Meet the Round Table Participants
Investors continue to struggle to find sources of return in a world of low interest rates, sluggish economic growth and looming inflation. And while the election of Donald Trump as the next U.S. president eliminated one uncertainty, it created others. In such an environment, real assets can offer opportunity. But investors have to know where to look, what to be careful of and how to invest. Tony Charles, global head of research and strategy for Morgan Stanley (MS) Real Estate Investing, Jim Clark, senior vice president and client portfolio manager at Nuveen Asset Management, and George Milling-Stanley, head of gold strategy at State Street Global Advisors, provide insight into why and how real assets can be a reliable investment choice today.
P&I: How has the role of real assets in an asset allocation strategy changed over the last few years?
Jim Clark: In the aggregate, especially in the institutional universe, it's grown in terms of the percent allocated. You've seen a broader acceptance, both from institutions and retail investors, of real assets as part of a diversified portfolio.
Part of the reason that you've seen so much growth in real assets is a function of slower growth, suboptimal inflation, and the desire for people to own predictable and reliable cash-flow streams that are attached to things like infrastructure and real estate.
Tony Charles: We've seen an increase in allocations to real assets. It's gone from say 18% to 25% over the past eight years. It's clearly becoming a more accepted asset class, more transparent and better understood by investors.
George Milling-Stanley: As the head of gold strategy at State Street, I tend to see everything through the gold prism. Tony's absolutely right that over the last few years, we have seen a big increase in strategic asset allocation investments into our group and in my case, specifically into gold. Investors started to look for liquid alternatives and gold certainly has benefited from that.
P&I: How do you define and access real assets?
Charles: There are many definitions of real assets. We limit it to real estate and infrastructure, listed and private.
Clark: Our focus is on infrastructure and real estate. We don't do anything with commodities. In fact, we run the other direction. And it's not because we hate commodities; it's because from our portfolio philosophy, we want there to be cash flow attached to them. So our definition of real assets would be a location-specific hard asset that garners a fee for its use through a long-term contract, concession or a lease.
Milling-Stanley: In terms of gold, there's no bad way for people to gain access. People can buy bars and coins. They can buy ETFs. They can trade the futures. None of these is a bad thing to do, but with a product like GLD [SPDR Gold Shares ETF], your exposure is very, very simple, very clear and very direct.
P&I: Why real assets right now?
Milling-Stanley: Perceptions of risk have changed — quite dramatically. We are in an increasingly scary world. For the Brexit vote we got a result without a resolution. We have other uncertainties like ISIS and the broader problems in the Middle East. It's a dangerous world out there and real assets are often a source of great comfort to investors.
Charles: Yes, I agree. Throwing in all the geopolitical risks you just mentioned, investors are looking for safer income-producing assets that are more defensive in nature to address some of those risks. Those are the characteristics of the real assets we look at.
Two other factors are the low-growth, low-interest-rate environment that we are in and potential inflation. Increasingly central banks talk about their willingness to overshoot inflation targets. If you see more inflation, that will benefit real assets given their hedging characteristics.
Clark: I think the 'why' really has to do with what we find compelling in what we invest in, specifically infrastructure and real estate, and the consistent and definable cash flow streams that are attached to these.
P&I: Tell us more about the macro drivers favoring real assets, including inflation, interest rates and other dynamics.
Clark: It really revolves around that slower growth/lower inflation/lower interest rate environment. The big lever that pulls valuation higher is discount rates and interest rates. As a result, in this environment, these assets actually even perform better than they do in a mildly rising inflation environment and that's not something everybody thinks about.
It's almost like a seesaw for duration as it pertains to a fixed income instrument. If you're talking about an infrastructure asset that has a 20- or 40-year concession, you have a pretty decent idea of what the cash flow is going to be. Those longer-dated cash flows are positively impacted when you do a present-value calculation by a declining discount factor or declining interest rate.
Milling-Stanley: Someone once said that in a world of negative real interest rates, gold behaves like a high-yielding asset. That's probably true for other real assets as well. For most of the 40 years I've been involved in the gold business, people have said to me, 'George, you're crazy. You picked an asset without a yield,' and for the last nine months, I've been saying, 'Welcome to 2016.'
And Tony is absolutely right about central bankers.
I wish central bankers around the world a lot of luck in containing inflation because once you wake up that beast, it's awfully difficult to put him back to sleep again.
Charles: That's a good point. With inflation, once it comes, it's very hard to stop. If you wait to invest in real assets once you see inflation rising, it's already too late.
Milling-Stanley: It's always a good move to position yourself well ahead of the risks that you're foreseeing, Tony, right?
Charles: Yes, yes, yes. In the last six months, people have been beginning to think about inflation. It's becoming more of a reason to think about real assets.
