Section Two: Fund Performance

Section Two: Fund PerformanceThe published track record of unlisted funds allows investors to analyse whether including the asset class in their portfolio would meet their investment objectives. MSCI publish the MSCI/AREF Property Funds Index alongside MSCI’s own equity and bond indices, promoting the UK real estate fund industry to investors around the globe.The past returns of individual funds enable investors to identify those fund managers that have a track record of delivering strong performance.Real estate fund performance
The Index provides data on the past performance of All funds and then these are broken down into six aggregations: Specialist, Low Geared Balanced, Other Balanced, Managed, All Balanced and Long Income. The total return from All funds has averaged 5.8% pa from 1990 to q3 2020. Over the same period the income component of return averaged 3.1% pa and capital growth 2.6% pa. This total return compares to equities, 6.2% pa, and bonds, 7.2% pa.The pattern of performance is dominated by the period spanning the Global Financial Crisis, with a nadir in the final quarter of 2008 of -18.5% and a peak return in q4 2009 of 10.5%. Over the last 10-years All funds have delivered a 6.1% pa return, higher than equities, bonds and property equities at 4.1% pa, 4.5% pa and 5.6% pa respectively.Figure 2.1, MSCI/AREF Property Fund Index: Components return

^{Source: MSCI/AREF UK Property Funds Index}

A full data series is available for Balanced funds but not the Specialist (available from the start of 2002) or Long Income funds (available from the start of 2012).The Managed funds generated a slightly lower return than the All Balanced funds, at 6.0% pa, but with lower volatility, 8.9%. This pattern has been more pronounced in the period between 2012 and 2019, with Managed funds under-performing Other Balanced funds by 124 bps pa.Table 2.1, Past performance by fund aggregation

^{Source: MSCI/AREF UK Property Fund Index}The strongest and least volatile returns have been generated by Long Income funds, although this performance track record spans a period of falling bond yields, which has pushed up the pricing of long, secure, income streams. Specialist funds have generated both the lowest and most volatile returns due firstly to leverage in the GFC and since and the calamitous performance from retail.

Figure 2.2, Past performance and volatility by fund aggregation 2012-19 (inclusive)

^{Source: MSCI/AREF UK Property Fund Index}As would be expected, the range of Specialist fund performance has been much wider than for Balanced or Long Income funds. Section three will seek to explain the factors driving the range in fund returns.Figure 2.3, Past performance and volatility for individual funds, 2012 to 2019 (inclusive)

^{Source: MSCI/AREF UK Property Fund Index}Performance drivers
The AREF fund data can be split into cash, leverage, investment flows, structure and stock. The split is complicated by stock factors that can have both a systematic influence and also drive variations in individual property returns. For example, developments are likely to perform relatively weakly in a downswing, as their cash flow prospects weaken, but individual developments may achieve a strong letting and perform relatively strongly.CashCash is a drag on fund performance when property returns exceed interest on deposits and vice versa in a downswing. Cash in Balanced funds has averaged 6.0% from q4 2004 to q3 2020, hitting a high of 10.2% in q1 2010. Cash levels have been much lower in Specialist and Long Income funds, averaging 2.9% and 1.8% respectively, from q1 2012 to q3 2020.Figure 2.4, Fund cash, % of GAV

^{Source: Authors own calculations using the PFV Handbook}The impact of cash on fund returns has been estimated by assuming all funds receive the return of 3-month Treasury Bills on their cash balances and estimating the performance of each aggregation with and without cash.In most time periods cash is estimated to be a drag on fund performance, but in the GFC the significantly negative property returns led to a strongly positive cash impact. The subsequent hoarding of cash to buffer liquidity led to cash being a significant drag on returns in the recovery.Figure 2.5, Estimated cash drag

^{Source: Authors own calculations using the PFV Handbook}Cash can be used when the fund is experiencing fund outflows to repay redemptions without forcing Managers to sell the underlying properties into a falling market. The impacts of cash and fund investment flows are therefore intertwined. A combination of low cash holdings and high fluctuations in investment flows is likely to maximise the negative impact of fund disinvestment in a downswing and a combination of high cash holdings and low fluctuations in investment flows is likely to maximise cash drag.Over the last 16 years cash is estimated to have reduced All fund returns by 14 bps pa, and by 23 bps pa for Balanced funds.Table 2.2, The estimated impact of Cash, q3 2004 to 2020 q3

Fund leverage
In Modern Portfolio Theory, investors are assumed to be able to borrow at the risk-free rate so the amount of debt does not affect risk-adjusted returns (the Sharpe Ratio). The funds in the AREF Universe however have had to borrow at a significant premium to the risk-free rate and although the cost of debt fell sharply during the GFC, funds had significant debt remaining on fixed rates.Figure 2.6, Fund interest rates

^{Source: Authors own calculations using the PFV Handbook}Further, the stock of debt in the AREF Universe was highest during the GFC, when returns were lowest, amplifying negative returns more strongly than the positive returns before and after.

