White Paper Iterval Fud Ivestig - Mutual Fud Access to Alterative Ivestmets Idividual ivestors have log wished for the same access istitutios have to alterative ivestmets. Iterval fuds have potetial to ulock this access for the widest possible audiece. The global fiacial crisis has caused a importat structural shift i ivestor prefereces towards alterative ivestmets ad away from more volatile equity markets. I additio, bod yields have plummeted i the aftermath of the crisis, leavig ivestors without the ability to geerate icome. I essece, the crisis highlighted a flaw i the way may ivestors approach portfolio diversificatio simply havig a rage of mutual fuds with access to differet sectors may ot be eough to create appropriate diversificatio. For istace, while the uderlyig ivestmet of a publicly traded real estate ivestmet trust (REIT) may iclude real estate, a ivestor s allocatio ca behave very much like the S&P500. Istitutios have implicitly ackowledged the limitatios of equity market ivestmets for decades, with most maitaiig a large allocatio to private ivestmets, icludig real estate. 1 The beefits of these allocatios have show a decrease i portfolio volatility, lower correlatios with equity markets ad the potetial for icreased returs. Historically, access to alterative private ivestmets has bee give exclusively to large istitutioal ivestors; but, this is rapidly chagig. The mass affluet 2 are ow demadig more sophisticated ivestmet products. 1 The Yale Edowmet Fud is a example of a private ivestmet platform with $20.8B AuM o Jue 30, 2013. The Edowmet targets up to 90% i alteratives icludig private equity, absolute retur, ad real estate, ivestmets.yale.edu/images/documets/yale_edowmet_12.pdf; ivestmets.yale.edu. 2 The mass affluet segmet geerally refers to U.S. idividual ivestors or households with $100,000 to $1M i ivestable assets, www.wikivest.com/wiki/mass_affluet. Resource Real Estate White Paper 1
Recogizig this tred, ivestmet sposors have developed ew ways for idividual cliets to access alterative ivestmets, icludig real estate equity ad debt through o-traded, 3 as well as corporate credit through Busiess Developmet Compaies (BDCs). 4 Now, a ew product type the Iterval Mutual Fud (ifud) 5 is providig the ext evolutio i alterative ivestmet products. As mutual fuds did for equities, ifuds have the potetial to ulock alterative ivestmets to the widest possible ivestor base while simultaeously providig greater price trasparecy ad liquidity. I additio, ifuds may icrease the efficiecy ad lower the expeses of ivestmets i alterative assets by aggregatig capital, thus decreasig costs as a percetage of assets a sigificat beefit give the immiet rule chages for commissio ad fee trasparecy o cliet statemets for o-traded ad BDCs. 6 Iterval Fuds: the meetig poit of alterative ivestmets ad mutual fuds The ifud is simply a mutual fud that offers daily ivestmet opportuities ad limited redemptios at specific itervals (usually quarterly). 7 This chage to the mutual fud structure creates large advatages, however; it allows the fud to simultaeously ivest both i private ad public assets with a structure that has both liquidity ad a daily et asset value (NAV). I tur, the sposor may create a portfolio of ivestmets with high yield ad low correlatio to equities, but without the usual limitatios of private ivestmets (illiquidity ad lack of price trasparecy). The liquidity feature ad price trasparecy, i cojuctio with sufficiet portfolio diversificatio, ca make ifuds suitable for a large pool of ivestors. This also allows iterval fuds to be held i both fee-based ad commissio-based accouts a importat beefit give the growth of fee-based assets ad the advisors eed to access alterative ivestmets that complemet existig mutual fud optios. Graph 1: Iterval Fuds - itersectio of alteratives ad mutual fuds Public Real Estate Correlatio INTERVAL FUND Private Real Estate Liquidity Graph 1: Iterval fuds offer higher liquidity tha private real estate, but reflect market fluctuatios. Private ivestmets ca offer higher yield ad less correlatio to the market, but they lack pricig trasparecy ad liquidity. Iterval Fuds ca capture the yield ad correlatio characteristics of private ivestmets, but also provide liquidity ad trasparecy. 