Lonsec’s review of the global property securities sector encompassed 23 funds covering 21 global property securities funds and 2 Asian-focused global property securities funds.

The report noted that most managers – particularly those based in North America – continued to be generally upbeat on the prospects for the sector going forward.  Momentum has continued to build behind the ‘yield theme’ across nearly all global markets and this trend has helped drive strong returns to the global property securities sector.

Sam Morris, Lonsec’s Senior Investment Analyst, said improving economic conditions would see direct property markets continue to benefit over 2015.

“The direct property market will benefit from better economic conditions in terms of increasing rental rates, occupancy levels, investment demand and capital values,” Mr Morris said.

Product evolution prompts first top ratings

Mr Morris said the global listed property securities market was presenting a greater set of investment options with new product development taking place over the past year.

In terms of ratings, this year’s review resulted in more positive outcomes generally, with four upgrades and two downgrades.

The Presima Global Property Securities Concentrated Fund and Resolution Capital Global Property Securities Fund have been upgraded to ‘Highly Recommended’ – to become the only two funds in the peer group to hold Lonsec’s top rating.

“We’ve seen some positive steps in terms of product development with the creation of some more ‘benchmark unconstrained’ strategies,” Mr Morris said. “In recent years we’ve also seen a product evolution, highlighted by the recent creation of the EQT LaSalle Global Property Rich Trust, which aims to deliver a return profile more akin to direct property than traditional listed property benchmarks.”

Risk versus return

With interest rates at historical lows, a key question raised by many investors is the potential impact on the sector when rates eventually rise. Mr Morris said global property securities had actually done reasonably well in rising rate environments historically.

“One possible reason is that rate rises typically occur during strong periods of economic growth with high business confidence, which leads to increased leasing demand,” Mr Morris explained.

While Lonsec believes there is a strong case based on diversification to include global property securities within overall portfolios, investors should be aware of additional risks associated with the asset class – such as the high volatility profile and the equity market risk.

“Property securities tend to behave more like bonds in stable markets but become more like equity in periods of high volatility and crisis. Thus it may be considered preferable for investors to utilise more defensive global property securities funds in their overall portfolios,” Mr Morris said.

“We also don’t believe investors should be relying upon global property securities funds as a source of income in an overall portfolio context – particularly those with currency hedging overlays.

“The key to investment selection in the global property securities sector is to identify funds managed by high quality investment teams and investment process, but with sufficient levels of active management. In upgrading the Presima and Resolution Capital funds, Lonsec believes it has found two such strategies.”

Other key findings of the report include:

• Global listed property delivered a total return of 28.4% over 2014, to outperform global equities by 15.8%.

• The US REIT market has significantly outperformed the broader global property securities market over 2014.  By contrast, Asia, which was weighed down heavily by Japan in 2014, delivered the weakest returns in global property securities markets.

• The largest gains across the market were in the Residential, Hotel and Healthcare sectors.

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Senior Investment Analyst Sam Morris commented, “Personnel changes have traditionally proved to be a persistent feature of the smaller cap universe, as talent looks to move if not sufficiently tied-in to overall business profitability or appropriately compensated.”

“In terms of the Lonsec peer group, approximately 50 percent of managers can be broadly classified as either an independent or boutique with the support of a cornerstone investor, such as Treasury Group, nabinvest or Challenger.”

There are a number of practical advantages in this business model.

“Key investment staff gain equity in the business, increasing alignment with investors and potentially their motivation for success,” said Morris.

“In addition, the investment team remains liberated to focus largely on investment functions, with things such as compliance, administration and distribution outsourced to the supporting backer.”

“Moreover, cornerstone investors provide much needed capital which brings stability in the early years of a new funds management business.”

Lonsec recognises that key person risk is a prevalent risk factor in many of the higher quality smaller companies products.

“Successful performance in this asset class is highly dependent upon the investment skill and experience of key individuals,” commented Morris.

“Nonetheless, Lonsec believes that key person risk is a risk worth taking and we recommend that consideration is given to the overall remuneration and incentive structure for key investment professionals.”

Smaller companies continued to struggle…yet fund managers restore faith in active management
The S&P/ASX Small Ordinaries Accumulation Index returned -23.4% in 2011, compared to the positive 13.1% gain in 2010. Despite this, the relative performance of small cap investment managers has been impressive, with the Lonsec Small Cap Peer Group outperforming the S&P/ASX Small Ordinaries Index by 8.3% over calendar 2011.

“This gives credence to the established view that the small companies universe is less efficient than the larger cap end, with few companies covered by brokers,” observed Morris.

“This enables professional investors to uncover attractive investment opportunities before being discovered by the wider market.”

As a result, Lonsec recommends active investment over passive strategies in this asset class.

“A well regarded small cap manager is likely to outperform the index through the cycle,” said Morris.

“Having said that, we are seeing more products coming to market offering beta exposure – although with such products, investors will be exposed to the full index – the good, the bad and the ugly.”

The perennial issue: how much is too much FUM?
Capacity is an issue that has long generated debate in the small cap sector. There is a divergence of views on the problems arising from too much funds under management – those managers with a large weight of money – such as BT, Perpetual and Acorn – are keen to talk down the negative aspects on the grounds that larger managers may:

• Enjoy greater access to company management
• Engender preferential treatment in IPOs or equity placements
• Influence company direction through substantial status.

On the other hand, smaller players place greater emphasis on the limitations of a hefty weight of money suggesting that larger managers are:

• Less nimble in the market
• Unable to access small company opportunities or exit large positions
• Inconvenienced by broader market awareness of substantial holdings.

“Generally, Lonsec believes capacity management is not a black and white issue – there are positives and negatives to low or high levels of FUM,” commented Morris.

“However on balance, we believe that managers with smaller FUM are better placed to add value and Lonsec’s higher rated managers will tend to be attractively positioned from a capacity perspective.”

The review
Lonsec’s Australian Equity Small Cap Sector Review encompassed 35 funds, of which seven attained Lonsec’s top rating of ‘Highly Recommended’. These included the Antares (Aviva Investors) Small Companies Fund, the Celeste Australian Small Companies Fund and the Perennial Value Smaller Companies Trust, all of which were upgraded as a result of this review.

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