By Richard Westlund
If your investment goals include seeking a higher return potential, addressing inflation risk or building a more diversified portfolio, it’s time to get real.
In the past year, many institutional investors have increased their investments in real assets, such as infrastructure, commodities, real estate, timber, farmland and industrial metals.
“We expect the trend of real assets investing to continue as investors move toward a higher strategic allocation to this asset class,” says Vince Childers, portfolio manager, Real Assets, Cohen & Steers. “We have seen a multiyear trend toward real assets, which has evolved into a distinct asset class rather than simply a portion of a broader alternatives allocation.”
Investors today are looking at real assets both strategically and tactically. Over the longer term, real assets can help to counterbalance the ups and downs of traditional assets.
However, real assets can be overlooked in a strong equities market – a situation that can create buying opportunities for investors looking closely at valuations.
“Many investors appreciate the diversification benefits of real assets when traditional asset classes go down,” says David A. Chang, senior vice president, partner, and commodities portfolio manager, Wellington Management. “However, the lower correlation also means that real assets may not rise as quickly as equities in some markets.”
On a tactical level, investors are drilling down into the real asset sector to find short-term strategies and themes that support their investment goals. “In today’s environment, many investors want to improve their potential returns, and are turning to active management strategies in the real asset space,” says Cara A. Lafond, vice president and asset allocation strategist, Wellington Management. “We believe there are great opportunities to add or initiate exposure to real assets based on compelling valuations.”
Because of global population and economic growth, institutional investors will continue to pay increasing attention to real assets, according to Jose Minaya, senior managing director and head of Private Markets Asset Management for the TIAA-CREF organization. “Global agricultural production will need to double by 2050 to meet expected demand, wood-based product demand is expected to increase by more than 60 percent in emerging markets, and infrastructure assets require significant upgrade”, Minaya says. “I believe we are just at the starting point in terms of demand for real assets.”
Seeking enhanced returns
In addition to increasing their allocations to real assets, institutional investors are also looking for new opportunities to enhance returns in commodities, infrastructure and real estate, for example.
“One approach has been to go deeper into the buckets of real assets, such as developing an opportunistic strategy around the theme of natural gas, rather than the energy sector in general,” says Lafond. “Maintaining a strategic allocation to real assets while looking for tactical opportunities resonates with many institutional investors.” For example, Lafond has seen strong interest in master limited partnerships (MLPs) due to investors’ desire for greater yield as well as for exposure to infrastructure.
That evolution of opportunities is also occurring in the commodities sector, according to Wellington’s Chang. During the 2000s, the commodity market was largely driven by demand from China, he says, adding, “Today, we are dealing with a market of commodities rather than a singular commodity market. As a result, there is an increasing diversification across real assets, exemplified by cross-commodity correlations having declined to a level last seen in the 1990s.”
The outlook for other types of real assets is also changing. “Real assets have evolved significantly in the past decade in sectors like energy, base and precious metals, and agriculture,” says Chang. “That includes the growth on the energy supply side in North America, the evolving nature of China’s demand for industrial metals given its large base and ongoing transition into a more balanced economy, and investors’ reduced appetite for gold and precious metals.”
Finding infrastructure opportunities
Pension plans, sovereign funds, endowments and insurance plans are among the institutional investors attracted to the risk-adjusted return opportunities in the infrastructure sector, says Graeme Conway, Americas Head of Macquarie Infrastructure and Real Assets. “Large investors are increasing their exposures and new players are also moving into this space,” he adds.
In addition, sophisticated iinvestors are digging into the infrastructure sector. “Infrastructure is an umbrella term that covers a huge array of risks and assets,” says Conway. “So investors are looking at the sector more carefully and choosing strategies based on their goals, such as growth, yield or geographic exposure. They are also thinking carefully about where they want to be positioned across the risk spectrum.”
For example, a revenue stream from a public private partnership (PPP or P3) toll road project in a developed emerging market will be affected by population growth, driving patterns and overall economic growth, Conway says. Utilities are affected by similar trends, but also face a regulatory risk since they may need government approval for rate hikes in the future.