Demographic changes around the world are also creating a lot of investing opportunities in real assets. India and China are rapidly urbanizing and infrastructure is a massive play there. In the U.S., the millennial generation's preference for renting vs. owning has hugely impacted the residential sector, and aging populations around the world are increasing the need for health care and aged care services. These changes are having a big impact on the way we think about real estate investing globally.
Also, environmental, social and governance is becoming more and more important, and real estate definitely has a massive sustainability component. Tenants in office buildings, for example, demand better sustainability performance. You can achieve a rent premium and an occupancy premium by having more sustainable elements in buildings. On the operating expense side, commercial buildings that have sustainability certifications have lower energy costs, and their repair costs are also lower.
P&I: Should institutional investors think of real assets as a strategic investment or a tactical play?
Clark: We think of an allocation to real assets as a strategic one, especially when we consider infrastructure. These are long-lived assets; they're not going to get up and walk away. They're going to be utilized over a long period of time.
However, there are tactical opportunities depending on where you're at in the economic cycle. You can add value by moving to areas that are undervalued. But over the long term, you always do want to have some sort of allocation to real assets.
Charles: It's a bit of both. If you think about real estate specifically, it's more of a strategic play because it is long term. Infrastructure's even more long term than real estate.
We're seeing investors becoming more sophisticated in using public markets both as a strategic and tactical overlay to their more strategic private market real estate holdings.
Milling-Stanley: That's a nice distinction. I have always believed that gold is a long-term strategic allocation. It should be a permanent feature of a portfolio. There are occasions when a tactical overlay can make a lot of sense on that kind of portfolio, using ETFs.
P&I: What are the values and trade-offs in investing in real assets via public vs. private securities?
Milling-Stanley: As far as gold's concerned, you want to be absolutely certain that whatever you're buying is the genuine article. And the best way to do that is through a listed vehicle, like a product like GLD for example.
Clark: At Nuveen Asset Management, we only do listed, though our parent, TIAA, has a very large private real asset portfolio. We think there are a couple of substantial advantages to the listed marketplace. It affords you the ability to better diversify across property types, across industry groups, across geographies and even across different pieces of the capital structure.
The liquidity that the listed market provides allows for the movement of capital to better allocate based on things like the regulatory and political environments as well as valuation opportunities. That also speaks to the previous question regarding tactical vs. strategic.
That's not to say that the private investment universe is substandard by any stretch. You would be best served, if you have the capital, to have an allocation to both. I don't think of them necessarily as substitutes for one another, they are more complementary strategies.
Charles: Both give you diversification and high income. Increasingly, we're seeing the largest plans and the more strategic plans understand that these strategies are complementary, not just as a tactical overlay that we talked about before, but also you can arbitrage private vs. public market value discrepancies.
P&I: Which real asset and why? When do specific real assets make sense in terms of the market cycle?
Charles: We like real estate. At the moment, it offers higher relative returns and produces income, which is attractive. Typically, real estate does better late cycle. In the U.S., we are definitely late cycle.
Infrastructure is also attractive. You get the inflation hedge but we also just like the predictability and the stability of cash flows.
Clark: We manage a portfolio of both real estate and infrastructure. Both have definable cash flows, but they are quite different in terms of their cyclical exposures. Real estate is a lagging and economically sensitive sector. Infrastructure is the opposite. They work well together within a portfolio because they're not highly correlated given the different underlying fundamentals that drive the businesses.
Milling-Stanley: I do indeed favor one asset over all of the others: Gold is a practical investment. The market's deep and liquid. Gold doesn't really correlate with anything else in a typical portfolio. And you can't say that of all real assets. Finally, gold has a very, very long track record of offering protection against unexpected events, whether they're macroeconomic or geopolitical.
P&I: What are the major opportunities in real assets that you see today?
Milling-Stanley: Gold had a wonderful steady bull market from 2001 to 2010. At the end of 2010, the speculative community piled in and caused a bubble. That bubble burst and a lot of people abandoned their strategic holdings or cut them back to dangerously low levels. The current price is in the $1,275 [per ounce] area compared to $1,895 in 2011. It is a golden opportunity for people to rebuild their strategic allocations to gold.
Clark: We've been looking more toward the infrastructure space and more toward non-U.S. We have been trimming our domestic commercial real estate exposure and adding more to our non-U.S. real estate, as well as non-U.S. infrastructure.
Charles: We see a lot of opportunities driven by the rapid growth in e-commerce, not just in markets like the U.S., U.K. and Japan, but also in China, India and Korea. You can play that either through developing logistics warehouses or buying stabilized properties. Additionally, listed real estate offers some attractive arbitrage opportunities in different parts of the world. Also, there's a lot of focus on renewable power generation, mostly in the U.S. and Europe. So lots of interesting opportunities in the infrastructure space as well.
P&I: What are some of the risks and limitations of real assets?
Milling-Stanley: As far as what keeps me awake at night when I'm looking at this gold price, the answer, frankly, is not very much. I sleep pretty well knowing that I own some gold in my portfolio.
