Events & News
January 2010
An Introduction to Real Assets
Real assets, also commonly known as hard assets or inflation hedges, are of increasing interest to investors. Such assets include real estate, energy, timber, and infrastructure. Although most institutional investors are comfortable with real estate, the other assets may be less familiar. In this paper, we briefly review and explain the strategic rationale for investing in real assets, today’s opportunities, the risks involved, and mitigating those risks. We also provide a very brief summary of the energy, timber, and infrastructure sectors.
Strategic Rationale
The advantages of adding real assets to a portfolio have been thoroughly demonstrated over the past two decades and are now well-recognized and accepted by institutional investors and consultants throughout the world. These key attributes include attractive risk/return profiles, excellent diversification, inflation protection, and the ability of top managers to add value in inefficient sectors. This paper will now take a closer look at each of these four benefits.
Strong returns
During periods of modest inflation, most real assets can be expected to produce equal to, or greater than, traditional asset classes.
As the graph above clearly illustrates, returns from private real assets have generally exceeded those of stocks and bonds over the past decade or so (see disclosure at end of paper for details on all chart data).
It is important to note that data series for real assets are not nearly as robust or pure as those for
traditional investments.
Still, Altius believes that returns in the mid-teens are achievable from a diversified portfolio of top-tier energy, timber, and infrastructure funds. Therefore, an allocation to real assets is likely to enhance the return of one’s portfolio (especially if partially drawn from the fixed income allocation).
Excellent diversification
The inclusion of real assets in one’s portfolio also contributes a second benefit: valuable diversification and volatility reduction for the overall portfolio. Unlike most traditional asset classes and even equity- oriented hedge funds, most inflation hedges have modest or negative correlations with stock and bond market returns. This means that adding an allocation to inflation hedges will reduce the volatility of returns from a portfolio.
As shown in the table above, energy and timber have low or negative correlations with stocks, bonds, and cash. Infrastructure, on the other hand, exhibits slightly higher, but still modest, correlations with traditional investments. Because private infrastructure data is rare or non-existent, public infrastructure stock returns have been used to calculate the correlations in this chart. Altius believes direct or private infrastructure returns have lower correlations and thus provide even greater diversification benefits than this chart would indicate.
Using long-term historical returns, asset allocation tools such as efficient frontiers, shortfall analysis, and Monte Carlo simulation will all demonstrate that the risk/return characteristics of a portfolio with, say, a 10-25% allocation to inflation hedges are superior to those of a portfolio without this valuable asset class.
Inflation protection
Real assets also provide a measure of protection against unexpected inflation and sustained periods of general price increases. Inflation—a rise in the general level of prices of goods and services—has been, and remains, one of the greatest potential threats to any long-term pool of funds. An example of the devastating impact of inflation from the not-too-distant past is the period from 1973-1982, when many endowments and pension plans lost an incredible 40% or so of their purchasing power.
As shown in the graph on the next page, returns from energy, timber, and infrastructure exhibit a positive correlation to inflation, while traditional asset classes show near zero correlation with inflation.
Real assets have historically provided attractive returns during inflationary times when traditional stocks and bonds have performed poorly. In effect, an allocation to real assets serves as an insurance policy against the harmful effects of inflation.
According to figures compiled by the University of Notre Dame investment office, there were 23 three- year periods in the 20th century when real (inflation-adjusted) US equity returns were negative. In 14 of those (61% of the time), high inflation was the major factor causing the sustained period of negative real equity returns.
Investors may disagree over whether today’s loose fiscal and monetary policies will result in significant inflation in a few years. Still, as Larry Siegel, former Director of Policy Research at the Ford Foundation, has written, "For almost all investors, the prudent thing is to hedge against inflation."
Great value-add potential
The final, but no less important, advantage of private equity investments in real assets is the inefficiency of these markets. Traditional assets classes are very efficient and it is difficult for even the best managers to consistently add value. In addition, there is little or no persistence of outperformance. In contrast, energy, timber, and infrastructure are inefficient sectors where the best managers can add substantial value. Sourcing, evaluating, and gaining access to these top-tier managers is difficult, but crucial. If you can’t invest with the best managers, it is probably best not to invest at all, as average managers are likely to disappoint. Over the past decade, Altius partners have built strong relationships and invested with many of these top-tier managers.