“Infrastructure assets like ports and airports might offer the investor greater return potential through the future development of retail, industrial or parking facilities,” adds Conway. “These are examples of the different risk and growth profiles within the infrastructure sector.”
Minaya says that investors don’t have to look at emerging markets for infrastructure opportunities, when there is a strong demand in North America. “The U.S. now ranks 23rd in infrastructure quality globally and the country needs $2 trillion in new investment just to get up to par,” he adds.
Because national and regional governments are reluctant to raise taxes, private investors will play an essential role in financing badly needed infrastructure projects. “That trend will create numerous opportunities for the private sector,” adds Conway.
Addressing investment risks
Inflation risk is a key concern for endowments, foundations, pension plans and sponsors and participants in 401(k) and other defined contribution (DC) plans.
“Unlike equity and fixed-income, real assets tend to have a positive sensitivity to unexpected inflation, a characteristic that is important to almost all investors,” says Childers. “Our research indicates that real assets have tended to outperform during precisely those periods when both stocks and bonds were underperforming at the same time.,” says Chang.
He and Lafond add that the improving global economy is prompting more investors to look at strategies to hedge inflation while still participating in growth opportunities. “Investors are interested in multiasset strategies that may include energy, real estate and TIPS (Treasury inflation protected securities),” says Chang.
Lafond says investors should also consider their liquidity exposures. “Liquid real asset exposures can help protect an investor’s broader portfolio in periods of unexpected rising inflation.”
On the other hand, investors with longer time horizons and less concern about liquidity tend to focus on private real assets, says Childers. The private and listed markets offer access to different real asset opportunities, providing benefits to including both types of investments, regardless of liquidity needs. Chang adds that some investors take a blended approach surrounding a liquid core with more opportunistic, less-liquid investments.
Finally, Chang points to the importance of aligning real asset allocations with investment goals. “Because real assets are diverse and dynamic, no one asset will hit every investment objective,” he says. “Therefore, investors should consider their objectives with regard to return potential, inflation sensitivity, and liquidity, and take a diversified approach within a real assets allocation.” n
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At the Threshold: Real Estate Investing in a Changing Environment - Co-Published by Wellington Management
The potential for rising inflation and slowing global growth could affect real estate sectors and regions unevenly.
Wellington Management real estate specialist and portfolio manager Bradford Stoesser shares his outlook for the
real estate market and explains his process for identifying investments with the potential to outperform.
By Bradford Stoesser
Real estate values have been supported by improving demand and tight supply, while receiving an additional boost from easy central bank monetary policy. Investors globally have been looking for ways to protect their wealth from currency debasement, and we believe real estate is an effective asset inflation hedge. While we think asset inflation is likely to continue for the foreseeable future — at least until governments adequately de-lever and stop printing money — we increasingly expect price inflation in real estate, manifested in higher rents, to surprise to the upside. Given this outlook, we favor shorter-lease-term subsectors that can more easily pass inflation on via higher rents, and we tend to avoid spread-investing business models that rely on low interest rates to keep borrowing costs low and returns on capital investment high.
Today, we find real estate investment trusts (REITs) attractive for a number of reasons, and we are looking carefully at opportunities and challenges that arise from market dislocations. At the macro level, we are concerned about a near-term global growth slowdown caused by emerging market currency volatility and current-account-deficit challenges, along with decelerating economic growth expectations among developed markets. We suspect that markets have become overly reliant on expectations of accelerating global GDP growth; consequently, we are focused on the sustainability of cash-flow growth and cognizant of the multiples we are willing to pay for that growth versus the greater surety of yield.
