Raise or hold on real assets proves tough call

Pension executives and other institutional investors are split between raising allocations to real assets or maintaining their allocations amid concerns about equity market volatility and inflation, a Pensions & Investments' survey shows.

The survey of P&I's Research Advisory Panel showed 51% respondents plan to maintain their current target allocation to real assets in the next three to five years, while 46% plan to increase their targets. (The remaining 3% plan to decrease targets.)

The advisory panel consists of executives at pension, endowment and foundation funds.

Real assets are an untapped asset class for many pension funds, foundations, endowments and other asset owners.

Actual and target allocations to real assets ranged widely among respondents. Thirty-eight percent of respondents said they have no current actual allocation, while 36% have no target allocation. At the other extreme, 8% have more than a 10% actual allocation while 8% also have more than a 10% target allocation. The survey didn't single out real estate.

The attraction of real assets focuses on risk-protection characteristics. Among the respondents:

• 49% invest or would invest to provide an inflation hedge;


• 24% invest or would invest to decrease their portfolio's risk profile; and


• 12% invest or would invest to increase their portfolio's return profile.

For real assets investors, performance has been in line with expectations. But 10% said real assets have performed above expectations, while 21% said they have performed below expectations.

The P&I survey focused on real assets in commodities, energy, farmland, infrastructure and timber.

Money managers and consultants not involved with the survey said in interviews that they generally recommend raising allocations to real assets to meet a changing landscape of economic and market challenges.

Bernard McNamara, executive director, global real assets, J.P. Morgan Investment Management Inc., New York, predicts allocations to real assets “could rise to as high as 25% or more of overall portfolios,” which should be diversified over a wide swath of the real assets spectrum.

Michael Forestner, Atlanta-based partner and head of private markets, Mercer Investment Consulting Inc., said: “Because most of those strategies are illiquid ... pension funds tend to have less tolerance for illiquidity. So the portions of their portfolios that go into (real assets) strategies tend to shrink a bit” compared to endowments and foundations, whose allocations tend to be larger.

“I think in general (asset owners) are continuing to allocate to the space,” he added. “We haven't had a big fluctuation. Clients that have had a real assets allocation, those tend to be fairly stable. But there are clients who are putting (real assets) in for the first time.”

Searches for real assets for clients appear to have grown selectively, according to a companion P&I consultants survey. For this year, as of mid-October, five of 21 responding consultants had done between 10 and 50 searches each for real assets. Last year, five of 21 did between three and 30 searches each.

But most consultants report no real assets search activity among clients in either year.

Cori E. Trautvetter, Chicago-based senior consultant at Pavilion Advisory Group, said: “Over the last three or four years there has been a definite heightened interest in real assets.” But generally, investors aren't ready to raise or make first-time allocations to real assets, she added.

“I would say probably the two areas we see the most interest in real assets are commodities” and real estate, Ms. Trautvetter said.

Yet while “clients mostly have realized commodities would be the way to go to protect themselves against inflation, the risk profile of commodities is very frightening for a lot of clients,” Ms. Trautvetter said, referring to precious metals, oil and gas, livestock and agricultural commodities as examples of investible commodities.

Commodities are viewed as a very risky asset class, “because commodities are really driven by a lot of supply and demand factors ... and you can get into a lot of political issues ... with oil and gas and so on,“ she said.

She said real assets, particularly real estate and infrastructure, have a mixed picture of delivering on their objectives in recent years. Real estate and infrastructure funds that bought before the financial crisis “have a lot of troubled property,” Ms. Trautvetter said. “But (for) those coming after the crisis — while it's still way too early to tell how those are going to play out — early returns have been extremely favorable.”

Mr. McNamara defines real assets as “large-scale, long-life, tangible, productive, capital-intensive investments like real estate or infrastructure ... whether it's regulated utilities like natural gas distribution or electricity distribution or water or waste water management, transportation assets ... ports, airports, toll roads, contracted power generation timber, farmland.”

“In general they deliver the risk/return characteristics that can address some of the many challenges investors are facing in their portfolios,” Mr. McNamara said.

Income and inflation concerns are driving allocations to real assets, said Mercer's Mr. Forestner.

It's “better than bonds,” he said, producing “a steady 6% to 8% type of return plus some growth for inflation.”

“The whole idea is to do better than bonds,” Mr. Forestner said. “Right now for core assets, it's high-single-digit type of numbers, something in the neighborhood of 8% is doable. That's pretty attractive. ... When people are looking at a bond universe that offers fairly paltry returns, looking at something (real assets) in that 6% to 8% range for core assets looks really good.

Investors can invest in real assets for return-seeking growth, he said.

“If you want, you can go more aggressive, a core-plus route where you would be ... engaged in developing new assets ... financing the construction of them, building a new power plant ... a new toll road, something along that nature,” where the expected returns are higher, he said.

Real assets can help pension funds meet their assumed rate of return, Pavilion's Ms. Trautvetter said.

“They do reduce risk in the overall framework because they are not as highly correlated to equities and fixed income,” Ms. Trautvetter said. “So they do act as a diversifier and therefore can increase overall return.”

But they have higher fees and oversight costs, also serving as deterrents to investing, Ms. Trautvetter said.

Mr. McNamara said reasons cited in the survey by investors for interest in real assets “is very consistent with not only how we talk about the benefits of real assets, but what we are hearing from investors.”

In terms of correlation with traditional assets, Mr. Forestner noted, “You are going to be tied to discount rates. As the rates go up, it is not going to be great for infrastructure assets in the short run. But if interest rates are up because of inflation, there is usually inflation linkage in the income streams.

“Because of the discount rate used to value assets, if you get an upward shift in interest rates, you'll likely see an upward shift in the discount rate used to value assets, which would decrease their value,” Mr. Forestner said.