Alternatives, Asset Allocation, Asset Managers, Consultants, Institutional Investors

How to Build an All-Season, Real-Assets Portfolio: Practitioners Opine    

Volatile equity markets and inadequate bond yields have driven a spike in investor interest in real assets this year. Investors are building larger and more diversified real-assets allocations, or considering doing so, by adding global and sector exposure, including infrastructure, maritime and international real estate to their real asset mainstay, domestic core real estate. IA spoke recently with four specialists in real assets investing and asked them to share some of their thoughts on the strategy and on what new and prospective entrants to the class should investors consider in structuring their exposure.

According to data research firm eVestment, total liquid real assets under management for U.S.-domiciled investors at the close of Q1 2018 stood at $20.7 billion, $19.4 billion at the close of Q1 2017 and $14.3 billion at close of Q1 2015. Total AUM in U.S. real estate investment trusts (REITs) for the same periods were $79.5 billion, $98.1 billion and $80.6 billion, and for global REITs $49.3 billion, $51.1 billion and $50.4 billion, respectively.

According to Pulkit Sharma, head of portfolio construction, real assets and other alternatives, J.P. Morgan Alternatives Solutions Group, “We define an all-season real assets portfolio as a collection of real assets that form the ‘Core Foundation’. These are real assets that exhibit enhanced resiliency across economic regimes. The Core Foundation can be viewed as an anchor allocation to real assets, given the similar attributes these investments exhibit: diversification from public stocks and bonds, inflation-protection, steady income and lower volatility of returns.” The primary component of the Core Foundation is core real estate, which typically comprises domestic exposure and, increasingly, international investments in developed markets, he said. “In the past five to 10 years, we have seen many investors add core infrastructure to further strengthen and diversify their Core Foundation,” he said.

The firm manages some $100 billion in global real estate and other real assets such as infrastructure and transport.

Infrastructure is additive because it enhances the defining characteristics of the Core Foundation: additional diversification, stable income and often more explicit inflation protection and greater downside resilience in difficult economic times, according to Sharma. He added that the third component of the Core Foundation, core transport, also exhibits foundational characteristics—most importantly, diversification, due to its global nature, plus enhanced income potential through long-term charters or leases with high credit quality counterparties.

“Over the long-term, a well-diversified portfolio of core real assets has the ability to generate attractive investment outcomes versus a 60/40 stock/bond portfolio: two to three times more income, a 200–300 basis-point-return premium, up to 20-30% lower volatility, low equity beta, low duration risk, better downside resilience and greater inflation sensitivity,” he claimed. He declined to share returns in the class generated specifically by JPMorgan.

“The way we look at things when it comes to real assets, the starting point is what is the role within the portfolio?” said Gabriel Nelson, associate director, liquid alternatives, at Pavilion Advisory Group, which has offices in Montreal, Minneapolis and Chicago.

For Pavilion, the role of real assets in a client portfolio is twofold: primarily, it provides diversifying earnings streams, as well as an unexpected-inflation hedge, Nelson said. He added that Pavilion has seen increased interest from client groups asking the firm to assess if they are properly positioned for increasing inflation.

Pavilion implements its strategy using liquid real asset classes or, where appropriate or clients have the ability to build in some illiquidity, through illiquid real assets, Nelson said.

He explained that Pavilion’s starting point is to achieve an equal weight for four liquid real assets using the equal-weighted, blended, real assets benchmark it has created.

“So, thinking holistically, one has 25% allocated to commodities and the other 75% allocated to diversified earnings streams. That would be how we think about a diversified real asset pool,” he said.

“Having a diversified real-asset portfolio is very important over a market cycle,” asserted A.B. Orr, executive director, alternative investments, Providence St. Joseph Health, a Reston, Washington-based not-for-profit health care provider—one of the largest in the U.S. with 50 hospitals in seven states. The fund has in excess of $20 billion in investable assets, managed via nine separate investment pools, each with its own asset allocation. Some have real assets, some do not, Orr said.

“It’s important for the simple fact that when you’re formulating asset allocations you are looking first at public equity and fixed income. Alternative investments, inclusive of real assets, diversify your portfolio—giving you enhanced risk diversification, risk mitigation and downside protection via low correlation with traditional assets. With a portfolio of 100% equity and fixed income, that won’t occur.”