Potential impact of inflation
Contrary to conventional wisdom, inflation is not universally negative for real estate values. Inflation accompanied by steady economic growth and job creation reduces the headwind of higher real rates. As long as price inflation does not overwhelm growth and lead to stagflation, many property subsectors can keep up. We have found that even in periods of relatively high inflation, shorter-lease-term subsectors such as self-storage, apartments, and industrials tend to produce returns that exceed inflation. In Figure 1, the bars represent the percentage of six-month periods of relatively high inflation — exceeding 2.5% on an annualized basis — during which the total returns of the asset equaled or exceeded the inflation rate. Even longer-lease-term subsectors such as offices can produce strong returns in a rising inflationary environment if the local rent cycle is on the upswing, although this varies, given the local nature of supply-and-demand dynamics.
The biggest question is whether or not inflation will accelerate faster than growth. This risk does not seem to be a focus for the market or for central bankers, whose legacy models may continue to count on cheap oil as a key driver of inflation expectations. A rapid rise in inflation without
economic growth could destabilize markets. Stagflation is not our base case, but it is possible. For now, we anticipate healthy longer-term growth, but we will hedge against a near-term growth scare or a sudden uptick in underlying inflation.
(See figure 1, previous page)
Additional benefits for investors
Today, we believe that REIT valuations are reasonable to attractive relative to equities and fixed income, although on an absolute basis we believe most asset classes look fully valued. In addition, fundamentals have largely remained steady or improved, helped in part by minimal new supply. The low historical correlations of property to other sectors, coupled with stable cash flows and strong historical returns, provide a compelling opportunity for investors to enhance portfolio diversification and employ REITs as a hedge against inflation. In particular, many REITs with low leverage, low dividend-payout ratios that are poised to grow, and better-than-average-quality assets, are particularly attractive liquid options.
Amid the choppy market environment that we suspect will persist, REITs can potentially offer investors portfolio stabilization. As Figure 2 shows, REIT correlations with equities decline over longer investment horizons. Measuring rolling periods of varying durations from 1998 to 2013, the correlation dropped to 0.4 versus the S&P 500 over five years. REIT correlations to private real estate, on the other hand, increased over longer time horizons, rising to 0.90 over rolling five-year periods. The REIT-to-equities correlation declines over time because the real estate cycle is generally longer than, and does not always correspond with, the broader economic cycle. Long-term investing in REITs effectively provides exposure to a distinct real estate asset class that is more liquid than private real estate. (See figure 2)
An active management approach
Like many market segments, real estate’s inefficiencies tend to be greater during times of economic uncertainty. We believe our active management approach in real estate is well suited to this environment because we can focus on sectors that have historically outperformed inflation. We also have the ability to take advantage of mispricing and differences in market-specific fundamentals. For example, concerns about currency debasement have led to misallocation of capital, creating excessive asset-price inflation in certain real estate markets. Of particular concern are the rapid price increases of high-end residential property in “24-hour cities” — primarily London and New York —
although the same phenomenon is occurring in select cities in emerging markets as well. Although these markets may not be in bubble territory, we believe prices will eventually correct when the easy money stops flowing.
Fortunately, widespread misallocation of capital has not adversely affected most commercial property markets. While this trend has, in general, not been a problem among public REITs, it has affected a wide range of cash buyers in the private markets, including large institutions, sovereign wealth funds, and private wealth funds. Some core, fully leased, A-quality properties, which certain buyers deem “trophy assets,” have been subject to these asset-inflation pressures. Nevertheless, most commercial property segments are seeing improving fundamentals thanks to relatively tight supply and increased occupier demand. With rents in many markets still below replacement cost, oversupply does not appear to be a meaningful risk, leaving landlords with flexibility to adjust pricing over the next several years.
