Will Regulator’s property fund notice period devastate the market?

17 July 2021

The majority of DIY property fund investors will flee the sector if the Financial Conduct Authority introduces a three to six month notice period, AJ Bell has warned.

In a survey of nearly 2,000 DIY investors, over half (54%) said they would sell their holdings if the regulator imposes a 90-180 day notice period, while three quarters (76%) of potential property fund investors said they would be put off investing.

The FCA’s proposal is intended to protect consumers after the UK property sector experienced a flurry of suspensions as a result of Brexit and the Covid-19 pandemic.

In its initial consultation last year, the FCA said that while fund suspensions exist to protect consumers in “exceptional circumstances”, it had seen repeated suspensions in recent years, suggesting there may be “wider problems” in the sector.

Laith Khalaf, financial analyst at AJ Bell, said: “Our survey suggests the majority of DIY property fund investors will fly the coop if notice periods are introduced.

“These numbers suggest the open-ended property sector could find itself facing an existential threat if the FCA imposes mandatory notice periods on these funds.

“As well as retail investors, multi-asset funds, multi-manager funds and discretionary portfolio managers might also think twice before investing in open-ended property funds, if they felt a notice period would reduce their own ability to rebalance portfolios, and provide liquidity to their own investors.

“There’s also the issue that under current legislation, notice periods of 90 days or more would make property funds ineligible for inclusion in an ISA, where rules state an investor must be able to encash investments within 30 days. HMRC is currently consulting on whether it can somehow work around these rules, if the FCA does introduce notice periods on property funds.”

The FCA is not expected to take a final decision on its policy position until the third quarter of this year, after which point it has said it will give firms a “suitable implementation period”, likely between 18 months to two years.

Khalaf said: “The fundamental problem with open-ended property funds is they are a square peg in a round hole. The underlying assets these funds hold take a long time to sell, while the funds themselves offer daily liquidity.

“This has resulted in funds holding high levels of cash, and suspending trading for long periods, which clearly isn’t a good thing for investors, and why the FCA wishes to take action to minimise the chance of this happening going forward.

“The doomsday scenario is that the introduction of long notice periods prompts a wave of further withdrawals, which proves to be an extinction event for the open-ended property sector. Hence why the FCA is taking its time in formulating the rules to avoid such dramatic consequences. It does at least seem likely that any introduction of notice periods would mean the number of open-ended funds on the market shrinks, with assets congealing around a few big funds.

“Notice periods are probably the least worst option, but they’re still not ideal for investors, and our survey suggests many will simply vote with their feet.”

Aviva and Kames have already announced the closure of their property funds after redemption requests stacked up so high the funds became unviable.

Khalaf said some investors may move out of property altogether, while others may move to investment trusts’ close-ended structure as they offer intra-day trading.

“Some [investors] may move out of property altogether, others may opt for investment trusts which offer property exposure, but whose closed-ended structure means they can be traded throughout the day.” – Laith Khalaf, financial analyst, AJ Bell

However, the cost of this liquidity is reflected in the discounts placed on many of these trusts and which may effectively act as a barrier to investors encashing.

Khalaf added: “The one thing that open-ended property funds do offer investors, in normal trading conditions, is the ability to buy and sell property holdings at somewhere near the market value of the underlying portfolio. That’s valuable not just to retail investors, but also to many advisers and institutional investors who want exposure to property, but don’t wish to take a position on whether a discount is warranted or not.”

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