Non-bank users dominated derivatives trades to a record extent in Q1 2011, writes Jane Roberts
The eye-catching figure in the latest quarterly derivative trading statistics was not the volume of trades, but the very high proportion of deals executed by investors and investment managers, rather than between banks. At 85% in Q1 2011, the ‘end user’ statistics are the highest since the market first got going in 2005 (see ‘Interbank v end-user trades’ chart, below). The figures bear out what banks and brokers have been saying for months: that more property investors are starting to use the market.
Relatively speaking, the volume was still low, at £456m, but bit by bit, more investors are coming in. “We saw more activity in Q4 2010 and Q1 from new sources,” says GFI-CBRE broker Ben Hyam. “One was a multi manager; another in Q4 was a local authority pension fund. There was a sense in that period that people wanted access to IPD beta and this was the quickest, most liquid way to do it.”
Managers of multi-asset-class clients and funds continue to use property derivatives to adjust their property weightings at an asset- allocation level. UBS, Hermes and Insight have all traded in the past 12 months. But an encouraging new trend is that of more investors and fund managers looking to use the market for the first time at a property level. They include DTZ Investments’ multi-manager business, pension fund USS (which did its first sector trade in Q4 2010) and Aviva Investors, which carried out a sub-sector trade in Q1 2011. Aviva has traded at asset-allocation level in the past.
Aviva pipped another manager, rumoured to be CBRE Investors, to the London City offices trade. CBREi has recently set up to trade for its clients and is monitoring opportunities and pricing (see below), as is another of the largest real estate investment management houses, LaSalle Investment Management.
“Both CBRE Investors and LaSalle are big names and we hope others will follow,” says Jon Masters of broker BGC Partners, which gave LaSalle some assistance in setting up to trade. He points out that a recent property derivatives trading game run by IPF offshoot the Property Derivatives Interest Group over eight weeks in February and March was oversubscribed and attracted 58 teams, “which shows there is great interest”.
Alan Tripp, LaSalle’s UK managing director, says the investment manager now has the capability for clients to access the full range of property derivative products, including over-the-counter swaps, EUREX Exchange futures and bespoke notes, although it is likely that wherever possible, future trades would be cleared through EUREX to minimise counterparty risk. He compares the time and thought that went into the process with the preparations LaSalle made to start investing in debt last year for clients.
Engaging with clients
“We’ve been very careful and with debt investing, for example, we involved clients in the process by clearing hurdles early on and we now have discretion for our current allocation of £400m. Derivatives are no different. We are not saying to our clients: ‘we are just going to start trading for you under our discretion”. I want to engage with them. If we think a derivative is the solution, it will be done in conjunction with clients.”
John Gellatly, head of Aviva Global Multi Manager, says his team has been monitoring derivatives pricing for a while and the chance to trade City offices came at a time when they wanted to make a tactical trade. “We wanted to play the City offices market, but knew it is hugely volatile and we were looking for a position where we were comfortable about an exit point, which was 2013,” he says. “We could have bought some secondary units in central London funds due to liquidate at that time, but at what premium? Or we could have bought central London listed securities, but they are looking fair if not fully valued.”
Aviva’s trade was between £5m and £10m and involved buying City offices and selling the All-Property IPD to clear a margin. “It wasn’t a big trade, but was important in demonstrating that we can do such trades for clients, and shows that for them the armoury of investment strategies is widening.”
The ability to use the derivatives market to get relatively quick and cheap access to property is attracting a few local authority pension funds to consider the market. It is also behind the launch of two specialist indirect funds: inProp’s UK Commercial Property Fund, the first pooled fund to offer a property market return via investing in derivatives; and Pacific Real Estate Capital Partners’ Liquid Property Fund, which is due to start trading this summer and will also invest in other indirect property instruments, including structured debt and equities.