3 A direct, log-term real estate ivestmet that uses the capital it raises from retail ivestors to purchase ad maage icome-producig properties, IPA.com, Ivestig i No-Traded. 4 A compay that is created to help grow small compaies i the iitial stages of their developmet, similar to veture capital fuds. May BDCs are set up much like closed-ed ivestmet fuds ad are actually public compaies that are listed o the NYSE, AMEX ad NASDAQ, www.ivestopedia.com/terms/b/bdc.asp. 5 While techically a cotiuously offered closed eded fud, the Iterval Fud ca also be described as a mutual fud which offers daily purchase for ivestmet, but liquidity for redemptios at specific itervals (usually quarterly). 6 O February 3, 2014, the Fiacial Idustry Regulatory Authority (FINRA) proposed chages to NASD Rule 2340 which would icrease disclosure o the fees ad commissios paid to brokers who sell o-traded. 7 Redemptios are shares bought back from the shareholder/ivestor by the fud uder a program referred to as the Share Redemptio Program (SRP) to provide ivestors with a limited form of liquidity. 2 Resource Real Estate White Paper
Replicatig a Istitutioal Approach to Real Estate Ivestmets Idividual ivestors access to real estate has traditioally bee limited to publicly traded ad o-traded. However, these products represet oly a portio of the available access poits to real estate ivestmets. Simultaeously accessig differet real estate ivestmet types ca optimize a real estate allocatio by capturig the beefits of listed ad o-listed ivestmets, while mitigatig their idividual disadvatages. For example, ivestig directly i real estate through istitutioal private equity ca produce moderate yields, growth ad sector diversity, but ot liquidity. Publicly traded are liquid ad give access to global ivestmet opportuities, o-traditioal asset types ad growth, but come with a lower yield ad higher equity market correlatio. Debt ca give yield ad pricipal protectio, but ca fall short o iterest rate hedgig ability. Chart 1: Characteristics of real estate ivestmet types Direct Real Estate Publicly Traded Real Estate Debt Private Equity No- traded US Iteratioal Preferred Real Estate Debt Icome Capital Stability Growth Iterest Rate Hedge Liquidity Chart 1: Breakdow of advatages ad disadvatages of the three mai types of real estate ivestmets. The shaded circles idicate favorability towards the relevat characteristic. I the followig example, replicatig a istitutioal real estate allocatio by icludig equal weights of direct real estate, credit ivestmets (debt) ad publicly traded would have produced a yield of 5.3 percet ad a total retur of 8.4 percet, with a volatility of 9.6 percet 8 sice December 2000. The Sharpe Ratio would have bee 0.88. 9 Figure 1: A istitutioal real estate allocatio 10 Real Estate 33% Credit Ivestmets (debt) 33% 100% Diversified Real Estate Icome Aual Icome 5.3% Aual Capital Appreciatio 3.2% Aual Total Retur 8.4% Publicly Traded 33% Volatility 9.6% Sharpe Ratio 2 0.88 8 The uderlyig data for equity markets used i this aalysis was based o the S&P500 Idex that produced a yield of 2.03%, total retur of 5.00% ad a volatility of 17.72%; the data for publicly traded REIT markets used was the FTSE EPRA NAREIT Global Developed Idex (RUGL) which produced a yield of 4.55%, total retur of 10.00% ad a volatility of 22.23%. 9 Sharpe Ratio determies a ivestmet s retur per uit of risk ad is calculated as total retur divided by volatility. 10 To create a hypothetical istitutioal real estate allocatio portfolio, we bleded equal segmets of direct real estate (NCREIF Property Idex: NPNCRE); debt (Wells Fargo Preferred REIT Idex: WHPSR); publicly traded (FTSE EPRA NAREIT Global Developed Idex: RUGL). Data as of 12/00 to 6/14. Source: Iteral Resource Real Estate data. Resource Real Estate White Paper 3