We aim to avoid companies that are vulnerable in a rising-rate environment and favor those for which catalysts for outperformance are independent of central bank policy. We believe that apartments offer the best near-term prospects because of firm fundamentals, home buyers’ difficult access to credit, and a propensity to rent by younger cohorts. The lodging subsector represents the best medium-term opportunity, given favorable supply-and-demand dynamics and strong corporate profits. We are positive on the office and telecommunications-tower subsectors, both of which we believe will surprise to the upside on improving fundamentals. Regional malls offer the best valuations in REITs, but they may lack near-term catalysts for share-price appreciation given the secular headwinds that remain in retail. Finally, we believe timber is the best way to play a long-term housing recovery, as saw-log prices have yet to catch up with price appreciation for wood products and housing. n
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For Alpha in a Real Asset Portfolio, Look Up the Value Chain - Co-Published by TIAA-CREF Asset Management
For Alpha in a Real Asset Portfolio, Look Up the Value Chain
By Jose Minaya, Senior Managing Director and Head of Private Markets Asset Management,
TIAA-CREF
Interest in, and experience with, real assets among institutional investors has never been higher. The package they offer of potentially attractive total returns, portfolio diversification, and protection against inflation is garnering more and more attention in today’s environment of near record low interest rates and historically steep equity valuations.
It is well known that a portfolio of core real assets – farmland, timberland, energy resources and infrastructure – can provide beta diversification to a traditional portfolio through steady income, capital appreciation, and the intrinsic value of the holdings. What is not widely known is that real assets also confer some advantages to their owners that are not available to holders of financial assets.
By virtue of their close relationship with adjacent companies in the value chain, the owners of real assets are able to identify and act on investment opportunities that would not be known or available to others. Private equity investments in processing and distribution companies that lie further up the value chain can bring real asset managers important benefits, including more efficient capital deployment, potentially attractive total returns, and meaningful diversification. This is a large market that is under penetrated by institutional investors and a source of potential alpha for real asset portfolios.
Obviously, real assets do not exist in an economic vacuum. Once they are produced in raw form, they enter a processing stream in which they are transformed into finished products ready for sale to consumers. Private equity investments in these “value chains” offer the real asset manager a way to extract more value from existing holdings while also diversifying revenue and reducing exposure to commodity prices. They help real asset owners capture more of the full retail value by removing an intermediary and provide market knowledge that helps producers adjust to changing trends in demand. In some instances, the operating asset may also act as an internal hedge to land investments, since profitability is often based on volumes processed rather than crop prices; if excess production pushes crop prices down, part of that loss can be offset through the increased revenue from processing higher volumes.
The rationale for investing in businesses adjacent to real assets in the value chain is much the same as for investing in real assets themselves, as they both benefit from the same growth drivers. For example, increased protein consumption, the growing interest in healthy living and rising demand from emerging markets benefit agricultural processors just as they do farmers and farmland owners. These businesses also provide the investors with same benefits as real assets: the potential for current income, long-term capital appreciation, and low correlations with traditional equity or fixed income investments.
To get the most from our real assets portfolio, TIAA-CREF began looking for private equity investments in 2010 that would complement our farmland holdings. As an almond producer – one of the world’s top five, actually – we have detailed knowledge of how almonds are purchased, processed and marketed, and the amount of value added at each stage of the production chain. We also have relationships with the businesses that perform those tasks and knowledge of prevailing market conditions. As investors, we quickly recognized that controlling some of the stages of production, marketing and delivery — the vertical integration that exists at the intersection of agriculture and infrastructure — would help us to derive additional value while at the same time mitigating some risks.
So, in 2011 TIAA-CREF acquired a minority equity stake in a privately held almond processer in California in order to capture the potentially attractive risk-adjusted returns it generates and to invest as long-term partners with one of the leading owner-operator management teams in the industry. This investment has allowed TIAA-CREF to improve our overall almond sector risk-return profile and helps us to better coordinate production and processing, thereby improving returns at each stage.
Not only do we benefit from their profitability, our investment with this almond processer also helps us understand the market and customize the product for our customers’ varying demands. In Japan, for instance, most buyers want to buy almonds that have been sorted and graded so that they get only small, perfect nuts. In India, by contrast, we sell almonds in the shell so that participants in the country’s employment program can add value processing them by hand.
Almonds are part of our farmland portfolio that is managed by our Illinois-based affiliate Westchester Group. Westchester invests in farmland and provides services to farmers that help maximize their returns. Our private equity investments are predominately made through California-based AGR Partners, which provides investment management, sources minority equity transactions and conducts due diligence in the agribusiness space. Both Westchester and AGR Partners leverage the broad infrastructure and institutional knowledge of TIAA-CREF’s asset management team.