GFI-CBRE’s Hyam says local authority pension funds’ interest “may be driven by the consultants advising them, who are more aware of derivatives and compare them with other real estate investment strategies to see if they are a more efficient way to get the return a client wants. “We have been asked to compare and advise on the alternatives: to see if physical property is available, what it would cost and the client’s investment timescale. If it is less than a year, the physical market is a non-starter, but if the client has a three-year view, that would be viable. Or the client could buy REITs or indirect property fund units.
“At a specific time any one of them could be the cheapest. For example, a City office derivative priced at 8% might be competitive compared with trying to buy units in a specialist fund such as Henderson Central London Office Fund or WELPUT, which might trade at a 3% or 4% premium to net asset value, and where you have the fees and costs of getting in and out.” Last year, Merseyside Pension Fund bought an All-Property note to make an investment in the sector. Scottish Widows Investment Partnership and ING REIM have invested in inProp’s fund on behalf of the daily-priced authorised property unit trusts that they manage. The fund offers a property investment with monthly liquidity, which they see as a useful addition to holding cash for managing their own subscriptions and redemptions. Prupim is also an investor.
InProp has pioneered the use of EUREX to mitigate counterparty risk for UKCPF. The fund manager negotiates bilateral calendar year prices ‘over the counter’ or off the exchange, then clears them through EUREX. This option is attractive for specialist investment managers such as LaSalle and CBRE Investors. Another advantage to trading and/or clearing via the exchange is that ‘back’ and ‘middle’ office functions, such as managing open positions, are carried out by the trading client’s selected exchange clearing member This works for All-Property contracts for single calendar years, but EUREX doesn’t yet offer the facility for other maturity terms or for sector trading Two years ago Legal & General Property decided that its managers should be able to use the widest possible range of derivative products, as this would be a competitive advantage, so its managers spent nine months getting set up to trade and it has all the functions in-house.
Since summer 2009, LGP has traded £320m of notional value for an increasingly wide pool of real estate clients. Mike Barrie, UK head of balanced funds, says the £1.1bn Managed Pension Fund and a corporate pension fund client are the latest in-house clients to get set up to trade. LGP’s Managed Pension Fund was recently opened to defined contribution pension scheme investors, who require more liquidity in their investments than is available in many property vehicles. DC schemes will invest via a product called the Hybrid Property Fund, which aims to manage volatility and liquidity, partly using derivatives “We have been saying to clients for a long time that the fast-growing DC pension schemes will have a big impact,” says Phil Ljubic, senior derivatives trader at Royal Bank of Scotland. Barrie and colleague Phil Baylis, who co-ordinates property derivative investing, “try and price every sector and take a view about where opportunities might be in our portfolio”, Barrie says.
Looking for different strategies
As an experienced market user, they would like to see liquidity develop as fast as possible for strategies other than pure long-only, All-Property trading. According to Barrie: “Sector pricing is getting better, but it is still not an especially deep market. It is the way we’d like to go, though.” They would also welcome more investors using derivatives to go short on property. “Lots of funds have to take long-only positions and I think this is an area of education that we still need to develop. Swapping sector positions, for example, is effectively shorting one sector. I’d like to see us develop the capabilities to do that and keep developing our skills.”
Other fund managers looking at using derivatives at a property level include Standard Life, Ignis and BlackRock. However, there are plenty of challenges: several large fund managers are not trading and one said that while it had no policy not to use derivatives, “everyone has been too focused on asset-level issues and traditional strategies to give derivatives much thought”. Property companies are waiting for bigger volumes before using the market. The low volumes led two brokers to throw in the towel, Tradition last year and ICAP last month. The remaining brokers, and the banks that trade, such as RBS, Bank of America Merrill Lynch and Deutsche Bank, think 2011 volumes will still be weak. “Guys like LIM and CBREi, which are coming in, are not going to do £500m,” says one.
