Accepting low liquidity for lower volatility: An (un)conscious decision by € 70 Billion invested in German special funds?

Real estate funds offer diversification for investors with limited investment volumes. German institutional investors can choose between pooled funds according to a) German legislation as embodied by the German Capital Investment Code („KAGB“) and with a German valuation approach or b) international standards of Anglo-Saxon origin with a “Red Book” valuation approach.Funds according to the German Capital Investment Code have been able to attract more than € 72 billion in committed capital within the last twenty years. The performance of two thirds of the funds’ capital, i.e. € 48 billion are monitored by MSCI and published on a quarterly basis (“SFIX”). Half of the capital invested is in funds with a European mandate. MSCI monitors also the performance of pooled funds according to Anglo-Saxon standards and publishes performance data like the Pan European Pooled Property Funds index (“PEPFI”). The comparison between PEPFI and German funds with a European mandate (“SFIX Europe”) offer insights in considerable difference for the years 2005 until 2017 despite a similar European allocation.While PEPFI clearly tracks the financial crisis and the subsequent recovery of the markets, SFIX Europe is showing a sideways movement. Over the whole period of 2005 until 2017 the annualized returns have been 3.5% for PEPFI and 2.7% for the SFIX Europe. However, the difference in volatility is far bigger: While the standard deviation of PEPFI is 11.3%, it is only 2.6% for SFIX Europe. Thus, according to measures like the Sharpe Ratio the SFIX Europe achieves a superior risk-adjusted return, since the SFIX Europe offers four times less volatility than the PEPFI, with comparable allocations and similar long-term returns.The paper discusses whether the discrepancy might lie in German valuation practice, which is based on long-term values and could lead to valuation reserves in booming markets. The paper also examines consequences of smooth real estate valuation which might reduce liquidity of pooled funds. If it can be assumed that there are reserves in a fund during market phases of high real estate prices, existing investors are not interested in taking in additional investors, since the entrants will not have to pay for reserves as reserves are not reflected in current valuation. During times of low real estate prices, investors will not be interested in allowing others to leave since the last valuation might not reflect yet the complete downturn.