Figure 2.7, Stock of debt

^{Source: Authors own calculations using the PFV Handbook}Debt covenants can also impair fund returns if they are, or are close to being, breached. This impact was very real during the GFC. The combination of these factors probably accounts for the reduction in leverage after the GFC:

Low Geared Balanced property funds entered the GFC crisis in March 2007 with 5.6% leverage (%GAV). That figure is now 0.9%.

Other Balanced property funds began the GFC crisis with 10.1% leverage, rising to 16.2%. As of q3 2020 that figure is 1.0%.

Specialist funds entered the GFC crisis with 27.5% leverage, rising to 46.8%. As of q3 2020 that figure is 31.5%, although this is up from 22.1% in q4 2018.

Figure 2.8, Fund leverage, % GAV

^{Source: MSCI/AREF PFV Handbook}The impact of leverage can be estimated by assuming that the performance of the underlying portfolios would have been the same with or without leverage (although in practice the portfolio would have been smaller and potentially less diversified without leverage). The debt interest has been estimated from the debt interest rates published in the PFV Handbook. Debt is estimated to have reduced fund returns by 48 bps between q3 2004 to q3 2020.Figure 2.9, The estimated impact of leverage

^{Source: Authors own calculations using the PFV Handbook}It is estimated that the small amount of leverage in Balanced funds would have reduced their total returns by 20 bps pa since 2004. For Specialist funds their much higher leverage has reduced returns from 3.2% to 2.0% pa.Table 2.3, The estimated impact of leverage, q3 2004 to q3 2020

^{Source: Authors own calculations using the PFV Handbook}Structure
The greater the performance variation in market returns between sectors, the greater the impact fund structure has in explaining relative fund returns. Estimating this performance variation depends firstly on your breakdown of the market.SegmentationThe appropriate breakdown of the market is a matter of much debate. Some investors prefer a very broad market breakdown, for example retail, office and industrial, and some prefer to look at structure on a more granular basis.The PFV Handbook breakdown³ is quite granular, breaking down the main sectors into broad regions, and the retail sector into three property types: standard, retail warehousing and shopping centres.
To devise a portfolio structure to meet their objectives, investors would require past performance data (MSCI/AREF data is examined below), current pricing and expected future performance for each category, for example City offices or retail warehouses.The match between the segmentation in the PFV Handbook and MSCI’s standard direct property indices is a powerful combination, ensuring consistency between the portfolio structure, the performance track record and current pricing of the categories. Forecasting houses typically also use a similar segmentation (as they usually forecast the MSCI indices).The importance of structureThe importance of structure has varied in the decade leading up to and after the GFC. From 2001 to 2010, the spread of returns across the standard MSCI Segments was from 4.2% pa on offices in the south east, outside of central London, to 9.1% pa on standard retail in the south east.
The standard retail in the south east segment conceals within it the highest performing sub-market of retail in the West End, with a 10.5% pa total return. The other category hides the even stronger performance of residential, which generated a total return over the period of 13.3% pa.

____________^{3 _{The current breakdown of 10 segments is a standard MSCI breakdown and would benefit from the addition of distribution warehouses and central London retail}}Figure 2.10, UK total returns by sector, 2001-2010, % pa

^{Source: MSCI Annual Property Index}The range of segment returns in the decade to 2020 is much wider than in the previous decade, from barely positive in shopping centres, to 12.9% pa on industrials in the south east.Once again, the top-performing category masked the particularly strong performance from a smaller sub-market, in this case London industrials at 13.9% pa. London industrials is now challenging residential and central London retail as the top performing segment of the last 20 years.Figure 2.11, UK total returns by sector, 2011-2020 (Q2), % pa

^{Source: MSCI Annual Property Index}The pattern of sector performance will have driven pooled fund performance more significantly over the decade after the GFC than the previous decade. This is particularly so for retail (as at September 2010 All Balanced funds had a 40% weight to retail). The Balanced fund allocation to retail has now fallen to 20%, admittedly a feat achieved in equal measure by the relative sector performance and by a reallocation - predominantly to industrial property.Figure 2.12, Structure of the MSCI/AREF Property Fund Index, % GAV

^{Source: MSCI/AREF UK Property Funds Index}The performance of each aggregation due purely to structure can be calculated by multiplying the sector weightings each quarter by the respective direct property performance (sourced from MSCI).The difference between the performance from structure alone and the deleveraged performance will reflect superior or inferior stock selection, fund costs and the profits / losses from transactions and developments (typically these profits and costs offset each other). The average difference of 1.1% pa on Balanced funds and 1.6% pa on Specialist funds looks close to what would be expected from fund costs.Figure 2.13, Impact of structure on Balanced fund returns

