Schrödinger's assets

Property funds are stinging investors once again because of a run of redemptions. Senior multi-asset investment specialist Craig Brown notes their net asset values are in a happy superposition right up till the point they get measured.


In the world of physics – admittedly not everyone’s cup of tea, but please entertain the nerd in me – there’s a thought experiment called ‘Schrödinger's Cat’. It’s a rather off-the-wall observation about quantum mechanics which points out, in simple terms, that if you place a cat in a box with something that has a 50/50 chance of killing it and then seal the box, theoretically the cat is both alive and dead until you open the box and see.

You may wonder why on earth I’m writing about some theoretical zombie cat that’s a posterchild for the paradox which binds the real world with quantum mechanics, but bear with me. This thought experiment feels a bit like what I see in some parts of the market right now. Some of the less liquid, more esoteric, and more ‘subjectively valued’ assets out there look a lot like a cat in a sealed metal box. Anyone running the box may tell you there’s a healthy cat in the box. But with much higher bond yields and souring economic sentiment, there certainly feels like there’s a greater than even chance that the cat ain’t happy.

Over the last decade or so, many investors have moved into these esoteric or alternative spaces to add diversification to their portfolios. While on the surface these assets can provide optical diversification during benign markets – when our theoretical cats are merrily munching on their Felix (other cat food brands are available) – when times get tricky that diversification tends to melt away.

Property is a good example of this. Property funds tend to be revalued quarterly, and in brighter days with supportive economic environments they usually go steadily higher because they are valued largely by professional estimates than by the vanishingly few actual sales that complete. This usually draws in a whole bunch more people who want a piece of those steady, ‘low-volatility’ returns.

Yet the rub comes in times like now, or during other shocks, like 2020 or 2016. Not only do you have an asset whose price is heavily linked with the strength of the economy, but the fund holding those assets also has a liquidity mismatch. It must cash out unitholders on demand in a matter of days, yet their buildings take months and a large discount to sell to raise that cash. Hence the groundhog day of redemption suspensions – locking investors in for indefinite periods – we see time and time again in open-ended property funds.

The observation kills the cat

As alluded to earlier, the problem with property funds is that the underlying values of their portfolios are measured mainly by estimates during the good times. When economic shocks arrive and property owners need to sell pronto, these valuations tend to shift sharply closer to actual observed transactions, which are at bargain prices because of the stressed environment. I think of this as the moment when property funds open the box, if you will, when reality hits those valuations, and the cat really hits the fan.

Ultimately, our multi-asset funds team don’t use property to diversify equity risk because, as has been the case almost every time we see economic stress, it’s destined to be a disappointment. If there are few transactions to observe (and infrequently) then it diminishes the reliability of the valuation in question.

We see this problem crop up in several esoteric niche spaces in the investment trust world as well, such as alternative income, where the net asset value (NAV) of the underlying assets essentially means another closed box. Investors trade the shares of the investment trust daily though, so the price can move to a discount or premium to the last calculated NAV, showing what investors really believe the value of the box to be. Some discounts to NAV in this space look optically appealing, yet the question remains: are they real discounts, or will the cat be ‘dead’ next time we open the box and the discounts reflect the reality? Or will the reality be even worse?

Real alternatives

Many of these alternative income-type assets exploded in popularity and abundance over the last decade or so as investors were hungry for yield, and these assets seemed to satiate appetites.

Many investors bought these assets where before they might have bought more vanilla things, like corporate bonds, or even government ones, simply because the yields on offer were so dismal. Some investors will be asking themselves, “Why take all this esoteric risk if I can start to get better yields for less risk elsewhere?” Those old vanilla assets suddenly look more appealing. While we didn’t get on board the alternative income bandwagon, we too find the yields on government and corporate bonds appealing now that the risk/reward calculus has meaningfully shifted. (For more on this listen to QuidDitch, the latest episode of our The Sharpe End podcast.)

In the spirit of keeping things simple we adopt the ‘duck test’ for diversifiers. “If it looks like a duck, swims like a duck, and quacks like a duck, then it probably is a duck.” So if something behaves like an equity in stress, and isn’t very liquid in stress, chances are it should be classed as an equity-risk asset.

