Real assets are traditionally defined as physical investments that maintain or increase in value in an inflationary environment. In a traditional sense, real assets are those such as property and commodities. When it is a financial asset such as a pot of cash, if inflation goes down then so does the spending power. Whereas when real assets go up in value, they maintain their real value.
But the real asset universe can be broader than this, and include an array of non-physical investments with ‘real’ characteristics that result in their value or cash flows increasing with inflation. An example of this would be an infrastructure project; if a company develops a piece of social infrastructure like a school or a hospital, they will then enter into a long-term contract with the government in exchange for building it. They will then receive a pre-determined cash payment for each year over the course of the project’s life and it will be adjusted for inflation.
Real assets can bring diversification to an investment portfolio, additional sources of income, and are also able to protect against inflation. Alternative allocations can play an important part in a portfolio, but because of their specialised nature, the sector requires expert research.
Alternative investments can be important for investors in today’s market. Investors are always seeking diversification beyond the standard equity and bond asset classes. In the six years since the equity market troughed in the 2009 crash, both stocks and bonds have increased in value enormously. In many markets, bonds are trading close to all-time highs and equity markets now look expensive relative to their long-term history. It seems that central bank monetary easing has been responsible for part of this price appreciation; therefore, as monetary policy eventually tightens there is the potential for this phenomenon to reverse. If this were to happen, offsetting gains in the bond portfolio would not protect falls in the equity part of a portfolio.
This highlights the need for alternative sources of returns in a portfolio. Some alternatives – notably real assets – are also able to generate a predictable income that allows income-seeking investors to reduce their reliance on high-yield bonds, emerging market debt and high dividend stocks, these have been popular allocations for yield-hungry investors since central banks slashed interest rates to record lows. Unless growth broadens out across the globe it is difficult to see how companies will be able to generate the increase in earnings and revenues that their current elevated share prices seem dependent upon.
Exposure in different backdrops
Adjusting alternative exposure for different interest rate and inflation backdrops can be difficult. Since 1992 the Bank of England has included an inflation target as one of its monetary policy objectives. This factor highlights the fundamental tension between interest rates and inflation; too much or too little inflation can spark a change in interest rate policy to try and influence its future path.
Understanding the relationship between inflation and interest rates is central to creating a portfolio of real asset investments. One approach is to invest based on the macroeconomic environment that you expect, paying close attention to expected rather than current movements of inflation and interest rates. No single type of real asset will provide positive returns in all environments, meaning a strategy with just one or two asset classes may struggle through certain periods. This argues for an unconstrained approach to real asset investing rather than a benchmark relative approach. With no benchmark the objective becomes creating attractive risk adjusted returns which protect against inflation over the long run.
Research is key
The real asset universe includes a wide range of investments with some valuations driven by supply and demand, some that are a function of discounted cash flows and some with elements of both. Real asset valuations can also be driven by adjustment in the general price level of transactions and contractual inflationary adjustments to cash flow. With valuations dependent on both interest rates and inflation, the real asset paradox is born: inflation can drive real asset valuations up but also encourage policy makers to raise interest rates, potentially driving real asset valuations down.
Challenges of real assets
As with all investment classes, the alternatives sector has its own set of specific risks and challenges which investors ought to bear in mind. At the top of the list is the difficulty of finding independent analysis on these niche asset classes, as most are not covered by the mainstream or industry press. In addition to this, comparative analysis, upon which many traditional investors rely, is also limited as they typically have few (if any) peers.
Additionally, a lot of these investments have high minimum investment levels, which can prevent typical retail investors from getting directly involved, so they are somewhat inaccessible. There are also long lockups, so investors would have to commit capital for a 10-year period. This has put investors off historically.
Another difficulty lies in the fact that the alternative asset universe is constantly growing and evolving, and many investments lack historical data on which to base quantitative analysis. Coverage of this vast and unfamiliar field can therefore be a daunting task, which investors should not undertake lightly.
Getting comfortable investing in alternatives requires thorough quantitative and qualitative analysis. Investors should examine the true drivers of the investment’s returns; understand the philosophy and process of the company, as well as the sustainability of the opportunity and the potential impact of changing regulations. For investors who can do the research, the alternatives universe can offer a wide range of opportunities for the income investor’s current dilemma.
Searching for new assets
When searching for new assets investors may want to identify asset classes that have predictable returns that are not impacted directly by the equity or bond market, and that can be sustained regardless of economic strength. Investors can also look for investments that are differentiated from those they already have exposure to. Investments can have an element of inflation protection and pay an income, which may be key characteristics that will prompt the investor to conduct further due diligence.
You can also look for areas that demonstrate resilience in an environment where equities and bonds are not performing well. Defensive and non-cyclical areas like ground rents and social infrastructure can seem like sensible places to invest. Demand for university courses persists through recessions – as does demand for student accommodation – so this is an area that could continue to deliver stable income.
As with any asset class, there have been some trends emerging in alternatives. With investors forced to look beyond government bonds for their income, a wide range of alternative income funds have emerged to satisfy this demand. There has been a trend out of the ordinary securitisation vehicles in the universe of alternative assets. More and more asset types are being securitised and recently there are some emerging trends in more esoteric types of securitisation such as film rights and healthcare.
Biotech has been an eye-catching investment recently. This is where drug companies sell a portion of their royalties for a capital sum as an alternative way to financing the company. These royalties from drug sales are designed to offer investors steady, long-term cash flows that are not necessarily reliant on drug company profits or share prices. The asset class is supported by the demographic trend of aging populations that should result in increasing future drug sales and the potential for attractive returns for royalty owners.
Alternative asset classes such as these often have the potential to deliver less correlated returns. But investing in them requires thorough due diligence on a niche area of the economy, which often is under-researched.
Solomon Nevins is a fund manager at Architas