Real Assets Playing a Larger Role

An Institutional Investor Sponsored Report on Real Assets

Investors are turning to real assets as they seek instruments that can help to diversify portfolios, hedge inflation risk, and generate returns. By Howard Moore

As investors look to diversify their portfolios and boost returns in a low-interest rate environment, they have been taking a closer look at real assets. “Since 2008, institutional investors have almost doubled their allocations to real assets, and based on our research, which include conversations with investors, we believe that allocations will continue to increase,” says Kevin Adolphe, president and CEO of Manulife Asset Management Private Markets. The real asset class typically includes real estate, infrastructure, commodities, timber, farmland, precious metals and other hard assets, and it is playing a larger role in the investment strategies of institutions worldwide. While private direct investment has been the traditional method of exposure to these assets, investors have growing options in liquid instruments as well as stocks in the operating, management and producer companies. Inflation-linked bonds are options as well.

“There is a need for assets that protect you as a long-term investor,” says Roland Lescure, chief investment officer at Caisse de dépôt et placement du Québec . “This is all about long-term risk management.” One significant risk is a durable rise in inflation, and pension funds in particular need a strategy to match future liabilities, he explains. Real assets have long been regarded as a hedge against inflation, but the search for greater sources of yield is another driver of their recent popularity. “The expected returns of real assets are attractive for investors now, especially with falling yields on their fixed-income investments,” he says, particularly as future liabilities grow.

Indeed, the bigger fear among investors is the low returns they’re getting from fixed income and volatility from equities. “The spread between capitalization rates and Treasury yields is currently at the higher end of the historical range,” says Adolphe. “As long as the current interest rate environment persists, there will be a need to make up for the low yields.”

The other benefit is equity-like returns. “If you invest well and maintain the assets properly, the value will improve beyond inflation,” says Lescure.

While inflation is not an immediate threat, it is now, as always, in the back of investors’ minds. “While no one is shouting ‘fire’ at the moment, we’d expect real assets to perform well if we were to face an adverse inflation surprise, but you don’t need a replay of the 1970s for a real assets allocation to make sense in a portfolio,” says Vince Childers, senior vice president and real assets portfolio manager at Cohen & Steers. “Investors increasingly recognize that allocations to real assets provide valuable diversification benefits, regardless of the inflationary backdrop.” Investors are taking a closer look at their broader diversification potential and performance during times when stocks and bonds underperform together. “What price in terms of opportunity costs or foregone returns might we have to pay to get the benefits of diversification and inflation sensitivity?” he asks. A portfolio that includes a thoughtful selection of real assets, as a coherent asset class, should satisfy investors very well in terms of inflation sensitivity, low correlation to other asset classes, as well as the strong returns intrinsic to the real asset class, he notes.

Strategically, it remains a good time to invest in the sector. “Inflation won’t likely pick up next year, or even the year after,” notes Lescure. “With interest rates so low, it should be easy to do better than the 2 percent a bond is giving you.” Real estate values have risen particularly, and there is a lot of competition for good deals, but opportunities remain. “Real estate has performed very well for the past four years,” says Adolphe. He notes that there has been a flight to quality. “In these types of assets, a good, strong investment will take you through good times and bad.”

While real estate has long been an established asset class, other components of real assets have not been widely incorporated into institutional portfolios. “The interest has grown among institutions and the consulting community also,” says Childers, “and recommendations for real asset exposure has been climbing in recent years.” In a report by Greenwich Associates, eVestment Alliance reports that investment in listed real asset strategies has increased 325 percent over the past five years. That overall growth includes a near-doubling of investment in commodities, a quadrupling of investment in U.S. REITs, and explosive levels of growth in global-listed infrastructure, master limited partnerships and multi-strategy real asset funds.

Some consultants are considering real assets a standalone asset class, breaking it out of alternatives. Investors are becoming more comfortable with the strategic rationale and historic performance data and are establishing allocations. However, according to the Greenwich Associates survey, most institutions report that they are underinvested relative to their real asset allocation targets. Childers notes, “We’re still in the adoption phase, and investors are asking, ‘how do we implement, how do we get to that target?’”

Part of the process involves deciding between liquid, or listed, real assets versus private investments. Underinvestment represents a challenge for institutions active in real assets. In private markets like infrastructure, timber, farmland, and others, an inability to find opportunities is often one of the main impediments to achieving target allocations, Greenwich Associates notes. For institutions experiencing difficulty sourcing attractive investments, liquid real assets, including REITs, commodities futures, global-listed infrastructure and equity investments in natural resource companies can provide an effective alternative. Fourteen percent of institutions say they use liquid assets as a placeholder until a direct investment can be implemented, and 11 percent say they use liquid assets to secure access to targeted investments they have been unable to achieve with private assets.

A number of investors have seen that it’s possible to capture similar economics of direct illiquid investments with liquid instruments. “You can replicate them in the listed market and also have the benefit of liquidity,” says Childers. Many investors are in the phase of building out a broader real assets allocation that has a more balanced liquidity profile and is often better diversified by region and sector.

There’s a flip side, however. “We’re wary of any solution that provides liquidity in an asset class that’s fundamentally illiquid,” says Lescure. In a wide sell off, liquidity evaporates, and he stresses that if you do invest in a liquid counterpart, you still have to make sure you manage that liquidity in the context of the larger portfolio and in the broader market.

As real assets become larger and more important components in a portfolio, benchmarking has become an issue. “You don’t have an S&P 500 of real assets,” says Childers. “There is no kind of generally agreed-upon, third-party index for real assets performance.” Participants in the market have created their own custom benchmarks of weighted average combinations of various measures from various sources. “Portfolio managers have built benchmarks many times based on the asset classes represented in their portfolios,” he says. One may have more in commodity futures and another may have a little bit less, and often this is because their objectives are slightly different in one way or another, for example. “Basically, long-term risk and return objectives helps to position you in a certain spot, and the rest falls into place,” he says.