The rise of real asset portfolios requires an understanding of the underlying characteristics and risk factors, rather than the labels, write Peter Hobbs, Guy Hopgood and Kathryn Saklatvala
The concept of the ‘real asset’, ‘tangible asset’ or ‘inflation-sensitive’ portfolio, firmly established in certain asset owner circles, has gained ground in recent years. Among US endowments, a portfolio consisting of real estate, natural resources and Treasury inflation-protected securities has long been popular.
Canadian and Australian investors, leaders in infrastructure, were also early to institute real asset units. The trend reached its zenith in 2016, when the California Public Employees’ Retirement System instituted a real assets division and the Canada Pension Plan Investment Board appointed a head of real assets.
For European asset owners, this approach has been slower to gain popularity. To some extent this is a side-effect of portfolio composition. Real assets other than real estate seldom featured until the post-financial crisis wave of infrastructure investment.
Timberland, a US staple, has only recently become popular. Master limited partnerships, used in the US for some traditional energy-related investing, do not have an international equivalent.
Yet the rise of infrastructure investment has been a catalyst for change. Infrastructure can be grouped with real estate because of its similarities, creating a bedrock for a real asset portfolio founded on core characteristics rather than labels.
While the post-financial crisis phase was marked by diversification towards real assets, in more recent years there has been greater emphasis on diversification within real assets.
A summary of real asset segments, arranged by risk-return profile and market size, is provided in figure 1. Their common theme is values based on contractual claims on physical assets.
At bfinance, demand for ‘niche’ sectors has increased substantially during the past three years. This has been encouraged by a compression in returns for core/core-plus real estate and infrastructure. Likewise, within real estate and infrastructure what was niche is now mainstream. Infrastructure funds are tapping into sectors that would not have previously been included, such as energy storage or data centres.
UK pension fund real estate portfolios often now include private-rented, long-leased and emergent sectors.
Investors can think of real assets in terms of the ‘four quadrants’ traditionally applied to real estate: unlisted, listed, debt and equity. Some vehemently argue against the inclusion of listed infrastructure and real estate investment trusts, but we urge a focus on contents rather than labels. Although they are correlated with stocks, correlation is also evident in some unlisted sectors. There is a similar divergence over the inclusion of debt strategies, which can offer yield and downside protection at a time of aggressive pricing.
Build it, buy it or brand it, many asset managers have now established real assets units in a bid to take advantage of industry trends. Ten years ago, it would have been hard to name a head of real assets at a major asset management firm. Today, the role is a common one as divisions bearing this label have sprung up at most global asset managers.
This nominal change has frequently been accompanied by the establishment of new asset classes and products; although many firms had expertise in at least one sub-sector, additional teams have been developed or acquired to flesh out the wider suite.
Meanwhile, specialist real estate or infrastructure managers have spread into each other’s territory and/or other real asset sectors, again through growth, M&A, or a combination of the two. Figure 3 illustrates these two variants of real asset managers, alongside two other distinct types – fund-of-funds managers and investor-owned houses.
No type is inherently superior but, given the recent organisational overhauls involved, investors should pay close attention to how the real assets function at a prospective manager has evolved. Where the group’s constituents have been brought together, they can face significant challenges in overcoming previous silos, developing a strong single leadership and working together on integrated products – including the real asset strategies with allocations to multiple sleeves that are explored next. In the case of mergers, staff turnover can be a significant problem. With acquisitions come risks around integration and the potential loss of key personnel.
A growing number of asset managers are developing a multi-real-asset capability, delivering several real asset types under one mandate. With investors creating more holistic real asset portfolios and asset managers developing broader divisions, it is perhaps logical that diversified real asset mandates would be the next step. These can be implemented in a range of different ways.
Over the past year, bfinance has supported a number of investors with searches for ‘diversified real assets’ managers. These have varied significantly in terms of preferred sub-sectors and implementation approaches. A small minority of investors appear to be interested in integrating real estate and infrastructure in this manner.
More popular is the single mandate for a range of niche real assets. Such mandates have necessitated fresh approaches to the market, with few ‘off the peg’ solutions.
Structures fall into three primary categories: pooled funds, ‘funds of in-house funds’ and ‘funds of external funds’ (classic funds of funds). Pooled funds blending real estate and infrastructure are relatively rare (figure 4), but there is a substantial group of managers offering wrappers around in-house products to achieve this effect.
Meanwhile, pooled funds for multiple niche real assets are somewhat more mainstream. Some of these niches are esoteric indeed; the likes of pharmaceutical intellectual property and music catalogue royalties stretched ‘real asset’ definitions to the limit. The allocation approach for funds of in-house funds varies considerably. In some cases, an internal team allocates clients’ assets to the funds. In other cases, managers offer a passive allocation (for example, 50/50 between two funds).
Pros and cons of multi-real-asset structures
Each of the three structures mentioned has strengths and pitfalls. Funds of external funds tend to be the most expensive, due to the double layer of fees, but the increasing use of secondary and co-investment strategies can help to cut the fee load. When a manager structures a wrapper around its own funds there is generally no additional layer of fees versus a pooled fund (figure 6). Meanwhile, pooled fund charges are on a par with single-sector versions of the strategies.
Analysis of performance records and teams can be tricky for funds of in-house funds, since records are composites of products and thus not highly representative, while pooled funds tend to have short-lived track records.
Alignment of interest should be watched with care; where an allocation capability exists, it is not always clear that clients’ assets are being invested in the sub-funds in a manner that best suits their interests as opposed to the manager’s fundraising timeline. In comparison, it is more straightforward to assess alignment of interest for pooled funds.
Customisation is critical to real assets. It is a label that means very different things to different investors. Here, funds of in-house funds might have a customisation edge. Their ability to piece together chunks of sub-funds can match well with the varying nature of investors’ demands. The potential downside, however, is the narrower opportunity set.
It is worth noting that very few multi-real-asset strategies exploit one potential advantage of breadth – taking a more tactical view on current market dynamics and pricing. In our analysis, the allocation teams for wrapper products do not generally engage in this type of decision-making.
As always in this sector, investors should beware of the labels. For example, one real estate manager pitched a strategy incorporating ‘social infrastructure’ – a term traditionally associated with availability-based payments from the public sector but, in this case, applied to nursery site freeholds and urban car parks with long-term corporate leases.
Peter Hobbs is a managing director, Guy Hopgood is a senior associate and Kathryn Saklatvala is director of investment content at bfinance