As show below, a allocatio of just equities ad bods (third pie chart below i Figure 2) has potetial to brig o more risk ad lower returs tha allocatios that cotai equities, bods ad diversified real estate icome. 11 Whe 10 percet of diversified real estate icome is added to the allocatio (secod pie chart i Figure 2), risk decreases, while returs simultaeously icrease. Whe 20 percet of diversified real estate icome is added to the portfolio (first pie chart i Figure 2), risk decreases eve further, while returs simultaeously climb higher. A istitutioal real estate allocatio may lower volatility ad icrease returs Figure 2: Hypothetical Portfolio Allocatio 7.8% 0 Historical Risk & Returs (12/00-6/14) Retur 7.6% 7.4% 7.2% 20% Yield: 4.0% 50% 0 10% Yield: 3.7% Equities 12 Bods 13 Diversified Real Estate Icome 14 7.0% 60% Yield: 3.4% 6.8% 7.0% 7.5% 8.0% 8.5% 9.0% Risk 20% Diversified Real Estate Icome 10% Diversified Real Estate Icome Equity-Bod Portfolio Aual Icome 4.0% 3.7% 3.4% Aual Capital Appreciatio 3.2% 3.3% 3.3% Aual Total Retur 7.3% 7.0% 6.7% Volatility 7.2% 7.9% 8.7% Sharpe Ratio 15 1.01 0.89 0.77 Figure 2: I the example sceario above, the three sample portfolios allocate various levels of ivestmet to equities, bods ad diversified real estate icome. As more of the portfolio is allocated to diversified real estate, returs icrease ad volatility decreases. 11 Show by a icreased Sharpe Ratio. 12 The uderlyig data for equity markets used i this aalysis was based o the S&P500 Idex that produced a yield of 2.03%, total retur of 5.00% ad a volatility of 17.72%; the data for publicly traded REIT markets used was the FTSE EPRA NAREIT Global Developed Idex (RUGL) which produced a yield of 4.55%, total retur of 10.00% ad a volatility of 22.23%. 13 The data for the bod markets used was based o the EFFAS Bod Idex for U.S. 10-year govermet bods (Bloomberg: USG5) which produced a yield of 5.35%, total retur of 6.98%, ad a volatility of 12.26%. 14 The hypothetical Diversified Real Estate Icome portfolio is the same bled as show i Figure 1. Please ote that you caot ivest directly i a idex. 15 Sharpe Ratio determies a ivestmet s retur per uit of risk ad is calculated as total retur divided by volatility. 4 Resource Real Estate White Paper
A tool for ew FINRA cliet statemet rules The o-traded REIT idustry faces a sigificat chage with the expected implemetatio of ew rules to cliet statemet reportig. 16 The chages for fee ad commissio trasparecy will have a cosiderable impact o the o-traded REIT market ad, i particular, its fee ad commissio structures. Coupled with a icrease i trasparecy o the et value of cliet positios, this chage is likely to make iterval fuds, which have retur profiles similar to o-traded, more attractive for both advisors ad cliets. Iterval Fuds may be part of the solutio for advisors impacted by the potetial of lower commissios followig the implemetatio of these ew rules. ifuds already ejoy liquidity ad trasparecy i pricig through a daily NAV. Advisors who have bee reluctat to make use of more opaque alterative istrumets 17 may fid ifuds suitable for more cliets by virtue of their liquidity ad trasparecy, expadig the use of alteratives by their cliets. The ability to aggregate capital through ifuds provides a further advatage to the idustry. Ecoomies of scale ad mutual fud implemetatio ca help decrease costs related to due diligece, research ad distributio. Just as mutual fuds led to the broadeig of equity ivestmet over the last two decades (with simultaeous fee compressio ad expasio of the idustry), ifuds may prove a similar catalyst for expaded market peetratio by alteratives. Aalyzig Iterval Fuds ifuds attractiveess to ivestors depeds o the cotet of their portfolios. Strategies will differ, some will iclude a rage of alterative assets i additio to real