This is an excerpt from FlexShares’ research paper on Expectations for Real Assets. Get the full paper here.
Expectations For Real Assets
In any market environment, we believe that real assets should be an essential element of every investment portfolio. Growing numbers of institutional investors have steadily increased their real asset allocations over the past few decades. We believe investors are looking for what real assets can offer: the potential for income, gains and capital preservation in an unclear global environment.
Investors continue to benefit from innovation within a variety of investment vehicles that focus on real assets. Furthermore, strong demand for real assets is being met with an unprecedented supply of opportunities for investment, and we believe trends indicate that it will continue to grow. The Real Assets classification (e.g., timber, water, infrastructure, natural resources, etc.) is continually evolving, influenced not only by new asset types, but also regulatory and issuance changes.
Defining The Asset Class And Its Potential
Real assets—which we define as real estate, infrastructure and natural resources—form the pillars of the global economy. As such, these classifications are inherently tied to global developments, inflation and other macroeconomic trends. Notably, the cash flows that historically have been produced by real assets can be valuable in times of both economic expansion and contraction. Real assets represent physical assets that are often linked to inflation—a favorable characteristic as potential demand rises in periods of economic expansion.
At the same time, increasing demand for the goods and services that real assets provide may be relatively predictable and inelastic (insensitive to changes in price or income), which can be helpful in periods of economic contraction.
While cash-flow stability has historically been characteristic of real asset investments, the fundamentals that drive the cash flows are distinct. As such, real assets can provide an effective way to enhance portfolio diversification beyond traditional stock and bond allocations.
Portfolio Diversification
Real asset returns have historically had low correlations to traditional equity and fixed-income investments. Our findings suggest they can provide an effective way to enhance the diversification of a traditional stock and bond portfolio. Individual real asset categories have also shown low correlations with each other—consequently investors may be able to diversify further by investing in more than one real asset class.
As highlighted in the chart below, the correlations of real estate with infrastructure and natural resources are 0.85 and 0.62, respectively. The return streams of two assets having a correlation of 1.00 would be perfectly correlated. These measures are relatively moderate because the drivers behind the returns of these categories are distinct.
Consider natural resource pricing, which for some assets, like timber, is highly dependent on short-term factors such as climate, temperature and water supply. In contrast, the cash flows from some infrastructure assets, such as toll roads, tend to rise with an expanding economy, while those derived from more essential services, such as utilities, tend to be more highly regulated, and consequently during times of economic weakness tend to have more locked-in levels of usage pricing.
Capital Appreciation Potential
Our research has shown that both income return and capital appreciation represented meaningful amounts of the historical total returns generated by real assets. Historically, many of these hard assets have tended to be long term and increase in value over time as replacement costs rise and operational efficiencies are achieved.
For many investors, this scenario may be visualized within their own daily experience as they observe the leasing of vacant space, the climb of toll road fees, the rising use of energy or increases in lumber prices. We believe that income from real-asset-related investments may help protect value on the downside, while operational efficiencies may enhance value on the upside.
Potentially Higher Risk-Adjusted Returns
Adding real assets may also enhance the risk-adjusted returns* of a mixed-asset portfolio. The chart below shows the various historical Sharpe ratios of the three real asset categories in comparison to stocks and bonds. The Sharpe ratio is a measure of return per unit of risk, which indicates whether an investment’s return sufficiently rewards investors for the level of risk assumed (the higher the Sharpe ratio, the greater the level of risk-adjusted performance).
For example, the 10-year Sharpe ratio for infrastructure as defined in the chart below is 0.214, which means that an investor should have a greater risk-adjusted return in comparison to an investment in real estate and in comparison to a Treasury bond which has a Sharpe ratio of zero. Only when an investor compares one investment’s Sharpe ratio with that of another investment can the investor get a feel for the return versus the relative amount of risk they can expect to take to achieve that return.
While real assets tend to retain value during economic downturns and contribute to value creation during economic upturns, performance generally lacks drastic movements in either direction. This potential performance stability may provide investors with portfolio benefits in a variety of market environments.
Implementing The Real Assets Portion Of A Portfolio
A number of considerations should be taken into account whenbuilding a portfolio of real assets. One approach for the initial structure isto define the investor’s objectives in terms of yield versus growth-orientedstrategy and sensitivity to the impact of inflation.
For the Yield Investor, a real assets strategy may emphasizeincome-oriented but inflation-sensitive investments that generate potentialsteady cash flows.
For the Growth Investor, a real assets strategy mayseek broader exposure to natural resources to help pursue a growth objective.
For the Growth Investor, a real assets strategy mayseek broader exposure to natural resources to help pursue a growth objective.
Building a real asset portfolio is a process that requires multiple considerations in terms of planning, implementation and monitoring. Real assets can play a fundamental role in a portfolio, depending on an investor’s objectives. Given the current low-yield environment, along with the potential diversification that real assets have historically provided, we believe that investors should consider them in order to create a well-diversified portfolio.
*Risk-adjusted return refines an investment’s return by measuring how much risk is involved in producing that return.
This is an excerpt from FlexShares’ research paper on Expectations for Real Assets. Get the full paper here.