Clark: Real estate, as mentioned before, is a lagging and economically sensitive sector. So as the economy is growing and doing better, real estate typically does a lot better with it. Infrastructure has its defensive characteristics and typically does better in a downturn, in relative terms The inflection point coming out of that downturn, or when beta and cyclicality are in favor, is when infrastructure typically underperforms.
Charles: Liquidity. You can't just pick up the phone and call a broker and trade private assets. It can take six months, 12 months to sell an asset.
Another risk, or rather limitation, is you need skilled resources. If you want to play globally you need to have resources in different cities around the world with different sector expertise. That's really important to actually succeed in this space. You have cycle risk, which was just alluded to. A risk that's been less prevalent this cycle is leverage.
P&I: What due diligence questions do investors need to have answered before making an allocation to real assets?
Clark: A lot has to do with understanding the sensitivities of these asset classes. In what market environments do they perform well? In what market environments do they perform poorly? How do these assets hold up in periods of stress? So it really revolves around being prepared, and giving the investor a framework for understanding what to expect.
Milling-Stanley: Anybody who's buying gold mining stocks should certainly be doing due diligence. When you're buying bars and coins, there's really not much that the individual investor can do except try to make sure he chooses a reputable dealer. On the GLD side, you don't have to worry about managers because there's no management. You would like to know as much as you can about the sponsor and the custodian. The final thing is that you want to be absolutely certain that the product you're buying has optimal liquidity.
Charles: When choosing a manager, it's really their ability and track record of delivering returns above a benchmark or their peers while managing risk. A lot of managers may be able to deliver higher returns but only by going into really risky asset classes or markets.
If you want to deploy capital globally, you need to find an investment manager who has deep local market and sector expertise. We like to differentiate ourselves around our ability to source transactions and to execute.
P&I: Are performance tracking and attribution difficult? In other words, are there appropriate benchmarks?
Clark: There are a number of relevant — domestic and global — benchmarks for real estate investment. That's true of both the listed and the private side.
There are different approaches to benchmarking within infrastructure. It is a very heterogeneous asset class. There still really isn't a private benchmark for infrastructure. That's why it's important for an investor to understand the philosophy and the positioning of each of the managers within the space.
Charles: For real estate, it depends. If you're looking at core real estate in the U.S., for example, it's easily benchmarked to the NCREIF 'Odyssey' Index (National Council of Real Estate Investment Fiduciaries' Open End Diversified Core Equity index). There are similar core benchmarks that are being developed in Europe and Asia. For opportunistic real estate investing, there isn't a single, great one available, so you have to benchmark yourself against other funds but nothing is readily available.
Milling-Stanley: As far as gold is concerned, for establishing the net asset value of an ETF, we look at the London Bullion Market Association gold price. But that's just for the NAV calculation. Our real benchmark is the spot price of gold minus the cost of administering the trust.
P&I: What part of a portfolio should a real assets allocation come from?
Charles: People are primarily allocating out of fixed income into real assets. We've seen the allocations increase to 25%. I think that could continue to increase given the lack of yield in other asset classes.
Milling-Stanley: For an allocation to gold, remove it from the two biggest components of most portfolios: Take half from fixed income, take half from equities.
What should the allocation be? The literature basically comes down to somewhere between 2% and 10%. I happen to think that 5% as a strategic allocation makes sense but in times of exceptional turbulence in financial markets, it makes sense to double those allocations or more, to as much as 20%. There can be plenty of occasions in gold when a tactical overlay makes sense as well.
Clark: A lot depends on what part of the capital structure they're investing in. Are they looking for the debt? Are they looking for equities?
Within the institutional space you find that investors often have direct carve-outs for real assets. In terms of funding from somewhere else, it's really client dependent.
For our real asset income portfolio, the most elegant solution would be to borrow from both equity and fixed income because you are getting exposures to each. But it really depends on client objectives.
P&I: What is your view of the future? How do real assets fit into varying economic and political scenarios?
Charles: To sum it up, globally, we have low growth, low rates and a lot more volatility coming from political risk. In this environment, real assets fit really well for a number of reasons but their safe haven status is key. Investors can deploy capital into real assets and not have to watch it every single minute of the day. Secondly, they offer strong risk-adjusted returns vs. stocks and bonds. The third reason is portfolio diversification.
Milling-Stanley: I would agree with every single point Tony just said. You've got low growth. You've got low interest rates. You've got high volatility. That's a nasty, nasty mixture.
We've sown the seeds for future inflation. We just haven't seen it yet. Gold in particular and real assets in general offer you strong protection and stronger risk-adjusted returns.
Clark: All the forecasts for global GDP growth continue to come down. It's harder to pay for the promise of future growth on an investment unlike real assets, where you have a high degree of certainty around the cash flows.
Owning real estate, infrastructure, commodities, gold and other types of real assets, that's just prudent investment decision-making. You want to have a lot of different exposures. And in this environment, real assets are likely to perform well.