Open-ended property funds and the dangers of survivorship bias
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Article Type
Research
Topics
Real Estate, Solutions
Published
February 16, 2024
Read time
4 mins
Author
Tony Yu
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You may have heard of the Second World War story where the Allies mapped bullet holes in planes that were hit by Nazi gunfire to help them understand where to strengthen the bodywork of Allied aircraft. At first, this seemed like a perfectly logical method of analysing information to conclude where planes were most vulnerable, and the results are shown in the famous image below with the red dots representing the mapped bullet holes.

 

Survivorship bias

 

Illustration of hypothetical damage pattern on a WW2 bomber. Based on a not-illustrated report by Abraham Wald (1943), picture concept by Cameron Moll (2005), new version by McGeddon (2016), vector file by Martin Grandjean (2021).

 

Needless to say, we now know this approach was an error. The red dots only represented data for the damage to the planes that made it back home. If aircraft was reinforced in the areas covered by red dots, it would ignore the data from fatally damaged planes that did not survive. This is known as survivorship bias, and the lesson is to be careful about the conclusions you come to when looking at information or data sets that have some sort of self-selection process.

 

So, what has this got to do with open-ended property funds? Well, in a similar way to how Allied commanders drew wrong conclusions from the planes that came back home, investors can end up focusing on the erroneous information when looking at the risks of investing in open-ended property funds. Because of course the open-ended property funds that exist today have gone through their own survivorship bias and self-selection process. Investors in open-ended property funds may overestimate potential returns by investing from a systematic pool of winners and at the same time underestimate risks by ignoring the losers that no longer exist.

 

Lets elaborate further. What are the typical attributes that investors, or their advisors, look at when selecting an open-ended property fund? Usually, investors will focus on characteristics you would ordinarily expect in any other manager-selection process - management expertise, investment style, portfolio strategy, portfolio composition and past performance (despite all the disclaimer warnings) are just a few of the things that investors will focus on when picking a property fund.

 

But these characteristics, or risks, are like the mapped bullet holes of the Allied aircraft that managed to get back home. A more important question that should be asked is this - what happened to the property funds that didnt survive? Are there other risks that investors are missing?

 

The answer, in our view, is an emphatic yes. If we look back at the history of open-ended institutional property funds over the past 20 years, we find that the single most important downside risk of an open-ended property fund, which we think investors consistently underestimate, is the impact of investor outflows. Managing outflows from a property fund in a lumpy asset class like property is not easy, and if outflows accelerate, this can lead to redemption runs and an array of unwanted outcomes for managers and investors - losses due to forced asset sales, skewed and riskier portfolios, and locked-up money due to redemption deferrals or dealing suspensions are just some of the issues that emerge. For some open-ended property funds in this position, there is no way back as they head towards termination or a forced merger, usually after a period of heavy losses or underperformance. And some investors, who may be unfamiliar with the history of open-ended property funds, may be surprised at how often this occurs.

 

The issue of heavy outflows from property funds is especially pertinent right now. Higher interest rates and better funded DB pension schemes over the past 12-18 months led to an acceleration of de-risking and the desire for many schemes to exit illiquid assets such as property. This has put an enormous strain on certain open-ended property funds which have struggled to sell enough assets to satisfy redemption requests. Some of these funds will not survive.

 

So, what is the solution for those investors that wish to remain invested in property funds over the long term? History tells us it is not easy to identify consistently strong performing property funds or stable funds that dont go on to suffer heavy outflows - some of the most popular or best-performing property funds from 15-20 years ago are no longer here today. Picking a single property fund and passively holding it over the long run, as many investors appear to do, is therefore a dangerous approach.

 

Thats why we believe the case for multi-manager portfolios of property funds is so compelling. Diversified portfolios of property funds can significantly reduce the performance and liquidity risks of investing in property. And actively managed portfolios of property funds, where allocations can be efficiently and quickly switched through primary and secondary markets when necessary, can mitigate the problems that emerge when heavy outflows impact a single open-ended fund. The performance and liquidity track record of our Aegon Active Beta Property Fund, which has paid all client redemptions on time, despite redemption deferrals of some underlying property funds, speaks for itself.

 

Like Allied aircraft in the Second World War, no property fund is completely bullet proof. But a diversified and actively managed portfolio of property funds, like the Aegon Active Beta Property Fund, has the bodywork in the right place to protect investors when it comes under fire.

Disclaimers

Author

Tony Yu
Property Fund Manager
Tony Yu, indirect property fund manager, is a member of the UK indirect property team, co-manages the Active Beta strategies and is responsible for developing portfolio strategies, overseeing the indirect property team’s fund-research effort and sourcing secondary-market deals.
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