Ideally, an investment portfolio should have a hedge against inflation, he said. “You don’t want every part of your portfolio to be negatively impacted by inflation. You want assets that react positively when there is a threat of inflation or actual inflation.”

In its May 2018 Real Assets Outlook, Verus placed a “positive view” on only three of nine real assets classes, namely: private real estate, private natural resources and midstream energy/Master Limited Partnerships (MLPs). It was neutral on REITs, commodities, infrastructure, neutral/negative on timberland, and negative on Treasury Inflation Protected Securities (TIPS) and farmland.

Regarding its neutral/negative call on timberland, the report said that “despite several years of disappointing returns within timber, we don’t see returns reaching beyond single‐digits on a go-forward basis. Competitive timber from South America has driven prices for certain softwood products lower and favorable hardwood markets in the Pacific Northwest remain difficult to access.”

Where to start?

Because of the relatively wide range of assets to use in a real assets portfolio, it can be difficult for a new entrant to the strategy to know where to start, Orr noted, adding that if he were entering into real assets for the first time he would seek out a real-assets diversified fund. “You want real assets but you don’t know the variance between different asset types. There are a number of competing funds in the market place that enable you to get started.” He suggested that “if you come from a fixed-income background, you may lean toward TIPs, for instance, or if from an equity background you may lean toward REITs. Take your background and start from there, and then use your hard-knocks education,” he advised.

The ability to hedge short term versus long term, needs for liquidity, and the availability of the product is important. REITs are readily available, but timberland is not always readily available to all, he said. Fees, too, are important—not all asset classes cost the same to gain the desired exposure. “These are the things that you must discover on your own and that you gain with experience,” he said.

Between 2012 and 2016, Seattle-based Vulcan Real Estate monetized some $3 billion in real estate, and is now in the process of rebuilding its portfolio, according to Ada M. Healey, vice president for real estate at Vulcan Inc.

The firm manages approximately $1.5 billion of real estate assets, which comprises land, operating assets and projects under construction. Its real assets portfolio includes holdings such as inflation-linked bonds. “Our owner also has an extensive art collection, which I would categorize as real assets,” Healey said. “In terms of real estate specifically, our development portfolio includes both commercial office and multi-family residential (rental) product types.”

She said the firm’s current allocation is about 50% commercial and 50% residential real estate. “We like the fixed-income stream from long-term leases at our commercial projects combined with residential income characteristics—residential can be marked-to-market more often due to the short-term nature of residential leases, she said, declining to disclose the performance of the firm’s real-assets investments.

Healey characterized a real assets portfolio as “investments that provide a material return above inflation. But, in terms of an “all season real assets portfolio,” she said, “you want to have geographic diversity—not just within the U.S. but also globally to manage risk more broadly. Also, it is important to include ‘economic’ diversification, not just geographic diversification.”

For instance, she said, a large position in Seattle and Silicon Valley/San Francisco, while geographically apart, would not meet diversification goals since the two geographies are highly correlated from an industry (tech concentration) standpoint.  “While diversification always reduces risk, this is less important in our real estate portfolio because Vulcan gets diversification from other non-physical assets.”

She posited that in the current environment of volatile equity markets, rising interest rates and the specter of rising inflation, the role of real assets/real estate in an investment portfolio is threefold:

  1. Return generator
  2. Hedge against inflation
  3. Combination of asset appreciation and income return

“Therefore real assets are a key component of any diversified investment strategy,” she said.

The bottom line

Real Assets are well-positioned versus traditional asset classes in today’s uncertain economic environment. According to JPMorgan’s Sharma, “One of the defining attributes of real assets is the diversification they provide to volatile and often correlated public equities. The performance of real assets is largely tied to the local markets in which they are located or operate, and they are subject to local supply and demand dynamics. Their connection to local markets is a key contributing factor to their low correlation to both fixed income and equities. From an interest-rate perspective, historically there has been very low correlation between interest-rate movements and the returns of real assets, in particular core real assets.  And that is because rising rates are generally consistent with an improving economic environment, which we are currently in, with healthy job growth and low unemployment. Again, in such a scenario, vacancies can be filled and rents raise—which is particularly true in periods of low new supply, like today.”


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