Property funds are stinging investors once again because of a run of redemptions. Senior multi-asset investment specialist Craig Brown notes their net asset values are in a happy superposition right up till the point they get measured.
By Craig Brown
In the world of physics – admittedly not everyone’s cup of tea, but please entertain the nerd in me – there’s a thought experiment called ‘Schrödinger's Cat’. It’s a rather off-the-wall observation about quantum mechanics which points out, in simple terms, that if you place a cat in a box with something that has a 50/50 chance of killing it and then seal the box, theoretically the cat is both alive and dead until you open the box and see.
You may wonder why on earth I’m writing about some theoretical zombie cat that’s a posterchild for the paradox which binds the real world with quantum mechanics, but bear with me. This thought experiment feels a bit like what I see in some parts of the market right now. Some of the less liquid, more esoteric, and more ‘subjectively valued’ assets out there look a lot like a cat in a sealed metal box. Anyone running the box may tell you there’s a healthy cat in the box. But with much higher bond yields and souring economic sentiment, there certainly feels like there’s a greater than even chance that the cat ain’t happy.
Over the last decade or so, many investors have moved into these esoteric or alternative spaces to add diversification to their portfolios. While on the surface these assets can provide optical diversification during benign markets – when our theoretical cats are merrily munching on their Felix (other cat food brands are available) – when times get tricky that diversification tends to melt away.
Property is a good example of this. Property funds tend to be revalued quarterly, and in brighter days with supportive economic environments they usually go steadily higher because they are valued largely by professional estimates than by the vanishingly few actual sales that complete. This usually draws in a whole bunch more people who want a piece of those steady, ‘low-volatility’ returns.
Yet the rub comes in times like now, or during other shocks, like 2020 or 2016. Not only do you have an asset whose price is heavily linked with the strength of the economy, but the fund holding those assets also has a liquidity mismatch. It must cash out unitholders on demand in a matter of days, yet their buildings take months and a large discount to sell to raise that cash. Hence the groundhog day of redemption suspensions – locking investors in for indefinite periods – we see time and time again in open-ended property funds.
The observation kills the cat
As alluded to earlier, the problem with property funds is that the underlying values of their portfolios are measured mainly by estimates during the good times. When economic shocks arrive and property owners need to sell pronto, these valuations tend to shift sharply closer to actual observed transactions, which are at bargain prices because of the stressed environment. I think of this as the moment when property funds open the box, if you will, when reality hits those valuations, and the cat really hits the fan.
Ultimately, our multi-asset funds team don’t use property to diversify equity risk because, as has been the case almost every time we see economic stress, it’s destined to be a disappointment. If there are few transactions to observe (and infrequently) then it diminishes the reliability of the valuation in question.
We see this problem crop up in several esoteric niche spaces in the investment trust world as well, such as alternative income, where the net asset value (NAV) of the underlying assets essentially means another closed box. Investors trade the shares of the investment trust daily though, so the price can move to a discount or premium to the last calculated NAV, showing what investors really believe the value of the box to be. Some discounts to NAV in this space look optically appealing, yet the question remains: are they real discounts, or will the cat be ‘dead’ next time we open the box and the discounts reflect the reality? Or will the reality be even worse?
Many of these alternative income-type assets exploded in popularity and abundance over the last decade or so as investors were hungry for yield, and these assets seemed to satiate appetites.
Many investors bought these assets where before they might have bought more vanilla things, like corporate bonds, or even government ones, simply because the yields on offer were so dismal. Some investors will be asking themselves, “Why take all this esoteric risk if I can start to get better yields for less risk elsewhere?” Those old vanilla assets suddenly look more appealing. While we didn’t get on board the alternative income bandwagon, we too find the yields on government and corporate bonds appealing now that the risk/reward calculus has meaningfully shifted. (For more on this listen to QuidDitch, the latest episode of our The Sharpe End podcast.)
In the spirit of keeping things simple we adopt the ‘duck test’ for diversifiers. “If it looks like a duck, swims like a duck, and quacks like a duck, then it probably is a duck.” So if something behaves like an equity in stress, and isn’t very liquid in stress, chances are it should be classed as an equity-risk asset.
When we think about trying to diversify our portfolios and provide protection, we try to find assets that are genuinely negatively correlated (i.e. go up when stocks go down and vice versa) through market stress. We try to avoid investments which look like diversifiers in good times, but which sting you when fortunes turn.
So, when thinking about portfolios, it might pay not to rely on Schrödinger's assets. You must open that box at some point and don’t want to risk finding Moggy has expired just when you needed him to chase troublesome vermin away.