In the last decade, the popularity of open-ended funds has grown. Before the COVID-19 pandemic, investors’ strategies included pursuing long-term income generation combined with less volatility, making open-ended fund strategies attractive.
However, the increased volatility in the market has investors questioning their investment strategies. How has COVID-19 impacted these strategies? Read on this article to learn more.
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COVID-19 is impacting asset classes in several ways. Potential fears related to ongoing outbreaks are leading the older age group to postpone the use of assisted senior living. The transition to online shopping has affected shopping malls and other brick and mortar store locations, with the shift to e-commerce creating opportunities in the storage and industrial space as manager optimism on performance in the industrial space remains high. The transition to online shopping and inventory supply and logistics continues to create a shift towards industrial spaces, encouraging real estate (particularly in cities) to be repurposed for this use. As the COVID-19 impact on the real estate sector continues to evolve, these various changes to the everyday business may mean that large real estate space demand will decrease with the influence of more online shopping and the introduction of a work from home lifestyle. On the other hand, decreasing property valuations may provide real estate investors with big investment opportunities in the future.
World markets are showing high levels of volatility. Historically, situations such as these have produced low investment levels in various private equity, real asset, infrastructure and debt funds. The illiquid asset valuations in these portfolios typically lag behind those in public markets and with liquidity reductions, investors look to redeem or reallocate to safer, more liquid assets due to the increased risk. In response, asset managers have been taking careful measures, such as suspending investment in open-ended real-estate funds, to ensure investors are made whole on contractual obligations.
The investment strategy of open-ended funds is predominantly stable core or core-plus real assets, acquired for the long-term, which produce operating income for the fund for quarterly distribution to unitholders.
Before the COVID-19 pandemic, investors’ strategies included pursuing long-term income generation combined with less volatility, making open-ended fund strategies attractive. However, the increased volatility in the market has investors questioning their investment strategies.
Valuations for core investment strategies are being impacted by the closing of shopping malls and many home renters defaulting on rent payments.
With a massive shift over to e-commerce, companies are finding themselves in a situation where they may require a smaller footprint in the traditional brick and mortar shopping malls, resulting in decreased occupancy rates for these traditional malls. Core funds, however, do have an allocation to industrial space, roughly 10 to 20% depending on the fund. Some managers are very bullish on this space and expect to outperform from prior decades. This may potentially help create a floor on returns well above expectations. As retailers shift online, the inventory once held in stores will shift over to the industrial space. The urban infill will be highly desirable as companies such as Amazon try to keep delivery costs down, increasing demand in the industrial space.
COVID-19 has also had an impact on the unemployment rate, leaving many individuals without a means to pay their rent. With the default rate on rent payments projected to rise, the decrease in the occupancy rate on multifamily homes will adversely impact valuations. For well-positioned asset managers, lower valuations provide an opportunity for buyers looking to get a return on their investment.
Core plus strategies increase cash flow through high-quality improvements, incentivizing tenants to pay a higher premium when improvements are complete. The higher leverage ratios required to make upgrades, coupled with the increasing rates of default on lease payments that are the result of the COVID-19 pandemic, continue to increase the uncertainty and volatility of the investment strategy. If there is a failure to collect on rent, improvements on the properties will not occur, and returns will diminish. The positive correlation between rent collections, property improvements, and future returns can potentially stress returns in core plus strategies in the foreseeable future.
Investment returns in private debt are dependent on borrowers’ cash flows to cover payments and avoid loan default. For borrowers such as hotels, the COVID-19 pandemic has increased the risk of not being able to meet debt obligations as occupancy rates decline, resulting in decreased revenue. Since the start of the pandemic, interest in distressed debt funds has increased. With more and more companies filing for bankruptcies and unable to pay off debt, asset managers are looking to raise funds to take advantage of this opportunity. Firms are seeking to fund record-high numbers, with 59 funds accumulating roughly $67 billion.
In a time where social distancing is a priority, high human density assets such as malls, hospitals, urban housing and school housing have all experienced losses due to COVID-19. However, valuations for agriculture investment strategies related to such things as land for crops and solar panels have not been impacted in the same way as real-estate. COVID-19, however, does pose potential risks to the agriculture strategy. A focus on supply chain and distribution issues and the need for increased sanitization and mask-wearing to ensure employee safety may potentially impact food supply. However, various assistance programs have been put into place to combat the issues COVID-19 has on the world’s food supply chain to provide support to those who run the farms.
Impact of diversification in open-ended portfolios
Open-ended funds typically have a more diversified investment strategy than their closed-ended counterpart. Open-ended funds also allow investors to access more capital if needed to grow their existing assets or purchase new ones. Investors may now view the historic lows as a good buying opportunity and wish to subscribe to existing funds to gain exposure to existing assets at attractive valuations and exit when market conditions are favourable. This makes the portfolio composition of open-ended funds more diverse compared to closed-end funds that buy and sell within a prescribed life. This being the case, the effects of COVID-19 may have potential impacts on diversification in these open-ended portfolios, and many of the real asset sectors such as real estate, infrastructure and private debt have all been impacted by the high volatility rates and increased risk in the markets. Fund managers should provide adequate disclosures to investors regarding these market impacts on their firm and the funds they manage. In particular, attention should be given to assets that are expected to be disproportionately impacted by recent events and to portfolios that are expected to face liquidity pressure.
- Core: Shopping mall, office building or multi-family home (or combination of these asset types) that is at or near 100% occupancy and does not require any significant capital improvements.
- Core Plus: Core asset, however, may require a new roof, elevators, reconfigured parking lot, etc. that will improve the property’s value.
- Debt: Loans (or mortgages) of borrowers that are not being paid back to the lender due to financial distress. Real estate managers may take ownership of the assets. Once ownership is taken, a core fund is established to hold the assets.
- Agriculture: Land for farming crops, hosting solar panels or similar, whereby the land is leased to the user, producing regular income to investors.
Open-Ended funds provide a degree of flexibility, unlike closed-end funds. In the current environment, some of the benefits of this long term investing strategy have been interrupted by current market volatility. In the near term, investors and managers may need to re-evaluate the health of their strategies. Still, the underlying flexibility of open-ended funds will remain favourable to those that can weather the unpredictability of today’s downturn.
Source: SS&C Technologies