by Chris Bedingfield*
The world has changed dramatically for asset managers in the past decade. For those who believe they have something different to offer the market, it has perhaps never been harder to start up on their own.
From super funds insourcing their asset management capabilities, to the chicken-and-egg circle of research houses who require track record before providing ratings that allow platform listings, it’s almost impossible to start a new funds management business from scratch today without some form of support. At the same time, some things don’t change at all – for better or worse.
In the five years since we launched the Quay Global Real Estate Fund, there are some questions we get asked, and some choices we made, that haven’t changed. In other cases, we’ve had to adjust our views and approaches to take advantage of the lessons we’ve learnt since starting our own business. Here are some of our key take-outs from the last five years:
- Size, and location, aren’t important
We’re often asked how a small team, based in Sydney, can effectively run a global listed real estate strategy. My question is: “How can a group of individuals, scattered across multiple time zones and geographies, run any kind of strategy?”
We believe the size and location of our team is an advantage that allows us to maintain a disciplined focus, and this belief has only strengthened over the past five years. An investment management team that is somewhat removed from the day-to-day noise is less likely to be distracted from its investment goals.
Another consideration is that a larger team might be compelled to own more securities, as each voice ‘on the ground’ is perceived to be too much of an information advantage to ignore. The most likely outcome with a larger, more geographically diverse team would be us owning more securities and increasing our turnover.
As George Soros once said, good investing is boring. Our relatively small team, all located in Sydney, is insulated from daily distractions and allowed to focus on long term returns, while keeping the entire process as boring as possible.
- Being overly conservative can lead to missed opportunities
As investors who are focused on capital preservation, it’s normal to underwrite each investment we make with a level of conservatism. This means allowing a margin of error when modelling the underlying cashflows of prospective or current investees. But while being conservative may provide comfort, we have also learnt that it can lead to missed opportunities.
A key lesson for us was that of selling too early. A few years ago we acquired stock in Hong Kong retail company Link REIT for ~HK$40 / share, and sold in the low HK$50s. As the company earned ~HK$2/share, we felt it was hard to see our CPI + 5 per cent total return above $50, so we were happy to take the return at that point. While the company had a terrific asset enhancement program, generating substantial returns on capital, we weren’t sure how long this could last.
Meetings with management never gave us enought comfort that the programs would last far beyond their disclosed pipeline – so we conservatively assumed they would last two or three more years and then normalise. On this basis, a +HK$50 share price was challenging from a valuation perspective. So, we liquidated our position. Today, Link REIT is HK$95/share, and the substantial asset enhancement programs remain ongoing. Ouch.
It’s okay to be conservative, but we need to remain mindful of ensuring we’re not leaving returns on the table. This lesson has served us well in recent years, as some of our ‘winners’ continue to deliver.
- ‘Common knowledge’ isn’t always right
When we told friends and family that we were leaving our relatively safe jobs to start a global real estate strategy, the not uncommon response was: “You’re mad”. This wasn’t because they believed starting a new business was risky (although it is), but because of the perception that interest rates were expected to rise as QE ended. After all, it was ‘common knowledge’ that real estate will perform poorly in such an environment. We were not convinced.
In this case our conviction held out and, five years later, our Fund has returned 15.4 per cent p.a. since inception (after fees and charges at 31 July 2019), exceeding our CPI + 5 per cent objective as well as the ‘growth option’ of local and global equities. Despite this, we still get people telling us that these are unusual times and this kind of performance wouldn’t usually happen. Of course, this is understandable because the recent rally in global bond yields coincided with the rally in listed real estate.
However, our argument has always been that real estate may be sensitive to interest rates (especially change in bond yields) in the short term, but the correlation is rarely static. The relationship was predominantly positive between 2004 and 2014 – global real estate prices rose at the same time bond yields were increasing and over the longer term the correlation between interest rates and unhedged global real estate is zero.
Essentially, for long term real estate investors, rising interest rates are the least of your concerns. What keeps us awake at night? It’s never interest rates. If there are any macroeconomic headwinds for real estate returns, it’s excess supply and the general economy. And rising interest rates are usually a sign of a pretty good economy.
- A broad universe doesn’t mean more opportunities
The global real estate opportunity set is large. At any one time, there can be a range of attractive investment opportunities. Not surprisingly, one of the questions we asked ourselves before launching the fund was: what is the appropriate number of securities to hold to deliver relatively low volatility, without overly diluting our best investment ideas?
We approached this problem by running Monte Carlo simulations of random unhedged global real estate portfolios which ranged from two securities up to 90 securities, over the period from 2009 to 2013. We plotted the volatility of each simulation, through which we ran a line of best fit, as illustrated by the following chart.
It was clear to us that most of the portfolio diversification benefits of additional securities occurred with the first 20 stocks. And beyond 40 stocks, the benefits were minimal. Indeed, the past five years have borne this out. The Fund’s 21-27 stock portfolio rolling volatility is not significantly higher than the global real estate index with +310 constituents. This means our portfolio can generate returns from the best ideas without significant volatility.
- An unhedged strategy reduces risk
When researching our strategy, we noted that almost all the existing global real estate strategies were currency hedged. Interestingly, almost no global equities strategies were hedged.We began with a blank piece of paper and were prepared to design the strategy by challenging the norms. And our research found that for an Australian dollar fund, an unhedged strategy was a lower risk proposition for investors. There are a number of reasons why:
- In periods of market stress, the $A generally depreciates (while USD and Yen appreciate), offsetting near term losses that may occur with our individual securities.
- While we argue interest rate movements have no long term impact on long term real estate performance, they can impact in the short term. They can also impact currencies in the short term, but in the opposite direction – again providing a buffer for $A returns.
- Hedging can precipitate liquidity issues, especially during times of economic and market stress (the worst time for liquidity issues). Remaining unhedged means we can be patient during such times, and never be forced to sell or liquidate positions at distressed prices to meet a margin call.
The following chart highlights that the rolling volatility of the global real estate hedged index is generally lower than the unhedged index, except in times of heightened market risk when the unhedged index benefits from the offsetting $A movements.
After five years we continue to believe an unhedged strategy will result in lower volatility and is less risky during times of market disruption – and, most importantly, avoid costly liquidity events.
- More knowledge means more success
Much is written regarding the benefit of compounding returns in the world of investment, but less discussed – although equally important – is the compounding effect of knowledge. The ability to learn from mistakes and adjust and enhance your approach accordingly is just as valuable. If we catalogue and learn from our own mistakes – as well as make an effort to better understand our wins – it should result in us becoming better investors today than when we began five years ago. And that’s an outcome that is to everyone’s advantage.
*Chris Bedingfield is a co-founder, Quay Global Investors.