Disappointing global economic growth in the recent past has moved central banks to intervene with aggressive monetary policy, fueling the drive toward riskier asset classes. Inflation has been muted and traditional fixed income assets have not provided the yield necessary to meet short and long-term income needs. In response, an increasing number of investors are looking to other asset classes to serve as sources of income and to maintain purchasing power.
Institutional investors have long incorporated real asset classes such as commodities, real estate, agricultural land or oil into their portfolios. The potential advantages to these types of exposure are many, and include dampening inflation risk, improving portfolio efficiency, accessing stable bond-like yields and participating in equity-like capital appreciation.
Financial advisors and individual investors are now following this wisdom and adding real assets to their portfolios, aided by two major factors. First, investment vehicles such as exchange traded funds (ETFs) join a growing menu of mutual funds that can make real assets more readily available. Second, the range of investment strategies is continually expanding, offering asset owners’ maximum flexibility in addressing all their real asset needs.
However, the sheer magnitude of available options may be acting as a headwind, hindering investors’ adoption of real assets. Potential users are often discouraged because they are not sure which real asset strategies are most appropriate to meet their investment objectives. At FlexShares, we believe this conundrum presents an opportunity – because there is a simpler way to take advantage of the benefits of real assets.
First, some background on real asset investing. Prior to the late 1980s, many investment professionals believed the best way to mitigate portfolio risk was to diversify holdings among different asset classes, focusing primarily on stocks, bonds and cash. This approach, popularized by institutional money managers, ultimately led to the model 60% equity/ 40% fixed income portfolio.
This traditional asset allocation continued to evolve as institutions sought investments that better matched their liabilities and also offered higher-growth alternatives. U.S. entities with pensions or other fixed long-term funding obligations started to expand their asset allocation to include hedge funds, private equity, foreign stocks and real assets. This approach was popularized by David Swensen, the chief investment officer of Yale University Endowment. Over time, a wide range of other institutional investors embraced more diverse asset allocations, and began to deploy a greater share of their investment capital toward real assets, as demonstrated in Exhibit 1.
In Swenson’s endowment approach, real assets account for approximately 30% of the total asset allocation and consist of “pure play” (or single-focused company) real asset investments and Treasury Inflation Protected Securities (TIPS), which are real-return financial instruments. Swenson’s asset mix excluded the commodity markets due to their volatile nature and lack of income opportunity. This allocation approach emphasizes long-term assets, stable inflation-adjusted income and current yield.
However, it also presents drawbacks for individual investors, who typically lack:
It’s no surprise, then, that many potential investors either avoided investing in real asset classes or invested in a sub-optimal, narrow manner.
One desirable solution may be a turnkey, equity-based real asset allocation product that addresses the identified drawbacks and, ideally, could be applied across the full range of client investment objectives.
Historically, the strong dividend payments of real asset securities have presented a good option for income sensitive investors. This is especially important in zero or near zero rate environments where traditional income producing assets such as fixed income, have compressed yields relative to historical norms. The income component is largely driven by the generally steady and predictable cash flows produced by real estate. Due to contractual and regulatory agreements, cash flows generated by real estate and infrastructure asset classes are high-confidence cash flows. As commercial and retail rental rates are re-negotiated periodically, they can better adjust in rising-rate or inflationary environments. Furthermore, because the infrastructure industry tends to be highly regulated, these companies are contractually allowed to make periodic pricing adjustments, typically based on the Consumer Price Index (CPI). While economic conditions may help or hurt asset-level performance, the contractual nature of infrastructure-related revenue streams tends to make flows more secure. Consequently, infrastructure cash flows persist even when economic growth is subdued.
In addition to income, the total return potential of real assets is another attractive feature, as highlighted in Exhibit 2. Due to their sensitivity to macroeconomic trends, real assets offer potential capital appreciation. When economies expand, the global demand for natural resources and commodities such as copper, iron ore, liquefied natural gas and grains all typically increase. This expansion ultimately affects related industries like home builders, infrastructure projects and fuel suppliers. The rapid growth in emerging economies, fueled by urbanization, raises demand for energy, industrial metals, infrastructure and housing. This increase in demand positively affects real asset growth and capital appreciation prospects.
The current non-seasonally-adjusted CPI level is historically low. Many investors, however, have liabilities that span multiple inflationary cycles as well as other expenses that march higher than traditional inflation measures (e.g., health insurance premiums), and so require inflationhedging tools to address these situations. Historically, real assets have responded favorably in rising inflationary or expanding economic cycles. As a result, real assets are strongly correlated to inflation, as highlighted in Exhibit 3.
Consequently, many investors seek real assets to diversify away inflation risk, while also complementing their return objectives. The attractive inflation sensitivity of real assets is a key reason why many institutional and retail investors desire real assets exposure.
Given rolling environmental, resource scarcity and inflation/disinflation concerns, the need for new sources of portfolio diversification has never been stronger. In the hunt for unique sources of return, we believe now is the time to consider real assets in your portfolio construction. Real assets may play a key role in driving global growth and providing strategic long-term investors with a new way to construct a more efficient and balanced overall portfolio. We believe an allocation to real asset classes in a traditional portfolio is beneficial for investors looking to minimize risk and also address income and capital appreciation objectives. It may provide improved inflation-adjusted annualized returns in periods of rising inflation and downside protection through income, along with equity-like upside.
For more information contact FlexShares at 1-855-FlexETF or visit us here .