THE ROLE OF PROPERTY IN A DIVERSIFIED PORTFOLIO

Investors lulled by the easy gains of 2019 have been in for a rude awakening as the spread of the coronavirus rattles equity markets. 

US and European indices fell into correction territory in late February as the disease extended its reach across the globe, marking the worst week for global stocks since the financial crisis of 2008.

It is a trend that may or may not hold for the longer term. But if 2020 turns out to be an uncomfortable year for risk assets, one silver lining does already stand out.

Bond allure

Government bonds maintained an inverse correlation with stocks, confounding worries about the fact that they had risen in tandem with equities for much of 2019, and therefore might fall when stocks do. 

The 10-year Treasury yield, which moves inversely to the bond’s price, hit fresh lows as equities plunged and investors looked for safe havens in late February.

As such, bonds still hold allure for investors seeking diversification. 

But fixed income instruments are not without their own challenges. 

With much of the bond universe now on low or negative yields, there is little income on offer and prices have a long way to fall if investors turn sour on the asset class. 

Hunt for diversification

All of this means that investors would do well to look further afield for additional diversification.

Both clients and professional investors may well have clear views about certain assets already. 

Anthony Rayner, a multi-asset manager at Premier Miton, recently argued that gold, which has been hovering around a seven-year high amid the equity volatility, remained a “marmite” proposition.

“Gold tends to divide investors: they either love it or hate it,” he said. “Funds tend to have exposure to gold permanently, or don’t go near it.”

Property comes with a similar story: it maintains its own appeal as a diversifier, and can serve other functions within a broader portfolio. 

The property conundrum

But the problems of recent years mean many investors struggle to justify an allocation.

To start with the positives, property still holds its own as a diversifying asset. 

The MSCI World index had a one-year correlation of just 0.27 to the average fund in the Investment Association (IA) UK Direct Property sector on 27 February and a correlation of 0.18 to the IA Property Other peer group average, FE data shows.

Given that a perfect correlation is 1, these figures suggest that both bricks and mortar funds and those with a focus on either property shares or a mixture of the two continue to stand out as diversifiers. 

When it comes to investment trusts, both the Association of Investment Companies’ UK Commercial Property and UK Residential Property sectors had negative one-year correlations to global stocks.

On top of this, property investors are not short of income at a time when bonds continue to test record low yields and interest rates remain suppressed after more than a decade of ultra-loose monetary policy. 

To give a few examples, the Threadneedle UK Property fund listed a yield of 4.6 per cent at the end of January. 

The major open-ended property funds run by Janus Henderson and M&G offered lower yields, of between 3 and 3.3 per cent.

However, these are far from unattractive in the current environment.

Property, like infrastructure and other real assets, can also protect investors from a break-out in inflation, given that real estate prices and rents can rise alongside the broader costs of goods and services. 

With governments around the world openly considering fiscal stimulus programmes, a resurgence of inflation could be a real possibility.

Other portfolio considerations might point to the need for a property allocation, too. 

Sterling has been weak against other developed market currencies so far this year, but could strengthen in the event of any breakthrough in trade talks between the UK and EU. 

In cases like these, investors would benefit from exposure to both sterling and the UK’s domestic economy – something that can come via the property market.

As such, property can still play multiple roles in a portfolio. But the challenges facing the asset class have meant many are far from convinced of its current merits. 

UK retail investors sold out of funds in the IA UK Direct Property sector to the tune of a £1.8bn net outflow in 2019.

A similar dynamic has applied to closed-ended funds. 

Around half of the 13 UK commercial property trusts monitored by Winterflood, the broker, sat on share price discounts to NAV on 24 February, suggesting investors remained uncertain about this subsection of the asset class.

The average discount to NAV in the overall group came to 3 per cent, though this was down from a 12-month average discount of 5.4 per cent. 

For those trusts on discounts, they ranged from a modest 3 per cent on the UK Commercial Property trust to 20.9 per cent on AEW UK Long Lease Reit.

Liquidity

Professional and private investors alike appear sceptical of property for a variety of reasons. 

The misadventures of open-ended funds operating in illiquid markets have played no small role here, though this is not the only obstacle to consider.

Liquidity is high on the agenda for advisers, clients, DFMs and fund managers in the wake of the Woodford scandal, and property is an obvious area where this can be a concern. 

This was duly illustrated by the suspension of trading on the M&G Property Portfolio fund in December 2019. 

The asset manager put the suspension down to “unusually high outflows” from the fund at a time when selling commercial property was proving difficult.

M&G’s fund was hit by net outflows of around £1bn in 2019, according to Morningstar, but other direct property strategies have had their own struggles. 

The data provider estimates, for example, that the Aberdeen UK Property fund was hit by around £790m of net outflows in the same year.

Property fund challenges

There are arguably reasons to be more optimistic about open-ended property funds, depending on your view of suspensions. 

The M&G fund has made progress towards reopening, recently noting that it would have a cash weighting of 16 per cent once a number of impending deals were completed. 

And in another sign of growing confidence in the market, the BMO UK Property fund recently moved to “offer” pricing, encouraging inflows, to reflect the fact that the fund’s managers were looking to buy assets.

The fact that only one fund gated in 2019, as opposed to the several that did in 2016, suggests that open-ended strategies have become better at managing outflows. 

However, there are problems with this. Many have simply run extremely high levels of cash, meaning that investors are getting less exposure to the desired assets.

For some investors, structural problems are too great to overcome. 

Ryan Hughes, head of active portfolios at AJ Bell, says: “With a clear mismatch in the liquidity of the underlying assets and the trading frequency, we will be steering clear of daily traded open-ended funds and believe that the fundamental structure of these funds should change.”

Other question marks hang over the sector.

The FCA, for example, has set out rules that would likely result in more frequent gating on open-ended property funds. This could be good or bad news, depending on an investor’s view of trading suspensions.

Similarly, some funds have moved to a new pricing structure which will prove divisive. 

Last year Janus Henderson UK Property moved from a “swing pricing” structure that shifts between “buy” and “sell” prices depending on investor flows to one where the price at which investors can sell out of the fund is lower than the cost to buy in at that same point.

The new approach means prices on the fund should be less volatile. 

However, investors may need to be invested for longer to make a return and are no longer able to make tactical investments by, for example, entering the fund at the cheaper “buy” price and selling out when it swings higher.

All of this means investors must think carefully about the merits of a property allocation and how they establish it. 

This goes beyond open-ended funds: investment trusts are better suited to hold illiquid assets but can find themselves exposed to share price volatility. 

Brexit effect

This has been an issue at a time when many investors are downbeat about the property sector.

This in part stems from Brexit-induced uncertainty, but also relates to the ongoing woes of the retail sector. 

With bricks and mortar retailers continuing to struggle against digital disruption, the property market has taken a hit. As such, funds perceived to have exposure to the high street or the broader retail sector can be subject to volatility.

Rory McPherson, of wealth manager Psigma, believes that for now some closed-ended funds in the sector may look expensive, despite the share price woes in this space, because of how they tend to behave in relation to other assets.

“We have owned Reits more recently but don’t have any allocation at the moment on valuation grounds,” he says. “Reits’ performance tends to be pretty highly correlated with movements in 10-year bond yields and hence we view them as being very expensive at the moment.”

Again, investors may take different views. Some may view property investment trusts as oversold in the context of their longer-term prospects.

Intermediaries can also consider those funds and trusts that invest in property shares – something that often gives exposure beyond the UK but once can introduce its own level of equity volatility.

With all diversifying assets facing problems of their own, some may be willing to accept the challenges of allocating to property. But investors should at least go in with their eyes open.

david.baxter@ft.com