^{Source: Authors own calculations using the PFV Handbook}The exception is Long Income funds, which experience a significant variation between that estimated from structure alone and deleveraged performance. This differential may be due either to the high weight in the other⁴ sector, or the performance differential within sectors between properties with long versus short unexpired lease terms. A more detailed performance breakdown of the other sector would be required to determine the relative importance of the two factors.Figure 2.14, Impact of structure on Long Income fund returns

^{Source: Authors own calculations using the PFV Handbook}There is a more negative gap between the estimated return on Specialist funds based on their structure and their deleveraged performance. This would be expected due to the higher fee levels.Figure 2.15, Impact of structure on Specialist fund returns

^{Source: Authors own calculations using the PFV Handbook}

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_{⁴ The growth of the ‘other’ category has rendered the term something of a misnomer as institutional investment has grown in previously niche sectors such as hotels, residential and healthcare. With Specialist funds dedicated to providing exposure to such sectors, the PFV Handbook should evolve to capture this changing market structure.}Net Fund Flows
“Buy cheap, sell expensive” is the simplest of investment mantras, however open-ended funds sometimes have to transact to meet redemption calls and retail investors are notoriously pro- rather than counter-cyclical in their investment approach.Even if funds are selling in weak markets, fund performance will theoretically be unaffected if properties are sold for their estimated market value (i.e. the valuations assets are held at on the balance sheet). We use the word theoretically because it is not possible to know whether the property was sold at or below market value as the data is not made available.To illustrate, assume that a property performs in line with the Index. In scenario one, the market falls by 20% and a property is sold for 20% below its previous value to meet a redemption requirement. The redeeming unit holders are paid out at a portfolio value 20% lower than the preceding period. If in a subsequent recovery the property values return to their previous levels, the remaining unit holders would benefit fully from this uplift. The fund performance in this scenario is therefore unaffected by the sale.In scenario two, the property is sold for 20% below its previous value but the remaining portfolio is held at a level only 10% lower. The redeeming unit holders are paid out a blend of the remaining portfolio value that is 10% lower and sale receipts 20% lower than in the preceding period. In the subsequent recovery, when the property values return to their previous levels, the remaining unit holders do not fully benefit from this uplift and fund performance is lower.Fund returns would therefore be expected to be lower if a fund experiencing redemptions when the market is weak (and conversely cash inflows when the market is strong) only if properties are sold below market value and the remaining properties remain in the portfolio at a higher value. This can be avoided if the remaining portfolio properties are marked down as far as the discount in any property sales to meet redemptions or if redeeming investors are paid out purely on the basis of the sale prices achieved rather than the full portfolio value.The performance differentials between the predicted and deleveraged performance for Balanced and Specialist funds occur at roughly the right point to suggest that property sales have dragged fund performance in the subsequent upswing. However, there is an error term in the calculations due to the difference in the actual cash returns and debt interest paid. To improve this and other analysis, actual fees paid, cash returns and debt interest should be published in the PFV Handbook.Market factor model
The significance of each of the market factors has been tested in explaining individual fund returns and fund risk-adjusted returns (the Sharpe Ratio).Most Balanced funds list in their Investment Policy and Objectives that their objective was to match or exceed the Index, a few mentioned risk but did not specify a measure. Over the period since 2007, 13 funds out-performed and 5 under-performed the Index.The Sharpe Ratio is calculated as the excess return over the risk-free rate (3-month Treasury Bills) divided by the volatility of excess returns, with a higher number meaning superior risk-adjusted return. All Balanced and Long Income funds had positive Sharpe Ratios, as did the six non-retail Specialist funds. The six retail Specialist funds with a full performance history had negative Sharpe Ratios (i.e. they underperformed investing in the risk free rate).Our analysis is a cross-sectional regression model covering the whole period 2007-2019, plus two further models dividing the period into the weaker market conditions between 2007-12 and the stronger conditions between 2013-2019.A return for each fund in the PFV Handbook for each quarter has been calculated using their portfolio allocation to each segment and the return of that segment in the MSCI Quarterly Property Index. Cash is assumed to return that of 3-month Treasury Bills. Long Income and daily priced balanced funds were excluded from the modelling due to either their small sample size or there not being a full performance history available. The other dependent variables are the debt-to-equity ratio, weight in development and the net balance of fund investment flows. Cash is also included to check for fund liquidity impacts.

As outlined above, net fund investment flows would not be expected to have any other influence of fund return and, by construction, neither would cash (as it is accounted for in the expected fund return). If either variable is significant, it suggests that managing fund liquidity has impacted fund return.