Today’s Opportunities for Real Assets
The strategic rationale for adding real assets to a portfolio is clear. However, investors often ask if today is a good time to invest. In other words, is it tactically a wise move? Before addressing that question, Altius stresses that it discourages market timing. Rather, we recommend that investors make a long-term commitment to this asset class (just as in private equity). We claim no ability to predict short-term commodity price cycles. That is why our investment strategy is designed to produce attractive returns even in unfavorable commodity price environments. Still, there are compelling reasons why energy, timber, and infrastructure will remain attractive investments for the next decade. Some of the attractions of each sector are described below:
Energy
- Rapid expansion taking place in China, India, and the Middle East will continue to push energy demand higher, despite the current economic problems.
- Little or no excess capacity exists anywhere in the world, due to 20 years of underinvestment. This applies to virtually all energy sectors: production, transportation, storage, and refining.
- Many of the world’s major oil fields are located in hostile countries with unstable political and/or social structures.
- Power generation and transmission are in great need of expansion and upgrading. CalPERS projects the need for $20 trillion of new capital expenditures in this area between now and 2025.
Infrastructure
- Governmental entities at all levels are looking more favorably upon private sources of capital due to budget pressures.
- The infrastructure investment gap over the next five years in the US alone exceeds $1 trillion.
- US traffic (vehicle miles traveled) is growing 15 times faster than capacity. Trends are similar
around the world. - A study by the Organization for Economic Co-operation and Development projects that $1.25
trillion per year will be expended on non-telecom infrastructure between 2010 and 2020.
Timber
- Global demand for wood products will march upward as populations grow and economies expand.
- Timber has historically generated high returns during inflationary periods (over 20% annually from 1973-1981).
- Institutional investors’ allocations to timber will increase over the next decade. Only 37% of US
pension funds and 52% of endowments have invested in timber (and most of these have less than 2% of their portfolio in timber). - European pension plans are ramping up timber allocations in pursuit of “low carbon” strategies to
positively impact perceived climate change.
Since it is not possible to accurately predict which specific sector will perform best in the future, Altius recommends that a real assets allocation include exposure to several key inflation hedges: timber, energy, infrastructure, real estate, and commodities. An in-depth analysis of all these strategies is beyond the scope of this paper. However, we will summarize the three major sectors where Altius has significant experience.
Major Sectors
Energy
The energy business encompasses a wide variety of sectors and strategies. There are many different approaches to investing in energy, but they can be broadly grouped into these major sectors/strategies:
1. Upstream encompasses two major strategies:
a. Exploration and drilling: Investing in the exploration and wildcat drilling for oil or natural gas is a speculative activity with a high risk/reward profile.
b. Acquisition, exploitation, and production: Making direct investments in producing oil and gas properties. Funds acquire, develop, and operate these mature properties on investors’ behalf. Value is added by reducing operating costs, boosting production, and/or drilling additional wells. Thus, the emphasis is on the control of physical operations and/or the enhanced exploitation of a property.
2. Midstream: The storage and transportation of oil, natural gas, and coal. Increased demand for energy, combined with the deferral of capital expenditures over the past two decades, has created a need for substantial expansion and upgrading of pipelines, tanks, terminals, and related facilities.
3. Downstream: The refining and distribution of oil, gas, and coal. No new refineries have been built in the US in 30 years. Retail distribution is a low margin business. For these reasons, few institutional investment opportunities are available in the downstream sector.
4. Independent Power: The creation and distribution of electricity by independent (i.e. non-utility) producers. Specific assets include independent power plants, transmission lines, and electric and gas distribution networks. Aging infrastructure, demand growth, environmental compliance, and renewable mandates have created a need for an estimated $1 trillion of investment in the next decade.
5. Equipment and services: Providers of the critical goods and services to companies involved in any of the above sectors. This strategy involves making equity investments in private companies operating in a range of energy industry sectors including exploration and production, technology, pipelines, oilfield services, and/or equipment manufacturing.