Overall, our strategy is to use the industry knowledge we gain from owning the key factor in the production stream to make opportunistic investments further up the value chain. Usually, we are interested in taking a minority stake. That gives us a larger universe of investment opportunities from which to choose – many businesses are owned by families that need capital but do not wish to give up operational control – as well as strong operating partners with aligned interests. We put particular emphasis on margins: we look for companies engaged in volume and value-added activities that let us be commodity price agnostic. We have a long-term focus, using dividends for current income and allowing the long-term capital appreciation to accumulate. n
The material is for informational purposes only and should not be regarded as a recommendation or an offer to buy or sell any product or service to which this information may relate. Certain products and services may not be available to all entities or persons. The TIAA General Account is an insurance company and does not present an investment return, and is not available to investors. TIAA-CREF Asset Management provides investment advice and portfolio management services to the TIAA-CREF group of companies through the following entities: Teachers Advisors, Inc., TIAA-CREF Investment Management, LLC, TIAA-CREF Alternatives Advisors, LLC, and Teachers Insurance and Annuity Association of America. Teachers Advisors, Inc., TIAA-CREF Investment Management, LLC, and TIAA-CREF Alternatives Advisors, LLC are registered investment advisers and wholly owned subsidiary of Teachers Insurance and Annuity Associations (TIAA). Real Asset investments may be subject to environmental and political risks and currency volatility.
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Exploring the Real Benefits of Liquid Real Assets - Co-Published by Cohen & Steers
Inflation protection is one of the key investment objectives of a real assets allocation. But how the allocation is structured can vary, depending on the investor type, liquidity needs and investment time frame. Cohen & Steers’ Vince Childers makes the case for a liquid approach to multiple real asset categories, including REITs, commodities, natural resource equities and global listed infrastructure. Vince is Senior Vice President and Portfolio Manager overseeing the Firm’s real asset strategies.
By Vince Childers, CFA
Real assets have a demonstrated sensitivity to inflation, regardless of whether they are accessed through public or private markets. While not a near-term concern, we expect that, as the post-QE era takes shape, the upside risks to inflation will far exceed those to the downside. Our research suggests that inflation’s most damaging effects occur when it comes as a surprise. To illustrate, we compared the inflation-adjusted returns of various asset classes over rolling 12-month periods when realized inflation exceeded the year-over-year consensus expectation.1 While the indicated betas were negative for stocks and bonds in these periods, they were positive for the real asset categories summarized below.
At the low end of the scale, the -2.4 inflation beta for bonds implies that, for a 1-percentage-point overshoot in realized inflation versus the prior year’s consensus estimate, the real returns for bonds were about 2.4% below average. At the high end of the scale, commodities’ 6.2 beta suggests that returns were 6.2% higher than average, measured on the same basis.
Broad asset class diversification is more important today than at any time in modern history.
Importantly, the diversification benefits of real assets go well beyond inflation sensitivity. Our research suggests that these categories can be particularly resilient during periods in which stocks and bonds simultaneously underperform their respective long-term averages. While such regimes were practically non-existent over the past decade, they have been observed with greater frequency over the long term—occurring in about 22% of one-year rolling periods from 1973-2013. A closer look, as summarized in the display below, lends support to our case for real asset diversification. Notably, the inflation-adjusted returns for stocks and bonds during these periods of joint stock-bond underperformance were negative, while the returns from real assets were uniformly positive. And this outperformance didn’t just occur over a few periods; the diversified real assets blend2 outperformed the 60/40 blend of stocks and bonds in about 90% of these disappointing periods for both stocks and bonds, suggesting that real assets can be effective in diversifying the drivers of a portfolio’s risk and return.
The diversification potential of real assets is enhanced by the distinct—and not always inflation-related—fundamentals underlying each category, as follows:
• The lease duration of real estate property types vary widely from days (hotels), to months (self storage), to many years (health care). Shorter-lease sectors can adjust rents if inflation moves higher; longer-lease sectors tend to deliver lower but more stable returns.
