Despite huge rebound in popularity UK property funds still struggle to outperform

8th December 2014

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The recent resurgence in the attraction of commercial property funds belies that fact that over the past 10 years they have failed to beat their very own index highlights new research.

Retail investors have collectively piled £2.9bn into property funds in the first 10 months of this year, according to numbers from trade body, the Investment Management Association (IMA) – more than was invested into the sector in 2011, 2012 and 2013 combined.

Property funds now account for £23bn of investors’ assets, up from £17.5bn at the beginning of the year.

Commenting on the rush, Laith Khalaf, senior analyst, Hargreaves Lansdown who compiled the research, said: “This year has witnessed a wall of money sweeping into commercial property funds, as investors search for income in a world deprived of yield by ultra-loose monetary policy. Commercial property funds are also used for portfolio diversification, as an alternative to equity and bond funds.

“However investors need to recognise the impact high costs will have on their investment, and factor this in to their assessment of the benefit of investing in commercial property.”

Recent performance has been strong, which in turn has bolstered the appeal of these funds. Notably over the 12 months to the end of October, the average property fund is up 10% while the FTSE 100 is flat over the same period.

But Khalaf asserted that not a single fund in the IMA and Association of British Insurers (ABI) property sectors have beaten the IPD Commercial Property Index over the past 10 years to the end of October. During the period the IPD benchmark has returned 77%, while the average bricks and mortar property fund has returned 38%.

The reason for this is not simply poor investment choices made by active managers, noted Khalaf, but the tax paid by some funds, and the high costs of investing in commercial property, which detract from returns. These costs, which include among others stamp duty, legal and vacancy fees, are over and above the annual fund management charge levied by the investment manager.

Khalaf said: “Some claim that as a result of these costs, the index return is unattainable, and so academic. Unattainable it may be, but academic it is not, because the gulf between the performance of the property funds and the property index is the only measure investors have to get some idea of what costs are doing to their investment. The cost of trading and ownership exists for any fund, but it is much more onerous for property than other asset classes like shares and bonds.”

Property share funds appear to have done a bit better- returning 59% over 10 years, better but still below the commercial property index. These funds invest in REITS and property companies, and may therefore have slightly lower costs. However they are much more correlated with the equity market than a direct bricks and mortar fund, so if investors are looking for diversification, investing in such funds may prove futile.

Comparison with other sectors

Putting property shares and bricks and mortar together, the property sector ranks 30th out of 33 sectors in terms of 10-year performance according to the analysis. Only money market funds, short term money market funds, and protected funds have returned less.

10 year returns
UK Equity funds 110%
Cautious Managed funds 58%
UK Gilt funds 57%
UK Corporate Bond funds 51%
Property funds 45%

Performance 31.10.2004 – 31.10.2014

Prior to the onset of the financial crisis commercial property funds, which invested directly in bricks and mortar were hugely popular among investors.

But following years of very strong capital growth, performance fell off a cliff when the credit crunch hit. Due to the illiquid nature of bricks and mortar i.e. selling a building is much more difficult than offloading  a share, many funds had to impose lock-in periods in a bid to stave off a Northern Rock style run on assets. As a result many property investors had to wait months to get their money out.

But as Khalaf noted this issue can be avoided by investing in closed-ended investment trusts which don’t have to meet investor redemptions. “However the flip side is there is likely to be greater volatility as swings in property values are exacerbated by swings in the trust’s price too,” he added.

In addition, gearing of investment trusts can also add risk, but long term investors may be willing to accept these features in return for the greater freedom afforded for the manager by the closed-ended structure.

Khalaf said: “We believe that open-ended funds have not been the best investment vehicle to hold commercial property. This is because they find it very difficult to cope with the large inflows and outflows, which often come at times when the fund managers want to do the complete opposite of what their investors wish to do.”

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