Traditional asset classes have enjoyed a remarkably strong innings for many years.  A portfolio consisting of 60% in global equities and 40% in global government bonds would have generated a total return of around 7% per annum (compounded) over the past 25 years (source: Waverton Investment Management, based upon FTSE All World Total Return Index and FTSE World Government Bond Index, in sterling terms). Fixed income contributed meaningfully to this fine outcome; the 10-year gilt yield began this period with a yield of over 8.5% and it now resides at around 1.3%.  This move equates to a total return of over 200%.  Simple mathematics tells us that the salad days for bonds are over.

Aware of the limited scope for bonds to offset declines in equity prices, many investors have been reflecting, not only upon future returns, but also upon portfolio risk and diversification.  The search for assets that have the potential to deliver returns that are less sensitive to traditional market moves has led some portfolio constructors to incorporate permanent allocations to alternative investments, in all their different guises.  For those who are also worried about re-emerging inflationary pressures, the presence of real assets within this allocation is particularly appealing.  Indeed, the track record of equities during historical periods of inflation is far from auspicious and, in today’s brutally transparent, internet-enabled world, companies are finding it much tougher to pass through price rises to their customers.  This new reality diminishes the scope for equities to provide investors with inflation-proof returns.  So, where should investors turn?

The institutional heritage of real assets

Institutional investors have been thinking along these lines for years, particularly as pension under-funding has become more acute.  With future liabilities to worry about, keeping pace with inflation is a priority and this has promoted the role of “real assets” into mainstream thinking for portfolio construction.

For US endowments, a portfolio comprising of real estate, natural resources and treasury inflation-protected securities has for long been popular.  Canadian and Australian investors, too, were early in instituting infrastructure investments, encouraged by local expertise.  After the global financial crisis, efforts to diversify away from traditional assets and into real assets gained pace and, as this trend has developed, there is now a greater emphasis on seeking diversification within the real asset space.

In taking these steps, institutions have sought to improve risk metrics as well as return outcomes and there is empirical evidence that shows how a permanent allocation to alternatives can enhance portfolio diversification, provide access to differentiated risk premia, improve volatility characteristics, mitigate downside risk and bolster long-term returns.  Equally, institutions also have the luxury of the scale and the time horizon to commit to assets that often enjoy a material illiquidity premium, bringing greater rewards in the long run.

The real asset universe

Broadly speaking, assets are considered to be “real” when they are backed by physical or tangible assets, often incorporating inflation-linked cash flows.  The real asset cohort includes:

• Property
• Infrastructure
• Asset finance
• Commodities
• Specialist lending (eg, lending to SMEs/consumer)

Each of these areas has a variety of sub-categories, each with particular risk attributes and return drivers.  Unlisted real estate and infrastructure have typically been held at the heart of real asset allocations but, as capital has chased the valuations of mainstream assets higher, institutional investors have looked to more specialist and illiquid asset classes, such as agriculture.  Moves into such niche areas have also been appealing from a diversification perspective, although large chunks of capital looking for a home have pushed up valuations in these esoteric assets too.

Indeed, the boundaries of the real asset definition have been stretched towards the realms of intellectual property (IP).  Long-lived IP assets are an expanding opportunity set, although they are not readily available through public markets.  Target areas are often established pharmaceutical technologies, music catalogue royalties and established patents or technological IP.

The characteristics of real assets

Mainstream real assets typically have hybrid characteristics, with stable income streams and the potential for equity-like upside from price appreciation.  From the point of view of inflation protection, the ability to raise income streams as interest rates (or inflation rates) increase is at the heart of their attraction for investors.

Specific real asset types can have both core and cyclical characteristics.  For example, high quality property assets with full occupancy are core in nature, while properties with construction/refurbishment risk incorporate cyclical risk.  Therefore, the way in which a real asset strategy is implemented is germane to the kind of outcome that follows.  Here are some of the recognised attributes of real assets, with examples of why the method of implementation is important within the context of investor expectations:

• Diversification to equities.  Example: real estate securities are highly correlated to public equity; bricks-and-mortar property assets are not.
• Diversification to bonds.  Example: infrastructure debt is highly correlated to bonds; listed equity infrastructure less so.
• Inflation sensitivity.  Example: Long-lease, inflation-linked income from property assets can provide a hedge against rising inflation; loans secured against real estate assets do not.
• Liquidity.  Example: listed infrastructure and REITs enjoy good liquidity in normal market conditions; private equity assets do not, particularly areas such as agriculture and timber.
• ESG. Example: exposures to transportation and energy are at risk of flouting ESG thresholds; retail and infrastructure can have progressive sustainability policies.
• Costs. Example: private equity is typically pricey, especially in niche areas; listed equity and debt is less expensive.

Picking up on the liquidity point, as indicated earlier, the observed risk/return benefit of a real asset component for institutional funds owes much to the long-term nature of the investment time horizon and reduced sensitivity to short-term pricing and liquidity issues.  The retail world takes a less stoic approach and the IA Direct Property sector is a good example of these issues.  Market distress (global financial crisis) and shocks (Brexit) can result in sudden market value adjustments of the underlying assets, as well as fund suspensions in the event of elevated redemption requests.  Therefore, it is no surprise that retail portfolios struggle to match the benefits that institutional portfolios draw from illiquid and private assets.

Accessing real assets

For so long the preserve of professional investors and very high-net-worth individuals, retail investors now have access to a wide range of specialist open and closed-ended investment funds for alternative investments, and specifically, real assets.  The availability of single-strategy funds in the areas of property (directly-invested and property securities funds), commodities (natural resources, energy, precious metals funds) and global listed infrastructure provide the means for investors to build their own specific or mixed exposures to real assets.

However, as we have seen in this brief article, the real assets suite is complex, incorporating a myriad of risks and opportunities depending upon the nature of the underlying asset and industry, as well as the choice of implementation (equity/debt, listed/unlisted).  To solve this problem, the use of multi-strategy real asset funds is a growing trend for institutional investors and high-net-worth clients, who are looking for help in building a diversified portfolio of investments that offers resilience through the economic cycle.  Given the illiquidity that characterises parts of the real asset universe, this is a challenging task and is best tackled by market specialists.

Responding to this growing demand, some asset management firms have taken steps to organise their specialist capabilities into co-ordinated real asset groups.  For example, in 2018, Aviva Investors established an integrated Real Assets function, aimed particularly at clients who are interested in the private asset sphere.

To date, relatively few multi-strategy solutions have become available in the open-ended retail market and it is not a surprise to find the likes of Hermes and Waverton offering inflation-linked and real asset strategies, given their private client/pension backgrounds.  Relevant expertise, complexity, cost and liquidity will be barriers to a proliferation of real asset product launches in a multi-strategy format.

What to look for in your real asset allocation

• Your primary investment objective: are you looking for an inflation hedge, protection against rising interest rates/inflation, diversification, improved portfolio risk metrics, attractive income?  As we have seen, different types of real assets offer different attributes and behaviours.  Remember that real assets are rarely a perfect hedge against macro-economic risks, but portfolios can be constructed to provide inflation-linkage.
• Liquidity: what is the liquidity profile of the underlying assets?  What is the liquidity profile of your choice of investment vehicle?  Are there access constraints and does it have the potential to suspend?  Does the firm have scale and expertise?  If it is a large institution, does the size of the asset base impair flexibility?
• Other general and specific risks: to varying degrees, real assets are not immune from elevated valuations/lack of opportunity, investor malaise, economic cyclicality, regulatory risk and government interference.
• Your time horizon:  If you are not in real assets for the long haul, think again.