Alternative ideas

This article is part of
Multi-manager – June 2016

Alternative ideas

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.