Market Commentary as of 6/30/08
Property companies around the globe faced hardships as aggregate returns were strongly negative during the second quarter. The US market suffered a pullback after a short-lived rebound during the first quarter. The threat of recession, a gloomy housing market, and upward pressure on bank lending rates further undermined already weak investor confidence in the UK property sector. In mainland Europe, total returns fell less steeply but were still down nearly 13% since April as tighter lending markets and inflationary pressures took their toll on stocks. Increasing volatility in the Asia Pacific region relative to the rest of the world resulted in June being the worst month of the quarter. The Shanghai Index as a whole lost more than 20% during the month, helping to drag down property companies as well as other markets in the region.
Volatility and uncertainty in the property markets will likely persist until there is better visibility on the ultimate extent of the economic downturn throughout the world. Little has changed with the Fund's positioning from the first quarter. We see the best value in Europe, especially in the UK, where the portfolio is overweight. We have the most concerns and are underweight in the Asia Pacific region, and continue to be neutral on the Americas.
The Americas
Canadian REITs fared much better than REITs in the US, finishing in positive territory for the quarter with total returns among the highest in the world. While we decreased the stake to Canada during the quarter, the Fund remained overweight relative to its Global Property Research (GPR) Net 250 Index benchmark, which contributed positively to performance. We like the comparative stability of the Canadian marketplace in general, though we are finding limited opportunities for new investment at present given the benign growth prospects for a number of Canadian companies. That said, the Canadian economy continues to be healthier than that of the US, especially in the resource-driven Western Provinces, though it's likely that the weakness in the US, its dominant trading partner, will eventually have some affect on Canada.
In the US, we remain most positive on the Retail sector, especially malls, exposure to which we increased throughout the quarter. Despite the negative sentiment surrounding the group in light of stressed consumer spending and slowing store sales growth, we like the long-term nature of mall leases, the lack of meaningful new supply, and the continued healthy demand for top-quality mall space from tenants. All the mall names held in the portfolio possess “A” quality portfolios.
Also within the US, we sold the Fund's only holding in the Hotel sector—DiamondRock. We think that hotels will continue to experience declining fundamentals, especially as leisure demand dampens, with the expectation that hotel companies will need to lower guidance for 2008. We added significantly to the Office sector during the period through the addition of Mack Cali Realty to the portfolio. Mack Cali is concentrated in the Northeast—primarily New Jersey, New York and Philadelphia—and the company possesses an attractive yield.
Europe
A large overweight position in the UK undermined performance in Europe as the Continent significantly outperformed UK stocks. A strategic underweight to the Austrian market, which avoided most of the region wide sell-off during the quarter, also negatively affected returns. On a positive note, being overweight the French market aided relative performance.
Individual stock selection had a slightly negative impact on performance overall. The lack of a stake in solidly performing Liberty Property, which is heavily exposed to the UK high-end retail sector, affected performance the most relative to the benchmark. Conversely, an overweight position in niche, self-storage company Safestore helped, as did the avoidance of developers like Quintain in the UK and Immo East, the latter of which focuses on Central European development.
We remain confident that the UK offers the best return prospects in the region and therefore continue to overweight the country. We like the high dividend yields and deep discounts to net asset value (NAV) currently available, which are higher than historic averages. The NAV outlook suggests that the UK has significantly more re-pricing potential than in mainland Europe. UK companies are less leveraged than their continental counterparts and should be less vulnerable to further market volatility. Finally, the UK sector still offers some potential for earnings growth to drive return performance.
Asia-Pacific
While volatility persisted, the region as a whole held up relatively well in losing only 6% during the quarter. Returns ranged wildly from country to country, however, with Australia posting losses in the double-digits and Japan staying positive throughout the period.
Our key strategies have not changed materially. We continue to favor Singapore for its growth potential and Australia for its defensive characteristics. Furthermore, we remain cautious on the Japanese and Hong Kong markets as growth continues to slow. The region will continue to face headwinds as global growth slows and gas and food prices increase—contributing to greater inflation.
As of June 30, 2008, Mack Cali Realty Group comprised 0.75% of the portfolio's assets and Safestore Holdings 0.55%.
Note: Risks of international investing include but are not limited to social and political instability, market illiquidity and currency volatility. The Fund is non-diversified and may be more susceptible to risk than funds that invest more broadly. Real estate funds may be subject to a higher degree of market risk because of changes in property values of the underlying property and defaults by borrowers.
The views expressed above are for informational purposes only and is not intended as investment advice. Since the date of the commentary, economic, market conditions and the portfolio manager's views may have changed. Holdings and weightings are subject to change daily. Holdings are provided for informational purposes only and should not be construed as a recommendation to buy or sell the securities mentioned.
Past performance does not guarantee future results. Investment return and principal value of mutual funds will vary with market conditions, so that shares, when redeemed, may be worth more or less than their original cost.