Advantages of an active investment strategy for real estate funds

Swiss real estate investments, particularly listed real estate funds, are an illiquid asset class. This is demonstrated, for example, by the fact that only around 29% of the market capitalisation of the SXI Real Estate® Funds Broad Total Return Index (SWIIT Index) was actually traded in 2023. With a slight increase in market capitalisation, annual trading turnover has not moved much over the past four years and is between CHF 16 and 19 billion.

However, there is a striking development: the share of OTC trading volume has increased steadily over the past four years, at the expense of the share of exchange trading volume (see chart). OTC transactions are primarily processed as block transactions.

Advantages of OTC transactions

Block transactions are mainly carried out by active fund managers. Passive investors, who must consistently track the index, are mainly active in the respective closing via the stock exchange. This ensures that there are no deviations in securities compared to the index.

Over-the-counter block transactions offer the following advantages over traditional transactions:

1. The spreads for block transactions are significantly lower than for traditional transactions via the stock exchange.
2. Active fund managers can use block transactions to circumvent the low liquidity in the order books of securities by instructing trading to actively search for a counterparty for the intended transaction.

Using inefficiencies of passive funds

Passive investment funds accounted for almost a quarter of the market capitalisation of the SWIIT Index at the end of 2023. This share has risen continuously in recent years with the growing trend towards passive investments in the industry. Looking at the current fund sizes of indirect Swiss real estate funds, the majority of which invest in listed real estate funds, the fund sizes of indirect passive funds were just under CHF 14 billion as of 31 January 2024. This is twice as high compared to active funds. According to Morningstar, passive funds also recorded significantly higher inflows of CHF 3.3 billion over the past five years than active funds with a value of CHF 1.3 billion.

This development generates the following advantages for active fund managers:

1. The market has become more inefficient due to the large number of passive holdings. Passive investors have to build up or reduce inflows or outflows within a very short space of time in line with the weighting in the benchmark. Due to the low liquidity, this can lead to price movements that no longer reflect the actual fundamental data. Active fund managers can utilise such inefficiencies. It is crucial that they are able to position themselves quickly in view of the low liquidity on the market. Above a certain size, this is no longer possible.
2. When real estate funds are about to be listed, active fund managers can acquire units ahead of time. This means that they do not have to acquire units at any price within a short period of time.

High return spreads open up opportunities

Another argument in favour of active fund management is the fact that the return spreads for listed real estate funds were exceptionally high in 2023. And we expect the average range of returns to remain above average in the future. We believe that the real estate market has become more challenging and that real estate fund managers are positioned differently. In our opinion, the higher interest rate level is not evenly reflected in the borrowing rates and discount rates of the respective funds or real estate investments. The transaction market has also become more challenging, which poses particular difficulties for managers with high redemptions and forced sales. The continued broad diversification of returns is good news for active fund management. It opens up opportunities to generate excess returns (alpha) for investors with the right positioning.