Tony Brothwell, fund manager for DTZ Investments’ direct mandates, points out that many investors’ derivatives strategy is still simply to buy into the market when swap pricing looks cheap. The new chairman of the Property Derivatives Interest Group, Prupim’s Will Robson, is well aware of the shortage of sellers in the market. He has made it a priority to approach one of the potential hedgers of property risk, the banks. Last year, the biggest quarter for trading was Q3 and July 2010 was the point when derivatives pricing was at its most bearish for 2010 and 2011. At one point, derivatives implied the property market would fall a further 5% than the low of 2009. Prices are flat in the direct market now and there is little divergence of views on values. “There are slow periods when the pricing is efficient, which is what we have now,” says GFI-CBRE’s Hyam. “And that is my reservation about volumes this year – unless we get a change in sentiment.”
Multi-manager arm leads CBRE Investors’ derivatives capability
CB Richard Ellis Investors recently put all the pieces in place to trade derivatives. The initiative is being led by the global multi- manager team in London, which looks at opportunities for both multi-manager clients and the clients with predominantly direct property portfolios in CBREi’s managed account group.
Kieran Farrelly, a director in the global multi-manager team, says that for multi- manager clients, “the most applicable use of property derivatives is for the UK relative return accounts and most of these allow the property derivatives option now. There isn’t much opportunity yet for an overseas derivatives strategy, but the option is there for when that market evolves.”
He says that clients’ parameters for trading are usually that exposure is long-only, with no leverage and with a 10-15% limit in the portfolio, “to get long-only exposure or sector rebalancing”. The firm’s client managers see derivatives as a useful addition to their opportunities for investment. A key criteria is whether a potential trade offers equivalent, or better value, than investment in an unlisted fund.
Like other investment managers, CBREi is “encouraged by what is happening at the sub-sector level. In the past, the market was all about the All-Property level. But once you get into sub-sector trades it will be more about operating at the property fund management level. We’re looking at this and would like to be able to trade contracts at this level of granularity.”
CBREi would like to see more liquidity for sub-sector trades, but already sees regular pricing from a number of banks. It would also like EUREX to develop its product range, especially to list sectors and sub-sectors on the exchange, which the team has decided to clear all its trades through.
“With bilateral swaps, there is counter-party risk and we quickly ran into obstacles getting International Swaps and Derivatives Association documentation in place and so on. It is hard to do in terms of time and cost when you have a large client pool. Using the exchange solves a lot of those issues. “For us property fund managers, it would be a big help if we could get EUREX going.”
Holistic approach helps new traders see full picture
It is interesting to see how LaSalle Investment Management has gone about building the capability to trade property derivatives, say Jon Masters and Charles Ostroumoff of broker BGC Partners.
“It is a holistic, management-driven approach, embedding the systems and processes needed within the organisation and empowering the fund managers with the necessary training and tools to evaluate, appraise, execute and monitor trades.
“This capability will give their property fund managers the competitive edge when evaluating acquisitions or disposals, as these systems and processes are embedded within the day-to-day business.
“If you have spent your working career buying and selling bricks and mortar, it is not easy to make the transition to trading paper whose returns are linked to the performance of a property index.
“While property derivatives may be quicker, easier and cheaper to execute compared with buying or selling a building, unless fund managers have complete confidence that their organisation is properly set up to trade and manage the business and operational risks associated with these products, it is unlikely that they will even consider it.
“When getting started, it is clear that the houses that eschew the ‘gate-keeper’ approach and implement in a holistic, company-wide way will be most able to take advantage of strategic trades and pricing in this market,” say Ostroumoff and Masters.
UBS fund follows derivatives route for fast lane in and out of property
UBS Global Asset Management has been using property derivatives regularly at asset-allocation level for several years. “We use derivatives in the Diversified Return Fund, which is our flagship suite of diversified growth products,” says senior portfolio manager David Buckle. “Funds of that nature are made up of a variety of asset classes and we choose to enter and exit both on a strategic, long-term and a tactical ‘in-and-out’ basis. We use property derivatives for both strategies.
