August, 2014 Print
As the conventional asset classes of equities and bonds continue to present challenges for local authorities, what part can real assets play? Matthew Craig examines the issues
The growing investor interest in real assets is a reflection of both unease with market conditions now and a forward looking determination to find secure investments that match pension promises. Under the umbrella term of real assets, most investors are looking at assets such as commodities, real estate, farmland, infrastructure, timberland, shipping and possibly more esoteric niches, such as aviation finance.
In 2008, many pension funds got a shock when equities showed their volatility and bond markets their illiquidity at a time of crisis. Asset values plunged, and it dawned on investors that supposedly safe fixed income assets carried more risk than was previously thought. In this scenario, holding physical assets which play an important role in peoples’ lives is a way of reducing reliance on financial markets. And since 2008, as central banks in the US and the UK have printed money to stave off depression, real assets are seen as a defensive play should inflation take hold.
The appetite for real assets is also due to long-term investors wishing to diversify their portfolios and find a better match for long-term liabilities. If real assets can also preserve and grow capital, as well as bring in stable cash flows, then those attributes are also positive factors encouraging investment. Allocations to these assets can fall under a general alternatives allocation or within an opportunistic investments bucket, or even as stand-alone investments. In a recent report on real assets, Standard Life Investments global thematic strategist, Frances Hudson, said: “Real assets are favoured for their diversification potential, arising from a lack of correlation with other assets and each other, and also their inflation hedging properties, making them very powerful in portfolio construction. Significant changes are taking place that could broaden the appeal of real assets to global investors, including banks scaling down their exposure to real estate, infrastructure and commodities.”
At present, most investors hold real estate and maybe infrastructure to fulfil the role of real assets. Investment in the likes of commodities, or farmland, is something that pension funds may consider and could do in the future, but relatively few have done so yet. According the UBS Asset Management annual report Pension Fund Indicators 2014, the average asset allocation to alternatives for UK pension funds was 9% in 2013, up from 1% in 1996, while real estate allocations have fluctuated between a high of 16% in 1974 (coincidentally a period of inflation in the UK) and 1% in 2004, when equity markets seemed rosy. Currently, real estate allocations are at 7%.
At the West Midlands Pension Fund (WMPF), there is a 4% allocation to infrastructure and a 9% property allocation, including both direct and indirect property. WMPF director of pensions, Geik Drever, commented: “There are no direct allocations for other real assets, but investments may be made as part of broader allocations, for example under Special Opportunities, where aircraft leasing investments are currently held.” Asked about the main benefits of real assets, Drever listed diversification, capital appreciation, yields and inflation hedging.
Comments from pension funds show that inflation protection is seen as an important aspect of real assets. The Strathclyde Pension Fund has a target allocation of 10% to direct real estate and their head of pensions, Richard McIndoe, said that he sees diversification and inflation protection as the main benefits of real assets, saying “the inflation protection aspect is increasingly important to us.” Surrey County Council strategic finance manager (pension fund and treasury), Phil Triggs, added that diversification and inflation proofing through index-linked income streams were the main attractions. “With inflation regarded as a future real threat, a switch to these assets is regarded as a good tactic,” he commented.
Up to 2008, many pension funds saw hedge funds as an asset that could protect against unforeseen market events, but once the global financial crisis hit, only a few specific hedge fund strategies gave downside protection. At the same time, the long-term fall in bond yields has made index-linked bonds scarce and expensive. In Pension Fund Indicators, UBS Asset Management put forward assets such as student accommodation, social housing, direct real estate, long lease property, direct infrastructure and ground rents as assets that could give inflation protection and diversification. While areas such as social housing and ground rents can give long-term, inflation-linked returns in the form of cash, investors have to take on risks such as illiquidity, tenant risk and other risks associated with property such as development and leverage.
Because of the various risks of real assets, pension fund investment staff and trustees have to build up their knowledge and understanding of the different assets and this can take time. Using pooled vehicles, or a fund of funds, could help, but this may add extra fees and investors may feel that a standardised product does not meet their own particular needs. McIndoe commented: “Each of the categories you list has their own challenges. With direct real estate it is the idiosyncrasies of individual properties, and the need for asset as well as portfolio management.” And according to Triggs, stamp duty is another potential obstacle.
The state of the market for each category of real assets is a factor that investors need to consider. WMPF’s Drever said: “Some aspects of the current environment make certain investments attractive, i.e. the lack of funding for shipping and aircraft, but conversely other aspects currently prevalent make certain investments less attractive, i.e. lots of money going into property which is pushing up prices.” And for large pension funds, finding institutional quality investment opportunities which are of sufficient scale can be an obstacle to investing in real assets. Drever added: “Furthermore, for large assets such as ships, aircraft, toll roads etc. there is some uncertainty of how exits can be generated to deliver returns to investors.”
Often, finding the right investment vehicle is a major challenge for investing in real assets. Commodities such as raw materials, oil, precious metals and agricultural produce and livestock offer another way to gain exposure to the industrialisation and economic progress of emerging markets, and diversification from listed equity and bond markets, but there is debate on how investors should tackle this area. Baring Asset Management recently said that resource sector equities are more attractive investments than direct holdings in physical commodities and that investors should focus on companies not commodities. Barings head of global resources, Duncan Goodwin, commented: “As commodity prices are closely correlated with rises in consumer prices, investment in the resources sector has the potential to act as a hedge against inflation. We believe the opportunities in the sector are as strong as they have been for several years and expect a positive re-rating of the sector and associated gains for our resources fund irrespective of the macro.”
While allocations to real assets are comparatively modest now, they are expected to rise over time, as investors get to grips with this asset class. Commenting on the role of real assets in pension fund portfolios in the future, McIndoe said: “They all could have a place. Infrastructure will continue to grow and will become a significant allocation for many funds – 5% to 10% or more. Farmland, timberland, leasing, shipping, etc will probably always be niche exposures of a couple of percent at most. Commodities may only appeal to a few funds but it may get decent allocations from them.” From her perspective, Drever mentioned property and infrastructure, and did not rule out other real assets entirely: “WMPF have had a long-standing allocation to property, and it is envisaged that this will be the case going forward. Infrastructure is a more recent allocation and we do like the benefits of inflation-linked income streams in this asset class, which is a good match to our liabilities.” Triggs also sees a role for real assets in future allocations and brought in a couple of other areas to consider, saying: “I see a place for all such assets. Some years back, the British Rail Fund was heavily into works of art. Fine wine is also popular, although the right expertise and proper storage are issues. The timing of such entries into markets is crucial, the right time usually being when it’s not topical or popular.”
In the future, more local authority funds could include real assets within alternatives, or as part of their hedging strategies. It could be that funds decide to specialise in particular areas they like and can build up expertise in, such as infrastructure or certain types of property. Other funds might decide to invest through new vehicles such as the common investment vehicles now under development. But we should not be surprised to see real assets gaining at the expense of conventional bonds and equities as part of a long-term reaction to the global financial crisis, and as part of a desire to diversify and improve risk management at pension funds.