Investors withdrew from the IA UK Direct Property sector in every month of 2019 with December's gating of the M&G Property Portfolio highlighting widespread concerns regarding fund liquidity profiles, and a growing proportion of assets now being allocated to vehicles in other sectors instead.
Almost £3.4bn was pulled from IA UK Direct Property funds over the course of 2019, according to FE fundinfo, without a single month of net inflows.
The exodus from property funds, however, did not have the same impact on the IA Property Other sector, which pulled in £534m of net inflows over the course of 2019.
Investment consultant at Fairview Investing Ben Yearsley explained that in September his firm completely exited the IA UK Direct Property sector in favour of exposure to two funds in the IA Property Other sector - Schroders Global Cities and BMO Property Growth & Income.
He said while this was partially driven by the conviction that "a daily dealing fund is not the right vehicle for physical property", the firm's exit from Direct Property funds was primarily a result of funds in the sector ramping up cash weightings in anticipation of further redemption requests.
By the summer of 2019, cash weightings within portfolios had more than doubled within the sector from an average of 10% at the beginning of the year to 20.5%. At present, this figure stands at around 16%, according to FE fundinfo.
Yearsley said: "The mounting cash weighting was probably the straw that broke the camel's back.
"In the Direct sector, many funds have around 25% cash weightings while still charging fees for managing the fund, whereas in the Other sector, funds are typically fully invested.
"How can you justify charging a 1% ongoing charges figure when you are only investing 75% of the fund?"
In September 2018, the IA divided its existing Property category into the separate UK Direct Property and Property Other sectors, following a consultation with members and the Association of Real Estate Funds.
Funds in the UK Direct Property sector must invest an average of at least 70% of their assets directly in UK property over five-year rolling periods, while Property Other funds may primarily invest in property securities, direct funds with a specialist mandate and hybrid funds.
Morningstar Investment management made the move to ditch its existing Direct Property exposure within its income portfolios in the wake of the Brexit referendum in 2016 when a number of funds were forced to gate, having removed them from its growth portfolios earlier that year on valuation grounds.
Morningstar IM CIO Dan Kemp explained that "the greater challenge" for his firm, which was exposed by the 2016 gatings, was that it has no direct contact with end clients who all come to its funds through advisers and platforms.
He said: "It is not only the illiquidity challenge that comes from direct property, but it is also the impact on the whole portfolio due to the infrastructure of platforms.
"Platforms have a number of different ways of dealing with illiquid assets. That introduced a lot of variability in the experience for end investors. That uncertainty is an unacceptable price to pay for access to property".
Choosing liquidity or volatility
No funds in the Other sector needed to gate as a result of the Brexit referendum and the sector as a whole outperformed its Direct counterparts as well as the wider market in the market sell-off that followed.
In the four days following the referendum on 23 June 2016, the FTSE 250 lost 13.7%, while IA UK Direct Property was down 1.8% and IA Property Other posted a positive return of 1.2%, according to FE fundinfo.
The Other sector's outperformance over this period is understood to be attributable to the flexibility of the sector in that managers could reduce exposure to sterling and other UK assets in a way that Direct Property managers could not.
The Property Other sector currently has an average exposure of 41.6% to North American assets, while UK assets account for just 10.8% of portfolios, down from 21.8% in January 2017.
Over five years the FTSE 250 has delivered a total return of 57.2% to 6 January, while the IA UK Direct Property and IA Property Other sectors have returned 22% and 41.2% respectively over the same period.
In addition, the Property Other sector shows significantly more volatility over a longer time horizon.
Over five years to 6 January the average Other fund has endured annualised volatility of 6.8%, compared to the Direct sector's average of 2.5%.
However, this is due to the increased liquidity of the Property Other's underlying assets. As a point of comparison, the MSCI World index has seen annualised volatility of 10.3% over the period.
Morningstar's Kemp said the flows away from the Direct sector "indicate how difficult it is for the typical investor to invest in illiquid assets such as property", and there must be "some compromise when trying to access these types of assets".
He explained: "The compromise of a Direct property fund is that you give up that guarantee of daily liquidity.
"If you opt for [Other] funds, which are normally more liquid, you expose yourself to additional volatility in the share price over and above the volatility of the underlying assets."
However, Kemp added that large funds investing in property securities where "volatility does not impact the client" can be good long-term income generators.
The hunt for yield
Property funds have played an important role in portfolios in the years since the Global Financial Crisis as bonds yields hit record lows and investors had to search elsewhere for income.
The average historic yield for the Direct Property sector - calculated by dividing the number of payments over the given period by the price - was 3.6% in 2016, 3% for 2017, 3.4% for 2018 and 3% in 2019, FE fundinfo data shows.
By comparison, the Other sector averaged yield of 2.4%, 2.6%, 2.6% and 2.5% over 2016, 2017, 2018 and 2019 respectively, largely because REITs are required to pay out a high proportion of their income.
Head of multi-asset funds at Tilney Ben Seager-Scott, who allocates a similar proportion of assets to both Direct and Other funds, said that while the Direct sector does present liquidity risk, the attractive yield proposition is worthwhile for investors.
He added: "When you are looking for real yield, you have to consider what risks you are prepared to take. In an extremely low interest rate environment, getting 3.5% from direct property - while historically not screamingly attractive - is an attractive proposition."
Seager-Scott said investors have to consider both sectors and be aware of each of their risk profiles, including the liquidity profile of Direct property funds.
He added: "With bricks and mortar, you have to be a strategic long-term investor because it is long-term investors fund managers are protecting when they have to gate a fund.
"[The M&G gating] could have sparked a domino effect where others would be forced to gate, but we did not see that and it was isolated to that one fund. Perhaps the investors that are still in the market are those that have taken a considered long-term view."
Political uncertainty causing concerns
To promote 'long-term investment'
Bucher became CEO in March
Following multi-agency pitch.
Develop education course
Client invested £25,000 through DFM service
FSCS referred 19
Wider reform desperately needed