THE ROLE OF PROPERTY IN A DIVERSIFIED PORTFOLIO
How advisers can consider property when building a portfolio
Global markets have reacted to the Coronavirus (Covid-19) outbreak in varying degrees of distress.
This has led to an increase in short-term volatility and has left investors concerned over how slowing economic growth in China, at least in the near-term, could spread to the rest of the world.
A key question for investors tackling market volatility triggered by the Covid-19 outbreak is whether the impact will be short-lived or will mark a longer-term inflection point for the global economy - perhaps even a recession.
And given that other asset classes are more correlated, such as bonds and equities due to quantitative easing, people are looking to other asset classes for diversification - property being one.
But as an investment option, property is not perceived as very liquid, with some property funds having had to gate in recent months.
So how can property work in a portfolio and can it help with diversification?
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Advisers split on using property to diversify portfolio
Advisers are divided in their approach to using property as a diversifier in a portfolio, according to the latest FTAdviser Talking Point poll.
The poll asked advisers the following question: “How likely are you to use property as a diversifier in your client’s portfolio?
The poll results were evenly split between those who said it was very likely they would do so (28.1 per cent); those who said they would not because it was too illiquid (37.5 per cent) and those who said it depended on the client (34.4 per cent).
The evidence shows commercial property is correlated with equities so really it does not add any diversification
Rob Wood, a principal at Wychwood Financial Services said he did not believe property funds acted as a diversifier even though the impression given was that they did.
This is because with property funds not being valued with the same regularity as an asset class, like equity, “a false impression” is given that property funds are not volatile.
Mr Wood added: “The evidence shows commercial property is correlated with equities so really it does not add any diversification. It adds liquidity issues but not diversification.
“With property funds, you see this illusion of low volatility, when in reality it is not the case.
“Equities tend to follow property when markets fall so they are highly correlated in that respect, but you don’t see that when you look at figures.”
Commercial property is an illiquid asset, and Real Estate Investment Trusts (Reits) or property investment companies are a far more appropriate way to own this asset than open-ended funds.
Mr Wood added he would rather use property shares as a diversifier than property funds.
Simon Gibson, chief investment officer at Mattioli Woods, said property was a very useful diversifier to a portfolio compared to sticking with the “traditional” 60:40 equity:bond split, for example.
Gold and private equity are also among the assets that he likes.
Mattioli Woods believes that closed ended structures are the right way for clients to own commercial property, unless they have the appetite and funds to buy property directly.
Mr Gibson adds: “Commercial property is an illiquid asset, and Real Estate Investment Trusts (Reits) or property investment companies are a far more appropriate way to own this asset than open-ended funds. The attractiveness of income is a not inconsiderable element of this diversification.
“While capital is in no way guaranteed, there tends to be a more stable valuation to commercial property than there is for equity, and when incomes of circa 4 per cent to 6 per cent are readily available from Reits, the attraction in volatile markets is obvious.
“Such property vehicles do have a correlation with broader equities, but it is not a high one. Indeed, in recent volatility caused by concerns around COVID-19, our favoured holdings have stood up well relative to the main UK equity indices.”
The firm uses commercial property as an asset class in most portfolios, not just as a diversifier but as an “attractive deliverer of total return in its own right".
The hunt for diversification amid Coronavirus and market fears
Words: David Baxter
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.
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.
Gold tends to divide investors: they either love it or hate it
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.
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.
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
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.
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.
House View: Seven reasons why London will thrive regardless of Brexit
With its diverse economy, global status and educated workforce, London can continue to thrive whatever the future holds.
In the three-and-a-half years since the UK voted to leave the European Union (EU) much has been written about how London’s status as a global leader in financial services could be weakened.
However, with a diverse economy, highly skilled workforce, wide tourist demand, world-class universities and cultural appeal, London will not only survive Brexit, but will continue to thrive.
There is more to London than financial services
If Brexit does result in a widespread exodus of financial firms from London (which we view as unlikely), the tech industry has the potential to become just as important, if not more so, in the future.