The debt-to-equity ratio will reveal if leverage has been accretive or dilutive to both fund return and risk adjusted return. As outlined above, if funds borrow at the risk-free rate and maintain their stock of debt, leverage should not have an impact on the fund risk adjusted return.

Development is our only measure of the style of the fund. Development exposure in the sample is very low, so any conclusions can only be very tentative, but development would be expected to add to fund return (due to higher risk) and a neutral impact on risk adjusted returns if the risk of development is priced appropriately.

The combination of leverage, cash, structure, development exposure and net investment flows explains nearly two-thirds of the variation in fund returns over the period 2007-19. After splitting the model by fund type, the explanatory power of the fund return model rises to 80% for both Balanced and Specialist funds for the whole time period and higher for the sub-periods. This result confirms that over longer time periods structure dominates stock as a driver of fund returns (Long Income funds are not included in the models, but as described above, they had a more varied pattern of returns).Figure 2.16, Importance of market factors in explaining fund returns

^{Source: Authors own calculations using the PFV Handbook}The combination of leverage, cash, structure, development exposure and net investment flows explains over three-quarters of the variation in individual fund risk-adjusted returns. As implied by their name, Balanced funds would not be expected to demonstrate a range in risk characteristics. The high R-squared for Specialist funds suggests that these funds are specialists by sector (retail, industrial etc.) not by style (core, value add etc.)Figure 2.17, Importance of market factors in explaining fund risk-adjusted returns (Sharpe Ratio)

^{Source: Authors own calculations using the PFV Handbook}Leverage across both aggregations has had a negative impact on either, or both, excess and risk-adjusted returns. This negative impact was focussed on the GFC. In the later period, when debt levels were reduced and market returns higher, leverage was neither a significant driver of fund returns or of fund risk. Conclusions regarding the effectiveness of improved debt management will have to wait for the next market downswing.Development exposure was a significant factor for Balanced funds during the weak market conditions when development exposure had a negative impact on both risk and return. The exposure to development however is so low that this result cannot be regarded as definitive.Cash and net investment were significant drivers of both Balanced and Specialist fund returns through the GFC. In the case of Balanced funds, this is evidence that liquidity management adversely affected fund returns through this period and for Specialist funds that the higher the cash holdings and the more positive the fund investment flows, the stronger the fund returns.Table 2.4 Factor regression model results

Key:
**significant at the 5% level
*significant at the 10% levelSummary

The published track record of the Index allows investors to analyse whether including unlisted funds in a mixed asset portfolio would meet their investment objectives.

There have been two long upswings in real estate returns over the last two decades punctuated by a significant reversal triggered by wider macro-economic events during the GFC. Over the 10-years since the GFC All funds have delivered a 6.1% pa return, higher than equities, bonds and property equities at 4.1% pa, 4.5% pa and 5.6% pa respectively.

The past returns of individual funds enable investors to identify those fund types and fund managers that have a track record of delivering strong performance.

The strongest returns have been generated by Long Income funds, although this performance track record spans a relatively short time-period. Specialist funds have generated both the lowest and most volatile return with returns hit firstly by leverage in the GFC and since then the calamitous performance from retail. Several non-retail, low leverage, Specialist funds have delivered superior risk-adjusted returns.

Cash is estimated to have reduced Balanced fund returns by 23 bps pa over the period q3 2004 to 2020 q3. Negative fund net investment flows are found to have significantly impaired fund returns during the GFC.

Leverage is estimated to have reduced Specialist fund returns by 116 bps pa and significantly reduced fund returns through the GFC. Balanced funds have reduced their leverage since the GFC, Specialist funds in q3 2020 had a similar level of leverage as prior to the GFC.

Estimates of the impacts of cash and debt are made using estimates of the interest received on cash and the interest paid on debt. The actual data should be added to the PFV Handbook to enable more definitive conclusions to be reached.

Within the macro-cycle there are sector variations. Mostly these deviations are fairly modest, even over long-periods of time, but occasionally they are substantive. In the latest cycle the rise of e-commerce has driven both weak performance from sections of the retail sector, particularly shopping centres and retail warehouses that formed the bulk of Specialist funds, and strong performance from industrial property. Not surprisingly, asset allocation has been the predominant determinant of fund performance.

Data on fund portfolio structure allows investors to construct their own ideal portfolio structure. The more granular the data provided the more allocation strategies can be supported. The current segmentation does not separate growth sectors such as logistics, healthcare, student accommodation or the private rented sector (PRS).

The next section will analyse the performance variations across individual funds to identify the importance of diversification and the stock characteristics provided in the PFV Handbook, such as vacancy rates and income security.