Historically, investment menus for defined contribution (DC) plans have been short on portfolio diversifiers, consisting largely of core equity and fixed-income strategies or products that combine the two. Even target-date funds have stayed mostly within the confines of stocks and bonds. This traditional approach has generally produced attractive returns over the long run, supported by a 35-year bull market in bonds. But now, bonds face a much more difficult return environment.
After years of slow growth and historically low interest rates, the global economy appears ready to accelerate amid an upturn in the business cycle and a more active mindset by policymakers, setting the stage for higher inflation and higher interest rates. As this occurs, we believe bonds are likely to suffer, making them less effective in counteracting the volatility of stocks.
At the same time, stocks could face challenges in sustaining near-record valuations. Healthy economic growth may provide a boost to corporate earnings, but there are still many unknowns about the impact of inflation on profit margins, as well as concerns around global calls for lower immigration, less outsourcing and higher tariffs, all of which could be negative for equities.
If bonds struggle to keep pace with inflation, any prolonged underperformance by stocks could affect investors’ ability to meet their financial goals. And for investors who are near or in retirement and hold significant fixed-income assets, this backdrop could make it difficult to generate sufficient income, arguing for broader portfolio diversification objectives.
In this environment, diversifying beyond stocks and bonds could become increasingly important. In recent years, an increasing number of investors have looked to solve this problem by carving out a portion of their portfolio for real assets. Today, the universe of listed real assets has grown beyond real estate to encompass other asset classes, including multi-strategy real asset portfolios.
Institutionally focused managers of defined benefit (DB) plans, endowments and foundations have long turned to real assets as a tool for diversifying portfolios beyond traditional stocks and bonds. A 2014 Greenwich Associates survey of institutional investors showed that respondents generally had meaningful allocations to real assets. By contrast, real asset investments in DC plans were well below institutional allocations, averaging just 4 percent.
DEFINING REAL ASSETS
“Real” assets are the structures and raw materials that allow the economy to be productive — the properties where you live, work and shop; the infrastructure assets that provide power and water or that enable transportation and communications; and basic natural resources such as food and heating oil. These tangible assets typically come early in the supply chain and tend to be sensitive to changes in inflation, either driving inflation themselves (such as higher energy prices) or having intrinsic value tied to replacement costs.
Direct investments in real assets typically require substantial capital investment and tend to be relatively illiquid. However, by investing in products that provide exposure to commodities futures or in publicly traded equities of owner/operators within real assets industries, investors can gain access to real assets with the added benefits of liquidity and daily pricing. This makes listed real assets a well-suited option for DC plans.
These categories share certain common characteristics but represent distinct markets with different drivers of risk and return. Note that while natural resource equities and commodities futures are joined by their common tie to raw materials (oil, natural gas, copper, etc.), they are separate and distinct asset classes, and their price behaviors can be quite different. Equity performance is driven by forward-looking earnings expectations reflective of a company’s business activities, whereas commodities futures, as spot assets, are primarily influenced by the near-term outlook for physical supply and demand.
In framing the discussion of real assets and their investment attributes, there are three key criteria for a long-term allocation:
1. Diversification potential from distinct performance drivers that generally result in low correlations with each other and with stocks and bonds
2. Attractive return potential over full market cycles, in both high- and low-inflation environments
3. Positive inflation sensitivity to protect against the potentially damaging effects of accelerating inflation on a portfolio concentrated in stocks and bonds
Looking at the core real-asset categories individually, we find that each offers potentially attractive attributes but also has inherent tradeoffs. Real assets have historically satisfied the three criteria listed. Each has had periods in which it has excelled or fallen short across one aspect or another. By combining the four core categories, the whole may be greater than the sum of the parts.
The distinct performance drivers of real assets have historically resulted in diversifying correlations — both with each other and with stocks and bonds. Considering the attractive historical returns of real assets, these modest correlations indicate the potential for meaningful diversification benefits that may result in better risk-adjusted returns. However, we also note that correlation statistics represent a relationship between two assets over a specific period, offering little perspective into their diversifying behaviors in particular market regimes. Specifically, we believe investors can benefit from asset classes that may perform well in challenging periods for traditional financial assets, when returns for stocks and bonds are both below average.