• Commodity returns are tied to near-term economic trends and the dynamics of supply and demand. Often, returns are event-driven, concentrated in short periods of time and have a high correlation with inflation.
• The return profiles of natural resource equities tend to be out of phase with commodities and typically lead the cycle. Exposure can also be gained from categories not found in futures markets—iron ore, uranium, potash and some agribusiness segments.
• The essential services provided by global infrastructure—energy transmission, utilities, transportation and communications—tend to generate stable cash flow, which is often tied to inflation.
Many investors seek real assets diversification through private markets; but sometimes for the wrong reasons.
In our view, there is no “extra credit” for not marking positions to market. We see no value in the illusion that private investment somehow limits risk—a fact that should be clear to any investor who, in the aftermath of the financial crisis, struggled to rebalance away from illiquid private positions.
We agree that the reported volatility of listed assets is greater than that of private investments. However, we also believe that the infrequent measurement and statistical “stickiness” of appraisal-based valuations of private investments can artificially smooth asset returns, thereby understating true volatility and leading many investors to discount listed investment opportunities. But even though the short-term volatility of individual listed real asset categories may be high, our research shows that a well-diversified real asset portfolio can carry lower volatility than the broad stock market. The returns across full market cycles from December 1972 through June 2014 (shown below) can be used to illustrate.
Regardless of the attractive risk/return profiles offered by liquid real assets, we acknowledge that investors with longer time horizons and less concern about liquidity tend to focus on private real assets. However, we believe that liquid and private real assets should play complementary roles as part of a broader, diversified real assets allocation, providing distinct approaches to investments with similar economic characteristics and sensitivities. Liquid allocations can enhance real asset allocations by providing:
• A liquid alternative to the long lock-up periods and limited secondary markets typically found in private markets. Market liquidity enables more rapid construction and rebalancing, while allowing the investor to respond quickly as market conditions change.
• Daily pricing that provides transparent, daily valuations. In contrast, we believe that private investments’ infrequent, appraisal based valuations can mask the inherent volatility underlying the asset class.
• Enhanced diversification potential. Private investments tend to own limited numbers of assets, while listed strategies typically hold many securities, each owning numerous assets. Diversification through liquid real assets can be more cost effective as well, without the high levels of capital needed to achieve similar diversification in private investments.
Outside of the benefits outlined above, we also recognize that some real asset allocations are best made with private investments, especially in certain niche and difficult-to-access markets. All told, however, our research suggests that liquid real assets can be an effective portfolio diversification tool, given the potential for i) attractive risk-adjusted returns, ii) an effective hedge against unexpected inflation and iii) prospective outperformance during periods when the core components of most investors’ portfolios— equity and fixed income—experience simultaneous subpar performance. Based on the long-term implications of these advantages, we believe that liquid real assets should play a much greater role in institutional allocations to real assets.
Endnotes: Data in this article as of June 30, 2014, Stocks= the S&P 500 Index. Bonds=BofA Merrill Lynch U.S. 7–10 Year Treasury Index. 60/40=60% S&P 500 Index and 40% BofA Merrill Lynch U.S. 7–10 Year Treasury Index, rebalanced monthly. The Diversified Real Assets Blend=an equally weighted blend of Real Estate, Commodities, Natural Resource Equities, and Infrastructure. Real Estate=FTSE NAREIT Equity REIT Index through December 1989 and the FTSE EPRA/ NAREIT Developed Index thereafter. Commodities=S&P GSCI through December 1990 and Dow Jones-UBS Commodity Index thereafter. Natural Resource Equities=50/50 Blend of Datastream World Oil & Gas and Datastream World Basic Materials through December 2002 and the S&P Global Natural Resources Index thereafter. Infrastructure = 50/50 Blend of Datastream World Pipelines and Datastream World Gas, Water, & Multi-Utilities through December 2002 and the Dow Jones Brookfield Global Infrastructure Index thereafter.