Losses among direct property funds in 2007 ranged as high as a 20.5% slide at Skandia Property (run by ING),
and double digit losses were the norm at most other funds in the group. The picture was even bleaker among funds focused on property securities, as equity markets immediately priced in negative investor sentiment and deteriorating conditions. Two of the hardest hit examples were SWIP UK Real Estate, which staggered to a 39.6% loss, and Aberdeen Property Shares, which fell 37.8%.
The property slump has several causes. First, UK property prices in general, particularly in the southeast, had reached levels that seemed unsustainable, with yields at or near historic lows. In this environment, the sub-prime-induced global credit crisis and the subsequent failure of Northern Rock left funding difficult to come by and spooked investors. The worst may still be to come: Keith Anderson, then CIO of fixed interest for BlackRock, noted in September that the vast bulk of mortgage resets in the States are due to hit in 2008. This may mean the more defaults are on the way, which could well have knock-on effects on UK credit markets.
Financial sector funds were also hit hard by the slump as even the biggest global banks did not escape the effects of the meltdown. Against that backdrop, AXA Framlington Financial was the hardest hit financials offering in 2007, with a 10.4% drop on the year, a significantly larger loss than the rest of its IMA sector peers and the Morningstar Sector Equity: Financial Services category average loss of 3.9%.
The slide points to the risks inherent in offerings focused on a narrow slice of the economy. With regard to direct property funds, it also highlights several issues that have long concerned us. First, there is an inherent conflict in investing primarily in illiquid assets in a fund that provides daily liquidity. Moreover, the nature of liquidity risk is such that problems are likely to arise just at the most inopportune times, i.e., when property is slumping. Finally, valuations are not set by the market, but by an independent standing valuer, usually on a monthly basis (some funds have recently moved to fortnightly valuations). This creates a risk that the valuations set will not be obtainable if put to the test on the market.
The degree to which the downturn will continue into 2008 and beyond is as yet unknown, but advisers are best served by helping their clients keep things in perspective. From a long-term point of view, an appropriate allocation to property should not be cause for concern. Those who have too much exposure, or who bought property funds to speculate, however, should reconsider their utility. With regard to financials funds, it is difficult to see why UK investors would need one--given the high degree of dependence of the UK economy on the global financial services market and the large proportion of financials in UK equity indices, it seems unwise to layer on yet more exposure via a specialty fund.
A version of this article previously appeared in Investment Adviser, Financial Times Ltd.
