Steven Grahame, fund manager, and Toby Hayes, assistant fund manager for Pacific's Liquid Property Fund, answer SCI's questions

Q: How and when did Pacific Real Estate Capital Partners become involved in the property derivatives market?
SG: Pacific's Liquid Property Fund received FSA approval on 26 January and is, together with the Euro ActivIncome Fund and segregated accounts, part of Pacific Real Estate Capital Partner business. I was previously cio, alternatives real estate at Hermes and developed the use of derivatives to gain efficient exposure to desirable diversity characteristics of property. I joined Pacific to drive the alternatives division and launch Pacific's Liquid Property Fund.

The fund focuses purely on property and targeting institutional investors. The offer is unique as it invests across the multi-asset classes of property, investing in indices such as direct property, listed equity, property debt and property derivatives. The aim is to deliver core property-like returns, but with daily pricing and liquidity.

Pacific Real Estate Capital was founded by chairman Sir John Beckwith and ceo Gerald Parkes, who previously ran Lehman Steven Grahame                                          Brothers' real estate private equity group in London. Both Sir John and Gerald have founded and built successful investment management businesses and are successful investors in the asset class. So providing a platform for new areas, such as the property alternative, was a natural extension of the business.

Q: What has been the most significant development in the market in recent years?
SG: Investors are increasingly looking for efficient exposure to diversifying asset classes. However, property has up to now been an illiquid and expensive asset class to access.

Pacific's Liquid Property Fund is a UCITS III vehicle, providing investors with the benefits of core direct-like property exposure (diversity), but without the costs and illiquidity. This is a significant leap forward and it seems we are the first manager to do this.

The UCITS regulatory standard has one of the highest regulatory requirements as only the most liquid assets can be considered. This provides investors seeking features of core property exposure with the comfort of liquidity.

Another development is the shift that has occurred in terms of market sentiment away from the hedge fund model, where there is little transparency and money is locked up. It is interesting to note that hedge fund strategies are moving into the UCITS III space.

Investors are also pressing much harder on fee structures and value for money. We only charge an annual management fee, which makes our fund very competitive.

Typical core property funds charge acquisitions costs (say a 5% entry charge) and significant management fees, plus an exit fee of 2%, which dilutes returns. It's also potentially frustrating for investors risking being illiquid at different stages of the property cycle.

In comparison, our total expense ratio is about 90bp, with no entry or exit costs as we don't buy direct property but gain diversified property exposure through the use of derivatives on indices. This keeps things simple.

Q: How has this affected your business?
SG: We have had to develop a new way of thinking to satisfy investor needs for a combination of direct property correlation, liquidity, openness and value of fees. Our response has been Pacific's Liquid Property Fund, a UCITS III OEIC offering daily liquidity and pricing. The fund provides investors with exposure to the underlying property markets, but with greater diversity than core direct property funds that typically invest in 30-40 buildings with constraints on geography.

Yes, we could use structured products. But we don't think this is ultimately what investors want as it also represents an additional layer of costs and counterparty risk.

We have daily independent pricing on the fund and have the capability to generate a shadow NAV to check the administrator. We have also developed a way of limiting our counterparty exposure, which benefits investors - there is integrity and innovation at every level of our approach.

We believe institutional investors will not only be interested in the fund, but also how the approach could be expanded to enhance direct property portfolios.

TH: The initial portfolio is derivatives-based via the IPD, Markit TRX and other property-based indices such as REITs indices. We hope to gain exposure to a wider range of strategies once we've reached critical mass.

Q: What are your key areas of focus today?
TH: The portfolio has three spokes: direct property markets (via IPD/NACREIF derivatives); property debt (Markit TRX); and property equity (REIT indices). We're expecting to maintain a UK home bias, but where and when appropriate invest internationally.

The asset allocation is flexible: we don't churn the portfolio, but have rebalanced it on a quarterly basis. We work hard to find value - in terms of the best risk-adjusted return - across different property asset classes and regions. For example, triple-A rated CMBS looks a bit expensive at the moment.

The focus of the fund is on 'developed core property' markets; in other words, the US, the UK and certain parts of Asia. Consequently, it benefits from international diversity.

Q: What is your strategy going forward?
SG: Our initial focus is on Pacific's Liquid Property Fund. However, we also see many direct property portfolios that could be more actively managed and market risks more effectively hedged. We are therefore looking forward to working more closely with institutional investors, who want to expand their property portfolios, manage market exposure or want to reduce their investment management costs.

Q: What major market development would you like to see in the future?
SG: We'd like to see more participants trading property derivatives. The basic issue is that the property and derivatives worlds don't mix easily: most players in the property world are surveyors and so derivatives are unfamiliar to them.

There is a disconnect between the two sectors and it will take time for property players to get comfortable with derivatives. They don't have the middle office skills that financial services participants do, for example. Still, there are some new entrants coming into the market.

The other issue is that the majority of property derivatives are based on the IPD index and are thus European-focused. Had they been developed in the US, they might have taken off more quickly.

Nevertheless, the advantages of being in the market are becoming more widely known in terms of helping to manage risk. The Property Derivatives Interest Group is doing a good job promoting the value of property derivatives and it is only a matter of time before the large property asset management companies to enter the market.

CS