Diversification is a key part of successful multi-asset investing, whether it be by asset classes, geographical regions, investment styles, funds or investment managers. Diversification works by constructing a portfolio of constituent parts with varying levels of correlation to each other so that if one part is not performing another will be.
Real assets offer attractive diversification benefits and yet have been under-represented in multi-asset portfolios. We believe there are strong investment reasons to include real assets and these are enhanced by the accessibility and liquidity that a real assets fund can provide. This article explains the potential benefits of real assets and the role they can play in a client’s portfolio.
What are real assets?
‘Real’ here means tangible assets such as buildings, toll roads, solar and wind farms, and commodities such as energy, livestock and grains, which derive value from their availability and usability by consumers and businesses. Liontrust’s Multi-Asset Diversified Real Asset Fund (DRAF) invests in liquid real assets across areas such as core infrastructure, renewables, specialist property and commodities among others. This seeks to provide an independent and diversified return stream from equities and bonds, potential protection against inflation, capital preservation and attractive income in the long run.
Accessibility
A multi-asset fund provides investors with accessibility to these real assets through a ‘one-stop shop’. For anyone including real assets directly within their portfolios, they will need to invest in between 30 and 40 holdings instead of one fund to gain the same diversification benefits.
There are also liquidity advantages of taking this approach especially when it comes to property. Real assets can play the same role that many investors have assigned to commercial property – in the “alternatives” part of the portfolio by providing diversification away from equities and bonds and the ability to provide a steady income. Commercial property is heavily exposed to the economic cycle and many open-ended funds have also struggled with liquidity. In contrast, a real assets fund can include, but is not limited to, specialist listed core property in which the focus is on transparent business models and resilient income. In this way, the fund can bring genuine diversification and provide access to real assets via liquid vehicles, minimising liquidity risk.
Diversification
Real assets share some risk factors with traditional equities and bonds but have low correlation to both and therefore offer diversification, and a different source of returns, within a multi-asset portfolio.
It is important to note, however, that similar to more traditional asset classes, different parts of the real asset universe may perform differently based on the market environment. In the later stages of a business cycle, for example, we can expect more defensive and stable-yielding real assets to do better whereas in an early expansion, more cyclical real assets are likely to outperform. Having the right mix of real assets dependent on the cycle will therefore increase the likelihood of achieving good outcomes over the long term.
Protection against inflation
Despite the current spike in inflation, we are not expecting a long-term, persistent increase. That said, inflation is expected to remain at or above central bank targets for some time as a consequence of the economies reopening and the extraordinary monetary and fiscal stimulus through the pandemic.
More traditional asset classes have been a less effective inflation hedge; core equities and bonds typically have a disinflationary bias and do well when inflation is low or falling. Stocks tend to outperform in a disinflationary economic expansion and bonds in a disinflationary contraction, but both have historically struggled when inflation moves higher, particularly long-duration equities – which are growth-oriented businesses in areas like technology that rely on future earnings and are therefore more vulnerable to an increase in the bond yields used to discount those earnings.
In contrast, real assets have offered more inflation protection (either direct or indirect), particularly over a full market cycle. In the case of core infrastructure, for example, most of the cash flows are contractual and/or directly linked to inflation, while in some of the specialist property sectors, rent reviews may also be inflation linked.
A unique feature of many real assets, again including infrastructure and areas of the property market, is that a significant amount of revenues benefit from predictable demand, making these assets more economically resilient and less affected by the business cycle. Given these sectors often provide critical services, used for social or environmental purposes, they also tend to enjoy accommodative government policy (through tariffs and grants) and regulation.
Attractive income
Not all real assets offer income and within DRAF, for example, we have exposure to commodities and gold that have no yield. Within our infrastructure and specialist property holdings, however, there is attractive income available.
Core infrastructure as a sector focuses on assets providing support for communities, such as schools and hospitals, and benefits from the kind of state-backed cashflows outlined above. We hold BBGI Global Infrastructure, for example, a globally diversified closed-ended infrastructure fund that invests directly in projects that have public sector-backed cashflows, with a 12-month historical yield of around 5.4% in June.
Renewables are another branch of infrastructure and while also benefiting from long-term contractual cashflows, these are a combination of government subsidies and revenues from selling electricity to power companies, and that element of demand from the latter introduces more economic risk. To compensate, yields are often slightly higher: Renewables Infrastructure Group, for example, offered a yield of around 6% in June.
Moving to real estate, UK property yields continue to offer an attractive premium above UK inflation. Supermarket Income REIT, for example, a portfolio of UK grocery stores with investment grade tenants such as Morrisons, Sainsbury’s, Tesco, and Waitrose, offered a yield of around 5.7% in June.
Why now?
While the long-term case for real assets as a core holding is clear, we believe current valuations also present a good entry point and potentially demand a higher weighting in portfolios.
Equities have rebounded strongly from their low in March 2020 and Morningstar data show global stocks trading at a price/earnings ratio of 25 times and a price to book of 2.8, both ahead of long-run averages. While off their highs after recent yield rises, government bonds also remain expensive, albeit less so than before, and offer limited prospect of real returns unless we see further market shocks.
Against a backdrop of higher inflation, however persistent it proves to be, multi-asset portfolios solely reliant on traditional asset classes could struggle to deliver client needs. The tendency of equities and bonds to underwhelm against a backdrop of rising prices, combined with full valuations across both asset classes, is a strong argument for an enhanced allocation to real assets.
Whatever the shorter-term outlook, we see a strong case to hold real assets within portfolios over the long term to bring diversification, income and potential inflation protection to portfolios.
