An open or closed case?

The negative publicity surrounding the problems in the German open-ended property fund industry last year re-opened an old debate about the relative merits of open- and closed-ended fund structures. As an asset class, property is perhaps more high profile than it has been for over a decade, and trustees who are not familiar with property are therefore likely to wonder if this is a fuss about nothing, or whether they should favour one over the other.

This may seem like an irrelevant consideration: the April 2005 INREV Investment Intentions survey showed that 95% of institutional investors preferred closed-ended funds.

This represents a significant change from the 1990s, when open-ended funds dominated the market, although open-ended products still account for over half the gross assets invested in property funds.

During the past decade, over 200 closed-ended funds have been launched, as property managers have responded to client demand.

Pension fund trustees should be asking whether this preference is justified and if there are circumstances where open-ended investment vehicles may be more appropriate.

From a pension fund / trustee perspective, the main advantages of an open-ended structure are liquidity and access. The pension fund can increase or decrease its exposure to property relatively easily and quickly.

Furthermore, access to open-ended funds is easier; small pension schemes may not be large enough to access closed-ended funds, which are typically set up with fewer than a dozen institutional investors.

Naturally, these advantages are not without cost. Greater liquidity for the investor means that the property manager must pay attention to managing inflows and outflows in addition to the ‘pure' management function.

The easiest way to do this is by discouraging excessive inflows and outflows through the levying of charges on investors who sell shortly after buying or in better educating potential investors about the longer-term time horizons that apply to direct property.

If inflows pick up significantly, the manager may find it difficult to find enough attractive investments - and getting cash into direct property is obviously more difficult than investing into equity or bond markets. A manager can guard against outflows by maintaining a cash balance, but this will act as a drag on performance and obviously partially negates the client asset allocation decision.

Some managers may choose to get round this problem by using listed property vehicles. However, while this can help manage liquidity, and these vehicles give similar long-term returns, listed vehicles tend to behave more like equities in the short term, both in terms of returns and volatility.

Closed-ended funds offer several attractive features for pension funds. They tend to be set up to follow a specific strategy (for example to invest in the German office sector) with a specified term - usually seven to nine years. Investors receive a seat on the investment board and hence gain greater control and oversight of their investment.

Again, there are drawbacks to these funds. Given that the fund will have only a small number of investors, the amounts invested have to be significant in order to give the fund critical mass, and unless listed, it can be difficult to liquidate the holding before the agreed date.

The differing time horizons of these funds tend to result in differing strategies. The longer-term approach required for an open-ended fund means that its strategy must adapt to the property market cycle in order to avoid long periods of underperformance.

This in turn means that benchmarks such as the IPD are more likely to be used, both in terms of portfolio construction and performance measurement.

Benchmarks are usually of less relevance to closed-ended funds due to the focus on a single strategy or area of the market.

In addition, the returns from closed-ended funds tend to be concentrated in the latter part of the fund's life, with initial costs depressing early returns while the later returns are boosted by any capital gains made on the underlying properties.

So how can investors use these products, and are they complementary? The major decisions are effectively about convenience and strategy.

Open-ended structures are more convenient for pension funds, but will provide market-like returns. If the pension fund is looking to take advantage of a specific trend or opportunity in a certain sector, open-ended funds are less likely to be effective.

A closed-end vehicle is a bespoke solution, more suited to pension schemes that have a clearly defined objective or purpose, and that are large enough to invest the higher amounts required to access such vehicles.

The off-the-peg nature of an open-ended fund may not give perfect exposure to property due to the need to have an eye on liquidity, but this is better than no exposure at all.

Ultimately, we believe that trustees and advisers should not be too concerned about fund structure; if they have a clear idea of what property exposure they want and how it will fit within their overall risk/return planning, the most suitable structure is likely to be an implicit, rather than explicit decision.

Kiran Patel is global head of research and strategy at AXA REIM