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The importance of portfolio diversification

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19 January 2016

David Prosser looks at how commercial property could be an attractive alternative for investors seeking diversification. 

It’s a new year, but a familiar story on world markets. The volatility that has characterised the first weeks of 2016 follows a similarly choppy second half of 2015 – and underlines the importance of portfolio diversification. How, though, do investors and their advisers achieve that diversification beyond the most liquid asset classes offering exchange-listed equities?

Commercial property provides a good example of that dilemma. As an asset class, property offers good diversification opportunities for investors whose existing exposures are slanted towards equities or fixed-income holdings. Moreover, analysts are bullish about the outlook for the UK’s commercial real estate sector this year: the property consultancy Carter Jonas, for example, is forecasting a total return of 8.8 per cent for 2016. That’s down on the 13.4 per cent it estimates the sector returned last year, but still very healthy, especially since a large chunk of the return comes from income, which is in short supply elsewhere.

The problem with commercial property, however, is getting exposure to it. The physical assets – office accommodation, retail assets or factory and warehousing, for example – are generally large-ticket items out of the reach of retail investors. Even if you could buy them directly, these are assets that are bulky and illiquid, and difficult to buy and sell quickly, especially during times of stress. They’re not suitable holdings for the vast majority of investors.

One alternative is to seek exposure to commercial property through an equity investment – in the large real estate businesses that develop land and build commercial property. That’s a reasonable approach, but it’s a different type of investment – a purchase of shares in a company whose value will be affected by a broad range of factors in addition to the value of its holdings.

The investment company sector provides a potential solution to this problem. More than 20 closed-ended funds offer commercial property exposure – and while these funds also pass on that exposure via equities, they are pure investment vehicles that exist simply to give shareholders a route into the sector. In that sense, they offer as direct an exposure to real estate as it is possible to get, without investing in the actual bricks and mortar.

Interest in such funds is strong right now. December saw two large fundraisings in the property sector of the investment company universe: Schroder European Real Estate Trust, a brand new fund, picked up more than £107m to invest in continental European property, while an existing fund, Standard Life Investments Property Income, raised just over £77m to finance the purchase of a portfolio of properties.

Closed-ended funds are not the only collective investment vehicles offering a route into commercial property, but they do offer a significant advantage over other options. Their structure is well-suited to illiquid assets. In an open-ended fund, unexpected volumes of investors seeking their money back could force the manager into unwanted asset sales – often at the worst possible moment since a period of stress is the most likely cause of a rush to the door – that sees property disposed of at fire-sale prices. Closed-ended managers, by contrast, have the luxury of dealing with a pool of assets that is fixed in size.

Commercial property won’t suit all investors, but it does represent a potentially attractive alternative for those seeking diversification this year. In which case, a closed-ended fund can provide a practical solution to obtaining that exposure.

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