Upstream investments offer greater inflation hedging potential than the other four approaches because returns are more closely related to energy prices. Of course this also causes returns from the upstream strategy to generally be more volatile and, in the absence of hedging, vulnerable to falling energy prices. The midstream and power sectors are less subject to commodity price declines. All sectors offer the opportunity to add value by improving assets or building better companies. Diversification by strategy in a dynamic area such as energy is certainly desirable and valuable as a risk reduction measure.
Infrastructure
Infrastructure encompasses a number of types of facilities with an important role in the functioning of developed economies. This includes major sectors such as transportation (toll roads, bridges, airports, port facilities), utilities (water, electric, waste), communications (cell towers), and social infrastructure (schools, hospitals, prisons).
The global market for infrastructure has expanded rapidly over recent years. According to Deutsche Bank, the infrastructure markets in Europe and the US together represent $10-12 trillion.
The infrastructure investment opportunity set is being driven by government entities at all levels pursuing private sources of capital due to budget pressures and the huge infrastructure investment gap (estimated at $1.6 trillion in the US alone over the next five years). As a result, a growing amount of private capital must be utilized worldwide for the construction and maintenance of infrastructure.
Timber
Timberland supplies the basic raw material for a critical global industry—forest products. Timber can be managed economically as a renewable crop on hundreds of millions of acres worldwide. Given the forces supporting the conservation of forests in their natural state on many public and some private lands, there is increasing pressure on the remaining privately-owned forests to supply the needed timber output. This represents an excellent opportunity for patient, long-term investors.
Timber has unique characteristics, including the biological growth of trees. This consistent, predictable growth is the major component of timberland returns. In addition to volume-boosting biological growth, trees also become more valuable per board foot as they grow larger (called in-growth) because they can be used to create higher value products.
Timber managers are generally categorized by the types of trees they specialize in (softwoods vs. hardwoods) and the geographical focus of their efforts. The value of all timber is affected to some extent by the same macroeconomic factors (primarily world economic growth). At the same time, various tree species have their own advantages and disadvantages and different geographical regions are subject to specific local factors including state environmental regulations and the strength of the regional economy. In building a timber allocation, therefore, an investor should obtain both wood type and geographical diversification for risk reduction purposes.
Risks and Risk Mitigation
The Risks
Space does not permit us to address the unique risks of each of the sectors described above, though they should be thoroughly discussed and understood before investing. As a group, however, real assets have some common risk factors that are associated with many alternative investments.
As previously mentioned, low correlation between inflation hedges and traditional investments is the secret to earning higher returns at reduced risk. When stock markets generate outsized returns, however, one would benefit from investments that were highly correlated instead of real assets with their low or negative correlations.
Illiquidity is another risk faced by timber, infrastructure, and energy investors. Funds investing in these areas can be expected to have a life of 8-12 years. This means a portion of investors’ money is inaccessible for quite some time. Managers must be trusted to perform for the long-term, which demands an elevated level of expertise and due diligence.
Vintage year risk is another concern that affects all private equity investments, including real assets. This is the risk that substantial investments will be made at or near the peak of a market cycle. Since poor vintage years can only be known in hindsight, it is important that investors make a long-term commitment to these assets and invest regularly over time.
Poor manager selection is another major risk. Choice of managers is so important because there is a wide disparity between the best and worst managers of alternative investments, including real assets. To a much greater extent than in traditional asset classes, manager selection is extremely important. Identifying, evaluating, and gaining access to top-tier managers is key to generating targeted returns.
Of course, the existence of these risks is what scares away many investors and enables others to earn attractive returns. Fortunately, there are concrete actions that can be taken to significantly reduce the above risks.
Mitigating Risk
There are several ways to reduce the common risks involved in real assets. First, ensure that all decisions are driven by sound policy rationales—not by recent returns. None of us can control the markets. We can, however, make certain that sound investment policies exist and that they are implemented wisely and efficiently. Second, thoroughly educate yourself and your investment committee about infrastructure, real estate, timber, energy, and commodities. Third, perform strong due diligence. Evaluating prospective managers requires great attention to the four P’s: people, philosophy, process, and performance. Fourth, make a long-term commitment to real assets. This is necessary in order to reduce the illiquidity and vintage year risks.
