Let's get real about real asset investment
Updated: Feb 16, 2018
We live in a volatile world of low returns. Real asset investments can help.
An ageing population, uncertainty about what happens next in the EU, rising UK inflation, low productivity, strong demand and QE are all serving to keep government bond yields constricted. There is no reason to think that will change significantly in the medium term.
Artificially low government bond rates could potentially compromise pension funds and challenges the traditional buy-and-hold bond strategies. This, low yield environment is an issue for even the most prominent asset managers. Alongside that, the dot-com bubble, the dual recessions of 2001-2003 and 2007-2009 showed us that traditional asset allocation methods were imperfect to a higher degree than we already supposed. It became clear that supposedly uncorrelated asset classes contained many more common risk factors than previously thought.
We believe most asset managers are underweight real assets
Now better asset allocation tech offers the opportunity to run risk-based portfolios, and that signals a sea change for how real asset investments. Investors are looking at real assets - real estate, infrastructure and commodities - and thinking about how best to diversify their portfolios. This is moving quickly: S&P noted that over a five-year period, investment in real assets have increased by 325%, with 80% of institutions targeting a weighting of up to 15%, and 66% of those feeling they would be still be underinvested at that level.
Redstone believes that long-dated liability matching characteristics offered by real assets offer are a valid alternative to bonds. That is reinforced as the yield from real assets has consistently outperformed other asset classes over a 25-year period. This bolsters their traditional diversification and inflation roles.
Below we take a more in-depth look at the attributes of inflation protection, diversification and yield.
Real assets provide a reliable hedge against inflation for two reasons. First, long-term returns have outpaced the inflation rate. Secondly, many commodities are components of inflation measures, like Consumer Price Index (CPI). That means when inflation rises, the price of those commodities also tends to go up which provides a built-in hedge.
We believe most investors are significantly overweight on bonds and merely shifting that allocation into equities is a missed opportunity. There are reasons managers are underweighting real assets. It is much harder to invest in real assets than it is to buy stocks and bonds - but addressing that underweighting could produce positive diversification effects.
Even in S&P’s real asset indices, which include inflation-linked bonds which are by definition highly correlated to CPI, the inflation beta is relatively low. These indices have demonstrated relatively strong inflation protection with a correlation of 0.43 to inflation and an Inflation Beta of 4.2, measured by year-over-year returns taken monthly. Commercial property, where a large part of Redstone's attention is focused, performs well with an Inflation Beta of 3.0 and correlation to inflation of 0.2.
Real assets are potent diversifiers, with low or negative correlations to traditional stocks and bonds - and to each other. Investments in farmland, timber and commercial real estate have exhibited low or negative correlations to stocks and bonds. The assets Redstone tend's to favour strengthen traditional portfolios because they are insulated from speculative trading in public markets.
A portfolio optimisation exercise conducted using mean-variance portfolio optimisation, based on 20 years of historical performan
ce, standard deviation, and correlations of returns by asset class demonstrated private real assets investments' potential to improve the risk-adjusted returns of portfolios consisting of stocks and bonds and diversify risks associated with publicly traded commodities and REITs.
REAL ASSET YIELD
The type of real assets that Redstone Advisory Partners prefer, also have the potential to provide bond-like income from leasing land and selling commodities, and long-term capital appreciation from rising asset values.
Of course, returns are the primary motivator in real-asset allocations. Over the last 25-years, real assets have provided equal or higher returns with much lower volatility than traditional stocks and bonds. Private real asse
ts have delivered a return of 10.45% outperforming both bonds (6.32%) and shares (9.26%).
There are practical issues for investors seeking to allocate to real assets. Real assets are relatively illiquid and lack industry-wide pools of expertise so acquiring and servicing deal flow can be problematic. In fact, according to Blackrock, only one-third (32%) of institutions have a real assets team. This challenge to increase the utilisation of real asset investment has been one of the primary drivers for Redstone's focus on co-investing on real asset acquisitions.
Low-interest rates are a tailwind for investment in real assets and though low rates now seem a semi-permanent phenomenon that will change over time. Changes in the central bank rates have less effect on long-term rates than on short-term interest rates, and thus impact Redstone's financing conditions less than is often supposed but the Fed has just upped its rate for just the second time in ten years.
The UK's Brexit vote highlighted the exposure which unexpected changes can lead to in this type of investment. £18 billion of property funds were temporarily shuttered. It is clear that one must be cautious not to provide apparent liquidity to an asset class that is fundamentally illiquid.
Redstone expects the real asset investment trend that has been underway for the last four years to accelerate. Real assets are underweighted in many portfolios; they are providing better yields than equities or bonds, and their attractiveness is improving with an unstable macro environment. For those seeking to generate a risk/return profile with inflation-hedging and diversification benefits, real asset exposure makes good sense. Of course, that's assuming that one can live with relative illiquidity.
Contact Mark Alexander at Redstone Advisory Partners on +44 (0) 207 193 1243 to this discuss this article.
Redstone is a family office, investor and global advisor focused on sports, real assets and TMT.