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01 April 2019

By Ronan Kearney, Director at Osprey Capital

Responsible for Fund Structure & Governance on the Verbatim Investment Committee

In the second of a series of five articles, Ronan Kearney Director at Osprey Capital and responsible for Fund Structure and Governance on the Verbatim Investment Committee, examines some of the investment assumptions many professional fund managers and advisers take for granted. He raises the questions: Are these investment assumptions justified? Or are there potentially alternative approaches to asset allocation and portfolio construction that could better serve the financial community?

Let’s take a closer look at Benchmarks for investing into UK property. Many asset allocation models in the last decade utilise the risk and return outputs from property benchmarks, even if they modify it to some degree. The risk and return outputs of property Benchmarks are very important in asset allocation, as property investment returns are quite high relative to the measured risk or volatility of those returns. As a result, including this data in their asset allocation allows modellers and fund managers to ‘free up’ some of their risk budget to invest in other asset classes. That is to say, this allocation to property acts in some way as a ‘volatility dampener’ to allow for the inclusion of other higher risk asset classes.

This is all very useful, and appeals to the British love of property as an asset class generally, however there are a few challenges with property Benchmarks.

In some cases Benchmarks are built on price data submitted by surveyors and other industry professionals. These prices may not be on actual transactions, but on estimates of investment growth. The obvious point here is that this methodology makes it difficult to include any element of transaction costs in the Benchmark, whereas actually buying or selling property does involve significant legal and surveying costs at a minimum.

This type of methodology makes it very problematic for funds that invest in real property to match the risk and return outputs of the Benchmark. In addition, physical property funds contain a lot of assets that may be hard to sell, and so have to maintain a significant cash buffer to manage redemptions. This is another challenge with many Benchmarks, as they make little or no allowance for cash holdings.

Finally in times of crisis, which seem to occur every decade or so in the property asset class, many funds find that they have to ‘gate’, or suspend dealing, or in some cases apply a discount to their unit price to discourage redemptions. The FCA is looking at this area in some detail at present, but it is an ‘event’ risk that arguably is not priced into Benchmarks.

It is clear therefore that for investors property Benchmarks are potentially difficult for two reasons. The first issue is that it is very hard to replicate the risk and return profile in practice by investing in unitised property funds. This in turn creates the second problem, which is that the asset allocation itself may not remain appropriate when advisers or fund managers attempt to implement it by investing in property funds. Either the risk profile or the return profile of the funds used will not match the Benchmark data, and so the client’s portfolio overall runs the risk of failing to meet its risk and return objectives.

So having failed to identify a fund, or a mix of funds, that can successfully replicate the performance of key property Benchmarks, we are left with the conclusion that an alternative Benchmark for property might be more suitable. In order to be successful, this Benchmark would need to take account of the costs involved in property investment, and also the event specific risks such as liquidity, in order to give an investable solution for investor portfolios. This would probably result in different allocations to property within portfolios, but would be more accurate in terms of the correlation calculations of performance and risk between asset classes, and would potentially offer investors a more realistic view on the investment outcomes of their asset allocation.

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