Using a well-managed fund-of-funds mitigates many types of risk: manager risk, because of the multiple managers utilized; due diligence risk, because of the research and evaluation provided by experienced investment professionals; and vintage year risk, as most funds-of-funds spread their commitments out over multiple years.
Benchmarking
Investment results for a real assets or inflation hedges asset class should be measured against reported inflation in order to assess whether the objective is being met. A benchmark consisting of a premium over the Consumer Price Index is appropriate and demands that required returns rise with increases in inflation. A benchmark of CPI + 5% or so would require the asset class to earn a return of 8%, which is between those expected from fixed income and equities, during periods of average inflation (3% historically in the US). A benchmark of CPI + 5% also matches nicely with most endowments’ financial objective of earning their spending rate plus inflation. The premium over CPI should be dialed up or down for individual institutions, depending on how much risk they are willing to take and what percentage of the asset class will be allocated to inflation-linked bonds, which have lower return expectations that other inflation hedges.
Can a Small Allocation to Inflation Hedges Really Make a Difference?
One often hears some version of this question relative to smaller asset or sub-asset classes. In a study directed by Altius’ Jay Yoder several years ago, the impact that a 10% allocation to inflation hedges would have had over the previous three decades was analyzed. A beginning market value of $1 billion was assumed and actual historical returns were utilized. It came as no surprise that a portfolio with inflation hedges would have had higher returns and lower volatility than one without. The magnitude of the differences, however, was astonishing:
1. The portfolio with inflation hedges would have had an ending value $482 million greater than the portfolio without inflation hedges.
2. The portfolio with inflation hedges would also have generated $300 million in additional distributions over this period (assuming annual distributions of 5%).
This shows that a 10% allocation can, indeed, make a significant difference to the performance of a portfolio. Over several decades, the impact can be enormous.
Conclusion
Large sophisticated investors have already made substantial allocations and commitments to real assets. Almost without exception, those institutions generating the best returns over the past decade or so have had significant allocations to real assets for many years.
There are clear and proven advantages to adding real assets to a portfolio. An allocation to the asset class allows investors to benefit from higher returns, reduced risk, a measure of protection against inflation, and the ability of top managers to add substantial value in these inefficient markets.
Chart & Graph Data Disclosure:
The Annualized Returns graph displays returns of the Cambridge Associates LLC Energy Upstream & Royalties and Private Equity Energy Index; NCREIF Timber; Macquarie all unlisted infrastructure funds; S&P500; MSCI EAFE; US Corporate Bonds/Barclays Capital Aggregate US Bonds. Periods covered: Private Infrastructure 9 years as of September 30 2009, Private Energy 10 years as of March 31, 2009, Timber and public indices last 10 years as of June 30, 2009, Corporate Bonds 1987-2009.
The Correlations with Traditional Asset Classes chart reflects data sourced from NCREIF, Merit Energy Company, P&I, Yahoo Finance, Bloomberg, Federal Reserve, and Dow Jones. Indices used: Public Infrastructure/Dow Jones Brookfield Index; Timber/NCREIF Timber; Energy/Ibbotson Direct Energy Index; US Corporate Bonds/Barclays Capital Aggregate US Bonds; US Equity/S&P500; Non-US Equity/MSCI EAFE; Cash/US 90-day T-Bill. Period covered: Timber/1987-2009; Direct Energy/1970-2004; Infrastructure/2003-2009.
The Correlations with Inflation graph reflects data sourced from Bureau of Labor Statistics, Federal Reserve, Bloomberg, Merit Energy Company, MSCI Barra, NCREIF, Macquarie. Indices used: Timber/NCREIF Timber; Energy/Ibbotson Direct Energy Index; Infrastructure/Cash-flows of publicly traded and government owned infrastructure assets; US Corporate Bonds/Barclays Capital Aggregate US Bonds; US Equity/S&P500; Non-US Equity/MSCI EAFE. Period covered: Timber/1987 to 2009; Direct Energy/1970 to 2004; Infrastructure/1986 to 2006; US Equity and Non-US Equity/1978-2009; Corporate Bonds/1987-2009.
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