When we think about trying to diversify our portfolios and provide protection, we try to find assets that are genuinely negatively correlated (i.e. go up when stocks go down and vice versa) through market stress. We try to avoid investments which look like diversifiers in good times, but which sting you when fortunes turn.

So, when thinking about portfolios, it might pay not to rely on Schrödinger's assets. You must open that box at some point and don’t want to risk finding Moggy has expired just when you needed him to chase troublesome vermin away.

Tune in to The Sharpe End — a multi-asset investing podcast from Rathbones. You can listen here or wherever you get your podcasts. New episodes monthly.

Important legal information

This area of the site is for professional advisers

Please read this page before proceeding, it explains certain legal and regulatory restrictions applicable to the distribution of this information. It is your responsibility to inform yourselves of and to observe all applicable laws and regulations of the relevant jurisdiction.

This section of the website is directed only at investment advisers and other financial intermediaries who are authorised and regulated by the Financial Conduct Authority (FCA).

The information provided in this site is directed at UK investment advisers only and must not be circulated to private clients or to the general public. It does not constitute an offer to sell, or solicit an offer to purchase any investments by anyone in any jurisdiction in which such offer or solicitation is not authorised or in which a member of the Rathbone Group is not authorised to do so.

I confirm that I am an investment intermediary authorised and regulated by the Financial Conduct Authority. I have read and understood the legal information and risk warnings below:

Important Information (Terms and Conditions)

The information contained on this site is believed to be accurate at the date of publication but no warranty of accuracy is given and the information is subject to change without notice. Any opinions or estimates included herein constitute a judgement as of the date of publication and are subject to change without notice. Furthermore, no responsibility is accepted for the accuracy of any information contained within sites provided by third parties that may have links to or from our pages.

Rathbone Investment Management Limited ("RIM") is authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. Registered Office: Port of Liverpool Building, Pier Head, Liverpool L3 1NW. Registered in England No 01448919.

In accordance with regulations, all electronic communications and telephone calls between Rathbones and its clients are recorded and stored for a minimum period of six months.

The information provided in this site is directed at UK investors only. It does not constitute an offer to sell, or solicit an offer to purchase any investments by anyone in any jurisdiction in which such offer or solicitation is not authorised or in which a member of the Rathbone Group is not authorised to do so.

In particular, the information herein is not for distribution and does not constitute an offer to sell or the solicitation of any offer to buy any securities in France and the United States of America to or for the benefit of United States persons (being resident in the United States of America or partnerships or corporations organised under the laws of the United States of America or any state, territory or possession thereof).

In order to comply with money laundering and other regulations, additional documentation for identification purposes may be required.

Rathbones shall have no liability for any data transmission errors such as data loss, damage or alteration of any kind including, but not limited to, any direct, indirect or consequential damage arising out of the use of services provided or referred to in this website.

Past performance should not be seen as an indication of future performance.

The value of investments and the income from them can fall as well as rise and you may not get back the amount originally invested, particularly if your client does not continue with the investment over the longer term.

Changes in the rate of exchange between currencies may cause the value of an investment to go up or down.

Interest rate fluctuations are likely to affect the capital value of investments within bond funds. When long term interest rates rise the capital value of units is likely to fall and vice versa. The effect will be more apparent on funds that invest significantly in long dated securities. The value of capital and income will fluctuate as interest rates and credit ratings of the issuing companies change.

Tax levels and reliefs are those currently applicable and may change and the value of any tax advantage will depend on individual circumstances.

Investing in emerging markets or small companies may be potentially volatile, as these investments are high risk.

The design, text and images are owned, except as expressly stated by members of the Rathbone Group. They may not be copied, transmitted, displayed, performed, distributed, licensed, altered, framed, stored or otherwise used in whole or in part or in any manner without the written consent of Rathbones except to the extent permitted and under the procedures specified in the copyright Designs and Patents Act 1988, as amended and then only with notices of Rathbones' rights.

Subscribe to the In the KNOW blog email