“At times we have entered and exited the property market on a tactical basis, perhaps over just a few months. Clearly, doing that on a direct basis has high costs because of the time and expense of coming in and out. So then we’d use derivatives.” Buckle’s team uses a pricing model to track whether pricing “deviates from fair value” and if its does, takes a tactical property strategy of going long or short “and probably holding for six to 12 months”.
In 2010, UBS took a 5% tactical overweight position at the start of the year for that fund and removed it at the end, which “was all done with IPD swaps”. Similarly, Buckle says that at a strategic level, derivatives are an additional option to trading in the direct market or REITs. “If in the Diversified Growth Fund we want to increase property exposure by direct investment, perhaps through a fund such as a balanced property unit trust, we might be held in a queue to get in. So until we are fully invested we might buy a property derivative, then sell it when we are in.
“The same problem arises whenever we have inflows into this fund; investors are held in a queue to gain direct investment, so we use an IPD swap. This ensures that the fund’s real estate exposure is maintained. “Any fund that has an allocation to illiquid alternative assets always faces times where it has more cash than it was expecting. In those circumstances we are always keen to put cash to work in synthetics. We could use equities, but that is a very crude proxy – the IPD swap market is efficient and a better match for property.
UBS would like to see higher derivative trading volumes, mainly to bring down the cost of trading. “There is still quite a big transaction cost for property derivatives, compared to other types of derivatives” Buckle observes. “It’s a 1-2% transaction cost, so holding it for weeks is a bit expensive, but it works when it is held for a few months.” He says it is “surprising that property managers haven’t elected to make funds immediately investible and dis-investible by using derivatives. We are surprised they haven’t come to people in the market like us, who invest in their funds, and told us they can get us in and out of property.”
Something that might trigger such a development is the fact that “a few years ago, real estate was considered the primary alternative asset – now there are hedge funds, commodities, infrastructure and a lot of the latter are quite liquid. There is a risk that people view the illiquidity of real estate as a disadvantage. “We track the discount to NAV to assess the liquidity of all these funds. I don’t think the investment community really understood this liquidity issue until the crisis, when there were big queues to get out. Now the queues are the other way: to come in. So on either side they’ve had problems.”
EUREX clears the way for a bigger market role
Volumes of property futures contracts traded or cleared through the EUREX derivatives exchange were minimal for the 18 months after the product’s launch in February 2009. But they jumped in September (see graph), mainly because inProp Capital’s derivatives fund began trading that month and clears all its trades through the exchange. Two 400-contract trades, a total of £40m notional, hiked the exchange’s number of outstanding trades to over 1,000 that month. Some of those trades have since rolled off. At the end of Q1 2011, there were 1,208 outstanding contracts, according to IPD. There was a block contract with a nominal £17.15m value in November and in Q1 2010, 400 contracts, worth £20m, went through. At around £60m of notional value, this is still very low compared with over-the-counter swaps volumes, but some fund managers say that whether they trade on or off exchange, they would prefer to clear All-Property trades through EUREX rather than have the bilateral counterparty risk of an OTC swap, suggesting that there is much potential for growth.
Stuart Heath, EUREX director and London head, said a rise in use of the exchange to clear trades “is a trend across all our products, because of coming regulations”. EUREX, however, still only lists single calendar year IPD All-Property Index contracts, not sectors or sub-sectors. There is daily pricing, with a 1% bid-offer spread at £5m notional on each side, but pricing has been more expensive than OTC equivalent trades and is more expensive to clear, as the 8.5% initial margin required is higher than for bilateral swaps. Heath hopes EUREX will be able to list retail, office and industrial property sector futures soon. “We have to be confident that there is sufficient market information and liquidity, then we have to get permission from our board,” he says. “We realise there is interest in sub-sectors, but are taking a step-by-step approach. If we go to the board in early summer, we could list by late summer.”