estate. However, there are a few essetial aspects ivestors should cosider whe examiig a ifud s merits: Ivestmet strategy: Uderstad what asset classes the portfolio comprises of as well as the largest positios i the fud. Iteral ivestmet maagemet versus fud-to-fuds approach: Does the ifud outsource ivestmet maagemet or keep this fuctio i-house? It is advatageous for the fud sposor to perform this importat fuctio, as it allows better risk cotrol ad more accoutability, i additio to potetially lower costs. Level of liquidity ad trasparecy: The liquidity feature of the ifud structure is a importat characteristic; a sigificat level of liquid assets will esure the ability to meet redemptios. Further, the allocatio to liquid assets improves pricig trasparecy. Coflicts of iterest: Coflicts ca arise if the portfolio maager is allowed to ivest i other fuds of the sposor. 18 The most trasparet way to esure o coflicts is to preclude the ifud from ivestig i other fuds of the sposor. 16 O February 3, 2014, the Fiacial Idustry Regulatory Authority (FINRA) proposed chages to NASD Rule 2340 which would icrease disclosure o the fees ad commissios paid to brokers who sell o-traded. Uder the ew rules, it is proposed that NTR cliet statemets will display the per-share price et of the REIT s expeses, with statemets showig the share value after the deductio of fees ad ay expeses related to orgaizatio, offerig ad property acquisitios. Mutual Fuds ad Iterval Fuds ted to have lower fees ad expeses ad report a price plus commissio cost basis o the cliet statemet as opposed to the NTRs curret et ivestmet structure. We believe fuller disclosure will beefit both customers ad the idustry, ad may lead to a more mutual fud-like fee structure, with differet share classes. 17 Oly oe i five of their cliets are ivested i o-traded, at preset. [Stager Survey of Advisors 2013] 18 This is the case eve if the fud board appoits a third-party sub advisor, if the board is composed of the sposor s represetatives. I such a istace, the sposor ca effectively hire ad fire the maager, which does ot esure impartiality whe ivestig i the sposor s other products. Resource Real Estate White Paper 5
Coclusio The demad for ucorrelated icome is leadig to ew ways for advisors ad their cliets to access alterative ivestmets. ifuds help meet this growig demad through a portfolio of alterative ivestmet securities. This ca replicate the beefits of a istitutioal approach to real estate ivestmet for a expaded set of ivestors. I additio, the flexibility of the mutual fud structure ca help advisors adapt to a evolvig regulatory ladscape. Importat aspects to cosider whe assessig the merits of a iterval fud iclude the ivestmet strategy, iteral maagemet, liquidity ad lack of coflicts. As the demad for ucorrelated yield cotiues to icrease, ifuds ca offer a importat tool to gai the widest possible access by the widest possible audiece to alterative ivestmets. Scott Crowe, Global Portfolio Maager Scott Crowe serves as Global Portfolio Maager for the Resource Real Estate Diversified Icome Fud ad Global Opportuity Fud. Prior to joiig the compay, Mr. Crowe was the lead Global Portfolio Maager for Cohe & Steers where he led a ivestmet ad research team of over 20 portfolio maagers ad aalysts. Mr. Crowe was accoutable for over $10B i FUM across the global, iteratioal ad emergig market portfolios. Previously, Mr. Crowe held the positio of Head of Global Real Estate for UBS equities research where he built ad maaged the US REIT divisio while leadig a global team of more tha 40 aalysts. Mr. Crowe bega his career at Paladi Property Securities ad was also a Associate Lecturer at the Uiversity of Techology Sydey. Mr. Crowe holds a Masters i Fiace from the Uiversity of Techology Sydey ad a Bachelor of Commerce from the Uiversity of NSW (Natioal Uiversity of Sigapore). 1845 Walut Street, 18th Floor Philadelphia, PA 19103 215 231 7050 www.resourcerei.com 6 Resource Real Estate White Paper