Real assets have shown the potential to provide attractive returns across full market or economic cycles. Since 1991, real estate and infrastructure stocks have outpaced the S&P 500 and produced higher risk-adjusted returns, as represented by the Sharpe ratio. It is also noteworthy that the equal blend of real assets produced solid returns despite a challenging environment for commodities, with lower volatility than stocks or individual real asset categories.
Returns for commodities over this timeframe were affected by a significant decline in prices from 2008 to early 2016, due to the downshift in China demand and an oversupply cycle. The commodity bear market also affected returns for natural resource equities. That being said, commodities have since seen substantial improvements in supply-and-
demand fundamentals due to a combination of supply rationalization and strengthening demand. This trend is likely to continue through 2017 and beyond as the market moves back into a state of balance.
Considering that the period since 1991 is notable for the absence of meaningful inflation, it is clear that listed real assets have been able to generate attractive full-cycle returns even without adverse, 1970s-style inflation shocks. However, if there is one factor that has historically characterized all real assets, it is their positive sensitivity to inflation surprises. This makes them potentially valuable in helping to protect a portfolio’s future purchasing power.
History shows that the impact of inflation tends to be most damaging to stocks and bonds when it is unexpected. Our analysis suggests that real assets tend to experience strong returns precisely during those periods, when inflation exceeds expectations.
The annualized returns of various asset classes in periods when actual inflation was higher than what was forecasted a year earlier. These periods were identified by comparing median inflation expectations from the University of Michigan survey of one-year-ahead inflation expectations to the actual year-over-year change in the Consumer Price Index.
In periods of unexpected inflation, real assets significantly outperformed stocks and bonds. Real assets also performed much better than their long-term average, contrasting with the reduced returns for stocks and bonds. The reasons stem from the economic dynamics that drive real-asset performance.
• Commodities are often direct inputs to inflation measures and generally respond to the same forces that drive prices for other goods higher, including stronger demand from increased economic activity, as well as supply constraints.
• Natural resource producers tend to benefit from higher prices, as they may earn higher profits on their capital base.
• Real estate owners generally have the pricing power to pass through higher input costs to tenants by raising rents. Higher inflation can also pressure the environment for construction due to higher costs for labor, materials and financing, reducing the incentive to add new supply.
• Infrastructure cash flows and asset values may have direct or indirect links to inflation. For example, some utilities and toll roads have rate escalators in their contracts tied to inflation measures.
IMPLEMENTING REAL ASSETS IN DC PLANS
The previous analysis shows that no single real asset class has excelled equally across diversification, total returns and inflation sensitivity. However, by combining them in a cohesive investment framework, investors can navigate those tradeoffs more effectively.
Historical analysis shows that adding real assets to a portfolio of stocks and bonds offers the potential to improve total returns for a given level of risk. These results can be attributed to the distinct return drivers of the underlying assets and their individual sensitivities to the business cycle, which provide potential diversification benefits.
A diversified multi-asset class approach to real assets not only offers distinct advantages from an investment perspective, it is also consistent with the objectives of plan sponsors and participants:
• A diversified, multi-asset class strategy effectively addresses the three objectives of diversification, long-term return potential and inflation protection.
• For the sponsor seeking to minimize menu clutter, a single real assets option can provide a streamlined solution that encourages sensible asset-class diversification.
• For participants, having access to real assets may help to increase confidence in their ability to achieve their financial goals at a time of uncertainty for stocks and bonds. Portfolios that are actively managed may provide an important advantage in achieving sufficient growth potential.
With stocks and bonds facing the prospect of subdued returns, many fiduciaries of DC plans are considering diversification options for their investment menu. Liquid real assets — including real estate securities, commodities, natural resource equities and listed infrastructure — may offer an attractive way to fill that diversification need, particularly as the market pivots away from quantitative easing and low interest rates to a policy-induced reflationary environment.
Vince Childers is a senior vice president and portfolio manager at Cohen & Steers.