The markets have reached an inflection point, prompting institutions to significantly increase their long-term allocations to real assets, argue Bernie McNamara, Michael Hudgins and Pulkit Sharma
The investment world has reached a tipping point - a realisation, if you will - that will dramatically alter the investment allocations of institutional investors. History shows that secular changes in the investment environment force dramatic changes in asset allocations. In the years following the Great Depression and World War II, many institutional investors were invested almost entirely in bonds, clinging to the stability of fixed income amid turbulent equity markets, volatile GDP growth, and low but bumpy inflation.
Then, in the 1960s and 1970s, the investment world reached an inflection point, as inflation began to spike and stock market volatility declined following two decades of stable, high GDP growth.
Investors moved aggressively into equities in search of higher real returns, and most institutional portfolios underwent a dramatic shift to the soon-to-be commonplace 60-40 stock-bond mix.
We believe we've reached another inflection point, and we are making a bold claim: that real assets - which include investments in infrastructure, real estate, shipping, and other large-scale, productive hard assets - should make up substantially larger allocations of investor portfolios, from the current average of 5-10%, to 25% or higher.
The rationale? With higher income potential than bonds and strong risk-adjusted return potential relative to equities, real assets provide unique solutions to the serious issues facing investors searching for income, growth, inflation sensitivity and portfolio diversification.
Investors are at various stages of this realisation, but those who recognise, embrace and act on it are likely to have better investment outcomes than those who do not.
A convergence of long-developing trends and rapidly changing realities has given rise to concern over the ability of equities and bonds to realise the absolute and/or risk-adjusted investment requirements of institutional investors. Fixed-income sectors are generally offering yields that are at or close to historic lows. The 29 June 2012 yield-to-worst for the US Barclays Aggregate Bond index was 1.98%, and future returns are not likely to exceed the coupon by much, if at all.
Equities have lagged over the most recent 10 years, with an annualised total return for the S&P 500 of 5.3% (as of 29 June 2012). In addition, uncomfortably elevated equity volatility implies a decline in the prospects for attractive risk-adjusted returns, particularly as expectations for the US economy have plunged. During the most recent decade (2000-09), US GDP growth averaged just 1.7% per year, and most forecasts are not much more optimistic for the US or other developed markets.
At the same time, the spectre of inflation looms in the mid term in the wake of massive fiscal and monetary stimulus, further threatening investors' real return potential. Although no-one can predict with certainty the timing of inflation increases, one thing is certain: when inflation occurs, it will be very painful for portfolios that are not prepared for it.
Real assets to the rescue
A new normal? Perhaps. A new world of uncertainty, heightened volatility and slower growth? Very likely. And investors are beginning to search out new opportunities that can deliver when the ‘big two' traditionals (equities and fixed income) cannot.
Real assets encompass a wide variety of tangible investments from the various flavours of real estate investments to infrastructure to alternative strategies offering access to natural resources that give investors optionality in this world of uncertainty. Thus, real assets provide the ability to serve as a stable source of income in weak markets and to participate in the capital appreciation associated with strong markets.
Why should investors increase their real assets allocations? First, these investments typically generate yields that are attractive against many fixed income alternatives. The stable bond-like payment structure - typically underpinned by long-term contractual agreements - can serve as a reliable base for stable mid-long-term total returns by contributing to price appreciation in up markets and offsetting losses if values decline.
Second, as a higher yielding, non-bond complement to fixed income, real estate and other real-asset categories offer the potential for equity-like upside. While bonds pay out a regular fixed coupon until they reach maturity, infrastructure payouts and equity values can grow in line with cash flow growth.
There are further potential benefits. The private real-assets investment universe offers multiple ways to access the real estate investment opportunity. These various investment opportunities come with equity-like total return targets ranging from a competitive 7-11% for core/core-plus property (gross of fees), 10-12% for OECD infrastructure, to those that are clearly attractive at 14-20% for value-added/opportunistic strategies (net of fees) for both real estate and Asian infrastructure.
Figure 1 attempts to present best estimates of expected returns for bonds, equities, property and infrastructure. Return estimates are based on public sources for bonds and JP Morgan proprietary research for equities, US property and infrastructure.
The various real estate investment strategies allow investors a flexible palette from which to construct a real estate allocation that does not require a significant compromise on returns whether sourcing the allocation from existing bond or equity holdings from the typical ‘big two' traditionals portfolio.
And low correlations between real assets and equities and bonds (figure 2) offer significant diversification benefits for investors willing to add real assets to the traditional stock/bond portfolio. More critically, a key point of the realisation is not simply that a higher allocation to real assets is worth exploring but that a more diversified execution makes sense too.
Figure 2 shows a colour-coded correlation matrix, demonstrating 20-year annual correlations for equities, fixed-income and various real asset categories. As the heat map shows, not only do most real assets exhibit low correlations with financial assets, but there are meaningful degrees of non-correlation among different real asset categories.
