Investors are missing the beneﬁts derivatives trades can bring at all points of the property cycle
Fund managers and investors still see property derivatives as only an occasional tool to use at speciﬁc points in the cycle, PRUPIM head of property derivatives Will Robson told a Property Derivatives Interest Group (PDIG) meeting last week.
In a seminar called Why aren’t you using property derivatives yet? Robson said investors that have started using property derivatives in the past three years have limited that use to top-down asset allocations, such as hedging property when the market is falling, or buying when they believe derivatives pricing looks cheap.
“People don’t see it as a tool to use all the way through the cycle” or “in an individual fund context”, he added. Robson gave three examples of ways PRUPIM had used the market: hedging 10% of one portfolio in January 2007; buying a structured note in October 2008 to improve one fund’s income return; and buying and rolling a contract to smooth returns and manage liquidity in an open-ended fund.
In the ﬁrst example, the swaps market price in January 2007 implied a 9.71% price to December 2008. By hedging 10% of the portfolio’s value at that price, the whole portfolio’s outperformance was boosted by 142 basis points in 2007 and 422bps in 2008 when the market fell.
In the second case, PRUPIM boosted 2008 and 2009 income return in a fund while carrying out “certain asset-speciﬁc measures, regearing and getting in new tenants, which meant fund income returns might dip below 125% of the IPD target”.
The manager bought a note in October 2008 that paid a quarterly ﬁxed-income return based on the IPD income return and closed it out a year later at a positive outturn. The third example, developed with broker ICAP, involved buying into the market via a swap and rolling it on at the start of each year to smooth the cycle. “Think of it as holding a lump of cash; it underperforms in the boom but outperforms in a downturn,” Robson said.
Legal & General Property senior fund manager Charlie Walker said the long lead-in time needed to be able to trade derivatives has stopped investors from being more active. Walker said that eight of L&G’s 17 funds now trade in derivatives, but even with 150 L&G staff working on derivatives in the wider group, talking to investors and IFAs and setting up the framework to trade had taken 18 months.
Another problem holding back the market is the fact that trades are stuck at the All-Property level. One or two banks have put out prices on sectors and sub-sectors, but with apparently no interest from the market.
However, PRUPIM has just completed a series of trades totalling £100m in several subsectors. British Land’s Simon Carter said property companies would use derivatives if sector trading developed, as “you could buy an asset you like that takes you too highly exposed in one sector, then sell some of the exposure”.
Paul Rostas, head of European derivatives at ICAP, said ICAP had been working hard to develop some liquidity. “But we told PDIG six months ago that end-users are in the best position to be price makers rather than price takers.” L&G introduced a weekly in-house derivatives trading game this year to help its fund managers gain experience.
Banks miss chance to manage exposure
The clearest example of a group that should be using property derivatives is banks, said Paul Ogden, partner at fund manager RPM, which recently launched a derivatives fund.
“They need it at portfolio level because they have huge real estate exposure,” Ogden said. “The problem is, they see how small this market is and think it is not worth bothering with.”
Ogden said his RPM and former Bank of America colleague Markus Wolfensberger developed the CMBS Index used in the US in the mid 2000s on behalf of BoA “because the bank had a huge risk”.
An interesting possibility is if RBS were to hedge its Asset Protection Scheme exposure, including the property loan element. Ogden added: “Now everyone is complaining that there is not enough stock while the banks have too much. There is a deal to be done.”