. For those invested in asset classes subject to heavy discounts, expect a swift pivot.
But for strategies exploiting price dislocation and continued investor and occupier demand in more resilient real estate asset classes, investors are comforted that the fundamentals are still present to outperform without a drastic change in approach – whatever the fund structure.
Varying preferences
To suggest that open-ended property funds are dying a slow death would be mixing up causality and correlation.
Any fund structure will be insufficient to an investor if the asset portfolio is suboptimal. Open-ended and closed-ended funds are the subject of close comparison, as though they’re like-for-like substitutes. The reality is that investors vary in their preferences, and as part of their diversification strategies across private markets they may desire a blend of exposure to optimise their portfolio’s efficient frontier.
“Tying up capital in closed-ended funds is not guaranteed protection”
In a new market normal of structurally higher interest rates, the architecture of open-ended funds could be particularly appealing to investors.
The positive correlation between bonds and equities is an indication that the traditional split is broken – core strategies in real estate, in sub-sectors such as logistics, will be essential to institutions seeking genuine diversification while retaining the advantage of deploying capital on demand.
On the inverse, tying up capital in closed-ended funds is not guaranteed protection. Exit values in closed-ended funds are a function of fund maturity dates which may not always align naturally with the market cycle. Resultant fund extensions and periods of illiquidity can serve to dilute returns.
Recognising opportunity
The competitive dynamics of deal-finding when liquidity is scarcer may also mean that open-ended structures give greater choice and right of first refusal to higher-quality real estate for those managers lucky enough to retain liquidity through more challenging periods in the market cycle.
Successful managers recognise the opportunities and drawbacks in both open-ended and closed-ended structures, and know how to operate both effectively.
There are regulatory questions waiting to be answered that have impacted confidence in open-ended structures, not least the FCA’s inquiry into liquidity mismatches. There also remain wrinkles that need to be ironed out, not all of which are entirely centred on commercial real estate.
The new regulatory framework arrived at will affect the “what next”. We’re still none the wiser on when the FCA will conclude its views. But only a full reversal of the regulatory environment bearing on open-ended funds would adversely influence their future – impeding investors’ crucial desire for choice and access in the process.
Aligning expectations
All debate aside, our view is as it’s always been. Investors with long-term investment horizons will seek to diversify their exposure to private markets, where high-quality real estate is a cornerstone of a balanced portfolio. Strategies that benefit from supportive structural drivers and inflation-hedging characteristics by virtue of lease-backed income are primed to achieve steady, stable returns that match investors’ expectations as to risk profile.
Successful funds must align investor expectations with downside protection. To that extent, structure will remain second to strategy.