In particular, emerging market real estate and infrastructure have demonstrated low correlation with virtually every other real asset investment. As a result, investors who like their home country core real estate for what it does for their portfolios may want to consider India and China real estate or OECD infrastructure as a complement.
Emerging market real estate offers growth-driven opportunistic investing in a low-growth world, and OECD infrastructure acts as an effective complement to core property given that it does similar things - for example, steady income potential, equity-like upside capability, lower volatility, and diversification to financial assets.
And all this is delivered with proven inflation sensitivity. A powerful supportive argument for a real assets allocation is that property and infrastructure cash flow and valuation offer a heightened level of inflation sensitivity that can contribute meaningfully to a portfolio's ability to generate returns that meet or beat inflation in most regimes.
The inflation sensitivity of real estate and infrastructure should also be relatively persistent, as that capability is generally supported by structural elements. These elements include clauses in leases and contracts that require annual rent (property) increases linked to inflation and the sensitivity of values to the increases in prices of inputs (for example, commodities) for the assets themselves, which, over time, support value appreciation.
As figure 3 illustrates, during the last period of sustained inflation in the US (1970-85), both private real estate and regulated utilities outstripped CPI substantially - a clear indication of the ability of real estate returns to respond to inflation, and the stability of infrastructure cash flow, given the continued utilisation of essential infrastructure assets, even during times of economic distress.
Building a diversified ‘real' portfolio
Historically, institutional investors have turned to real estate for diversification from their traditional financial assets. For many investors, the first step in this search for diversification has been to invest in domestic core real estate.
Yet, increasingly, the sheer variety of well-defined real estate strategies allows access to a more global, diversified set of investment opportunities. And the full real-assets palette only increases the opportunity set, as well as potential to create diversification along multiple lines, including style and geography, as well as major investment themes such as income, value and growth.
For example, just as they have long done with their equity allocations, investors can gain exposure to real estate strategies offering different nvestment styles, including value-added and opportunistic. Strategies can also be selected to deliver global diversification; an allocation to emerging markets through housing, office and infrastructure developments supporting the enormous growth and mass urbanisation of developing Asian economies provides exposure to both global diversification and economic growth.
While growth is slowing in the developed economies, the emerging markets enjoy more attractive prospects for growth-induced cash flow and price appreciation that should exceed that of developed economies over the medium and long term.
These real estate and other real assets strategies will generally act differently over time, delivering on different themes. Investors can use these degrees of non-correlation to their advantage in building more diversified allocations to meet their specific objectives.
As figure 4 demonstrates, there is a wide range of real estate categories, each with a unique set of risk-return characteristics. For example, while US and European core and core-plus real estate generates income-driven returns and sensitivity, an allocation to European value-added real estate delivers complementary style diversification (focus on finding upside - that is, value) and global diversification.
As already mentioned, an allocation to strategies focused on, for example, China and India, inject a combination of growth and global diversification that is sorely lacking from the traditional US or European real estate allocation, even if diversified across different styles. Similarly, infrastructure can deliver on these themes.
Finally, figure 5 demonstrates that there are concrete benefits to be earned by putting other real estate sectors into a real estate portfolio with the objective of building out a diversified allocation.
Compared with the typical, diversified real estate portfolio of either US or European core and value-added, a globally diversified portfolio looks better on a number of risk-return metrics, including a significant increase in the Sharpe ratio, supported by an increase in target return and decrease in volatility. Adding infrastructure to this portfolio also offers improvement in the risk-return profiles.
Although it is still early in the process, many investors have had this realisation and are acting upon it. Figure 6 presents ‘The Realisation Pyramid', which summarises the real-assets exposure of over 2,500 institutional investors. Levels range from no real-assets exposure in the traditional category at the base of the pyramid, where investors are relying solely on stocks and bonds, up to the enlightened level, where investors are allocating 25% or more to real assets across a range of different categories.
And while only 7% of the plans reviewed have allocated 15% or more to real assets (that is, they are in the diversified or enlightened levels), these investors represent nearly 30% of total assets under management across all of the investors in the sample.
This statistic reflects the fact that, on average, larger investors have been at the forefront of increasing allocations to real assets. Many of these investors are high-profile institutions in the US, Canada, and Australia, and most have featured substantial allocations to infrastructure, among other real assets, for close to two decades.
Our expectation is that over the coming years more and more investors will have the same realisation. As investors face considerable challenges in their portfolios, particularly within their public market allocations, real assets present attractive alternatives to the ‘big two' .
Real assets deserve to be considered as a foundational asset class (that is, a third traditional asset class), offering an attractive mix of options for yield, growth, diversification, lower volatility, emerging market exposure and inflation sensitivity. And early movers should continue to be rewarded in the midst of this revolution - or evolution - in asset allocation.
Bernie McNamara, Michael Hudgins and Pulkit Sharma work in the global real assets team at JP Morgan Asset Management