There Are No Easy Answers for This Risk

Investors are turning to hedges like real assets to protect against the potential of long-term inflation. But there is no magic bullet to offset the dangers of rising prices.

Cole Burston/Bloomberg

Cole Burston/Bloomberg

With U.S. inflation at its highest rate in 31 years, investors are looking to real assets as one option to hedge their portfolios.

As a result, the current outlook for real asset funds — particularly infrastructure — is the most bullish it’s been in years, according to one source, PitchBook’s 2021 global real assets report released this week. Authors Rebecca Springer and Jinny Choi attribute the potentially bullish future of bridges, roads, tunnels, and bridges directly to rising rates of inflation.

The outlook, however, isn’t the same for all types of real assets — tangible investments such as property or gold that rise in value along with inflation. Infrastructure funds have produced reliable returns (“in the region of 10 percent” according to PitchBook) for the past decade and are expected to provide ample opportunity for institutional portfolios in the near future.

Oil and gas investments have a mixed record of protecting portfolios from the destructive power of inflation. Energy-related stocks and commodities have a history of volatility and have even suffered double digit losses in some years when consumer prices have increased significantly.

PitchBook reports that performance and fundraising for natural resource funds, such as oil- and gas-related assets, have been on a steady decline over the past ten years. With commodity prices skyrocketing the funds are currently doing well, but PitchBook questioned whether that is sustainable.

“Limited partners have been pulling out of oil and gas since 2010,” Springer told Institutional Investor. “There are also [environmental, social, and corporate governance (ESG)] pressures LPs are facing. They’re wanting to pivot their portfolios to be more clean-energy focused, and so, many of them are making the decision not to commit to oil and gas and mining funds for that reason.” Still, for investors willing to go there, oil and gas might benefit from the flight of capital away from the sector, according to the analysis.

PitchBook’s positive outlook on real assets is rooted mostly in optimism surrounding infrastructure. Over the past decade, fundraising for infrastructure funds has remained steady. By the end of the third quarter of 2021, infrastructure funds raised $73.3 billion.

“There are more LPs building out allocations to infrastructure, either increasing their existing allocations or allocating to the strategy for the first time,” Springer said.

In fact, the report said, in a three-year horizon outlook, infrastructure outperformed other real asset strategies “significantly,” garnering returns of 8 percent to 10 percent, in contrast to the low and negative returns of other real asset strategies.

“For LPs, a significant factor in the attractiveness of infrastructure investments is the highly resilient nature of the strategy. Infrastructure funds continue to produce reliable returns while oil & gas and other real assets fund types exhibit far more volatility,” the authors wrote.

Infrastructure works as a strong hedge against inflation’s impact on portfolios because it often benefits from inflation, said Springer. When it comes to other alternative investments, “some of those companies might be a bit more inflation-exposed,” she said. But investments in bridges and toll roads often come with detailed contracts that lay out what happens during periods when prices rise. “On the infrastructure side, you have assets that have pricing contracts that are tied to inflation, so they tend to do quite well.”

Richard Bernstein, who spent almost two decades at Merrill Lynch before founding his own firm in 2008, is also a real assets-for-inflation booster. According to a report from Richard Bernstein Advisors released Tuesday, Bernstein predicted that the inflationary environment will last longer than originally expected and will continue at a higher rate than expected. Bernstein has a history of good calls. He joined Merrill Lynch in 1988 and debuted in third place in Quantitative Research on the II’s All-America Research Team in 1991. He went on to appear in the ranking 24 more times — including ten times at No. 1 — in Equity Derivatives, Portfolio Strategy and Quantitative Research.

As a result, Bernstein suggested investors rethink portfolio allocations and overweight inflationary assets like energy and materials.

While alternative managers are hawking their inflation protection options, traditional asset managers argue that value stocks, growth stocks, cryptocurrencies, and technology companies will guard portfolios. Stocks of companies that are value plays, for example, often own factories, plants, or real estate that appreciate during inflationary times. The one thing that all of these investments have in common is that they are imperfect inflation hedges.

As the inflationary environment persists and more investors move into infrastructure strategies, PitchBook’s Springer said there may be room for emerging managers to step in. Right now a handful of large managers dominate the space, which requires a lot of capital for each investment. But as demand rises, institutional investors may want to turn to smaller, differentiated players, who can offer strategies all along the risk-return spectrum.

“As LPs become more sophisticated and comfortable with the strategy, they’re going to want to diversify even within their infrastructure allocations,” Springer said. “This means there could be opportunities for emerging managers to carve out a space within a strategy that has been dominated by very large managers for a long time.”