Media and technology is now a much faster-growing sector for London, with a multitude of start-ups based in the city.
The fact that both Google and Apple chose London as their European headquarters demonstrates the broad level of long-term confidence that businesses have in the city.
The tech sector is also more flexible and vibrant, and less restricted by regulations and red tape than the finance industry.
The city’s legal sector also continues to expand, with many foreign companies and individuals choosing to settle legal disputes in the UK capital.
Likewise, insurance also remains an important and long-standing industry for London.
London is perfectly positioned to trade as a world city
London’s geographical location between Asia and North America means it is perfectly positioned as one of the command centres for the global economy, along with New York and Tokyo.
Leaving the EU is unlikely to affect its status as an influential global city.
In the most recent Schroders Global Cities Index, London was ranked second, finishing behind Los Angeles.
The index aims to rank the most attractive cities to invest in over the next 10 years.
London has a highly developed transport infrastructure which includes Europe’s busiest airport (London Heathrow).
In addition, it is London’s cultural appeal which includes museums, theatres, art galleries.
There are also vast amounts of open spaces and parks that attracts so many people to the city.
London is the biggest city in Europe and one of only two Alpha++ cities in the world
With a population of almost nine million, London is the biggest city in Europe and one of the largest in the world.
It is one of only two cities in the world to be ranked Alpha++ by the think tank Globalization and World Cities Research Network.
Alpha ++ cities are those that are most integrated with the global economy (the other Alpha++ city is New York).
The bigger London gets, the more efficient it becomes and the more people it attracts.
This is the power of urbanisation.
The vast number of people living in London, and the fact that increasing numbers of people are living in the centre of the city, also means that services such as car sharing are able to operate effectively.
Throughout history, London has continually reinvented itself
Founded by the Romans, more than 2,000 years ago, London has a long and impressive history.
The city’s historic and cultural attractions, which include Buckingham Palace, Westminster Abbey and the Tower of London, mean that London is a major tourist destination.
According to the most recent annual Global Destination Cities Index, London was the third most visited city in the world, with 19.1 million visitors in 2018.
The city also benefits from a world-renowned theatre district, a diverse range of shops and shopping districts, world-class restaurants and a number of world famous sporting venues.
London is also home to a wide range of museums and art galleries, including the Victoria and Albert (V&A) and the Tate Modern.
London is home to a number of world-class universities
London has one of the highest concentrations of universities and higher education institutions in the world and a student population of more than 400,000. A
mong this list are a number of world-class institutions, such as Imperial College, University College London, the London School of Economics and Kings College.
Although Brexit may make it more difficult for EU students to study in London, increasing numbers of students from Asia (China, in particular) will more than make up for any potential decline in the number of EU students.
In fact, students from the EU has been a low-growth area for a number of years, with Asia the biggest growth area.
The university sector is now such an important part of London’s economy that the government would be reluctant to impose any restrictions on foreign students to maintain the sector’s economic viability.
London has a large and well-educated workforce
As the UK’s capital and the biggest city in Europe, London continues to attract talented and educated people seeking employment or the opportunity to study or start businesses.
According to official data for 2017, 56% of people living in London are university graduates. This compares to 33% in the North East region of the UK.
The economic strength of London is improved by higher quality graduates. These graduates often gain higher paying jobs, fuelling positive demand in the city.
London has a well-developed (and expanding) public transport network
London’s extensive public transport network encompasses buses, trains (both over ground and underground), trams, riverboats and a cycle hire scheme.
Crossrail, a new 73-mile railway running through London from Reading in the west to Abbey Wood and Shenfield in the east, is due to open in late 2020 or early 2021.
The new high-speed line, which will be known as the Elizabeth Line, will not only speed up the journey time into and out of the city, but will expand the capacity of London’s public transport network and open up the city to its outer suburbs.
Tom Walker, Co-Head of Global Real Estate Securities