Written By: Matthew Craig
As local authority pension funds look to adapt to the prospect of cash flow challenges, Matthew Craig examines the role that real assets can play in delivering performance combined with diversification and inflation protection
As pension funds become more mature and conscious of their liabilities, so real assets become more attractive as an investment. This is due to a number of factors. Mature pension funds have less room for large variations in funding level, due to market volatility from listed equities. They may also be moving from a cash flow positive status, where contributions exceed pensions in payments, to being cash flow negative, which places more emphasis on generating an income from their assets. So assets which can generate a stable, predictable income and which should not fluctuate in value makes sense. Real assets can answer this need.
When discussing real assets, it is important to define what the term means. “Our definition of real assets is that they are tangible, as opposed to shares or bonds. Many would consider that real assets are assets where the price varies due to the impact of the real economy, and they could include index-linked bonds, but exclude nominal bonds,” commented Colin Pratt, investments manager at Leicestershire County Council. Pratt said that his fund invests in infrastructure and property, which are tangible assets, as well as being one of the relatively few UK pension funds to invest in timberland, or forestry.
“We consider property to be an asset class in its own right and it has a separate weighting to infrastructure and timberland, which are part of an inflation protection allocation we have had since 2012, along with index-linked bonds. Our target weight for property is 10%, for infrastructure it is 5% and for timberland it is 2%,” Pratt said. He added that the main benefit of property as an asset, as with most assets, is the prospect of reasonable returns. “It is also a diversifying asset class against some other asset classes, but nobody really wants diversity if it impacts significantly onto returns, so it is slightly disingenuous to pretend that this diversification is a massive driver of why we hold it. It is the prospect of relatively safe, relatively steady returns relative to other assets, delivered over the long term, that will be more than enough to meet our overall investment return target, which is the key attraction of property,” Pratt explained.
As an asset class, property is diverse, with a wide range of possible investments. Pratt said that Leicestershire County Council invests directly in UK commercial property assets, and also invests in pooled property funds. In the pooled funds, Pratt added that managers have a UK property benchmark, but with discretion to invest off-benchmark. “The pooled property funds are about one-third invested in core UK property funds and two-thirds invested in more specialist funds for property niches such as student accommodation, or the residential sector, where returns are expected to enhance returns from mainstream UK property,” he commented.
For pension funds looking to find a reliable income over the medium to long-term, there are property niches which can help, although some might argue they are not real assets in the strictest sense of the term. M&G co-head of alternative credit, William Nicoll, said issuing a 40-year mortgage on social housing could fulfil the requirements for investors interested in real assets. “You don’t actually own the properties but have security over them through lending money to the entity that owns the assets. It is very good, long-term, secure debt for a pension fund to hold against its liabilities. You can argue it is better than owning the asset directly, because you are then exposed to the rental market,” Nicoll commented.
Nicoll added: “Sale and leaseback is another example of something which is not strictly speaking, a real asset, but which can be a very good, secure, long-term asset. If a property manager buys a supermarket store site and leases it back to the supermarket for 25 years, the yield will have very positive characteristics, and can help as a matching cash flow for pension fund liabilities. The yield should be linked to real living standards and inflation in the economy, which is an attribute of real assets.”
While property has been a staple of local authority pension funds for many years, assets such as infrastructure and timberland are newer on scene. Both of these asset classes have similarities to property, but also important differences. They are tangible assets, which can give reassurance to pension fund trustees and members. They are also assets which, as Pratt alluded to, can give protection against inflation. This, coupled with their diversification attributes when compared to listed equity and bond markets, makes them useful assets to hold for pension funds concerned that quantitative easing and other central bank policies have made listed markets unstable. The addition of real assets such as infrastructure and timberland to investors’ portfolios also illustrates a general trend towards broad-based portfolios. This can be summed up as a move away from the old 60:40 portfolio, with assets split between equities and bonds, and towards the Yale endowment model, with a wide mix of alternative and real assets.
For Pratt, infrastructure is a fundamentally different asset to property. He characterises infrastructure as coming in two forms, one with known, predictable cash flows, which can be linked to inflation and are often set through regulation, with little operational or economic risk involved. “That is what I would call safe, steady infrastructure. As an alternative to high risk bonds, it has higher risk exposure and higher returns,” Pratt said. However, his fund’s preference is for a more proactive, dynamic approach to infrastructure, where there are opportunities to reshape the operations of a company, improving operating margins and profitability. “We invest directly via funds which are investing in wind farms, solar power and electricity generation and distribution, for example. Many assets are overseas, as there is a huge range of assets available. This kind of infrastructure often has cash flows that are linked to inflation, but they are undoubtedly more risky than many infrastructure assets and have potentially a much higher return.”
Local government pension scheme (LGPS) members have been explicitly encouraged to invest more in UK infrastructure by the government, through actions such as then Chancellor, George Osborne’s call for “six British wealth funds”, or the merged LGPS pools, to invest in this way. While many at pension funds see infrastructure as an attractive asset to match their long-term liabilities, they are also wary of being used as a source of capital by others. So official encouragement has, in some ways, meant pension funds have been even more careful than usual about infrastructure, but they are now investing in it. For most LGPS funds, infrastructure is accessed via fund managers, rather than directly; the latter may come later, when the enlarged pools are able to exert their scale benefits. As an example of current trends, Essex Pension Fund recently awarded a £150 million infrastructure mandate to IFM Investors and JP Morgan Asset Management.
Timberland is seen as a more esoteric real asset by many UK investors, but Leicestershire’s Pratt is an investor. He said that timber is widely used in property construction in regions such as North America and Australia. “So it can be seen as a geared play on house building in North America,” Pratt said. He added that flexibility is another advantage of timber, in that it does not have to be harvested annually. “You don’t have to cut down trees if the price isn’t right. It would put back the cash flow, but the timber gets bigger and more valuable every year,” he commented. In addition, timber has an inflation linkage, as its use is related to economic activity. In terms of access, Pratt said: “We invest in timber through global funds. There is almost no commercially-viable timber in the UK and almost none in continental Europe, because the returns are insufficient for outside investors like us. The main focus is timber grown in North and South America, as well as New Zealand and Australia. China is a big user of Pacific region timber from New Zealand and Australia, for example.”
For most LGPS members, real assets are likely to become valuable tools to diversify, generate returns and provide protection against inflation. And in a period when financial engineering and highly complex products are often led to volatility and eventual disaster, there is something deeply reassuring about using assets which are tangible and relatively easy to understand, assess and value. Giving investors the ability to sleep at night is an underestimated quality and it is something that real assets should be able to do.