Publications

- September 1, 2019: Vol. 6, Number 8

Constructing a real assets portfolio: What private wealth experts have to say

by contributing executives

Trillions of dollars have flowed into real asset in recent years and all indications are that trend is just starting to gain momentum. Witness institutional capital — the likes of pension funds, endowments, foundations and sovereign wealth funds — which, in less than 10 years, has grown the space by $20 trillion, with another $40 trillion expected to be placed in real assets in the decade ahead.

The standout performances of real asset-rich endowment and foundation portfolios have captured the notice of private wealth chief investment officers and advisers, as they look to move beyond two-dimension stock and bond portfolios, which are not expected to perform to past levels for some time to come. What’s more, while many asset classes perform poorly in an inflationary environment, a portfolio of real assets provides diversification and a hedge for inflation-driven liabilities and protects against losses in rising or high-inflation scenarios.

But there is still the question of the approach and considerations CIOs and wealth advisers should be taking into account when diversifying and fortifying client portfolios with real assets.

 

Mike Perry, head of U.S. advisory services, Nuveen

When looking to diversify a portfolio beyond stocks and bonds, investors should consider a wide range of real assets and related risk factors like geography, currency, geopolitics, climate and changing consumer preferences.

Real assets such as farmland and real estate are highly idiosyncratic: each sub-asset class has a risk/return profile that is shaped by distinct and sometimes highly localized factors. A soybean farm in Brazil, for example, has little in common with an almond farm in Australia. Similarly, our research has shown there are winners and losers among global cities positioned to capitalize on global economic and demographic trends. An increasing concentration of the world’s population in cities, for example, will create different real estate investment opportunities in Asia-Pacific cities such as Tokyo or Singapore than in cities such as Los Angeles or Berlin.

Creating a truly diversified portfolio of real assets means considering a wide range of investment mandates and sub-asset types. To effectively manage risk and achieve optimal returns, advisers and their clients should evaluate the widest possible range of options, be they investments in warehouse facilities benefiting from the rise of global e-commerce, or in multifamily properties designed to house an urbanizing workforce, or in farms that produce specialized crops to feed the expanding global middle class.

 

Ryan Sullivan, co-head of real assets, Aberdeen Standard Investments

As is often noted, investors primarily use real assets to bring better diversification, inflation mitigation and consistent yield-generation benefits to their portfolios, typically as a hedge against a portfolio or broader economic downturn.

These benefits are real and accessible through liquid securities such as treasury inflation protected securities (TIPs) and real estate investment trusts (REITs). While investors tend to remember these diversification and inflation-hedge benefits, many fail to consider private real assets as an avenue for enhanced alpha generation. At a point in the economic cycle when valuations in other asset classes, such as equities and private equity, have reached inflated levels, investing in private real assets may be beneficial.

A strategic and meaningful allocation to private real assets brings a great opportunity for enhanced alpha generation by function of an illiquidity premium. The illiquidity premium — which compensates investors for longer capital hold periods — delivers enhanced alpha generation through superior active investment strategies and manager selection.

This asset class is also considered relatively nascent and inefficient, allowing increasingly sophisticated investors such as family offices, high-net-worth individuals, and endowments and foundations to leverage their capabilities in direct and secondary-market investing for greater returns.

Finally, greater active management of private real assets allows the aforementioned investors — many of whom prioritize investments that align with ESG principles — to tailor their portfolios to “greener” investments such as agriculture and timber.

Generating alpha through allocations to private real assets requires a degree of sophistication, but duly compensates investors with meaningful returns as a complement to inherent portfolio diversification and inflation-hedging benefits.

 

Jon Bren, investor and consultant, KBS

When constructing a portfolio of real assets investments, the return profile of the investments should be measured against options in the public markets, and also the positive fact that real-asset investments are not subject to the daily volatility of the public markets. Part of the real-assets investment analysis includes the liquidity of the underlying investment/asset, as well as the expected hold period for that investment. The benefit to owning real assets is that, in most cases, the investor is purchasing a real asset at net asset value (NAV) and not paying for “air” (i.e., a multiple to earnings that moves every second based on many factors unrelated to the actual asset).

I split my expected return profile into two buckets:

  • 6 percent to 12 percent net return profile
  • 12 percent and greater return profile

There are real assets that provide a return of 6 percent to 9 percent net. Those real assets are typically structured to provide current income from dividends or distributions, based on cash flow derived from higher quality underlying assets. Examples are high-quality commercial real estate, as well as debt portfolios lending on real assets.

The 12 percent-plus target return bucket will typically have a longer hold period and less liquidity. That is the tradeoff that needs to be made for this type of return profile.  Examples for this bucket include: value-add and development commercial real estate, private equity and venture capital in scalable areas of high-growth opportunities, such as blockchain and medical technology.

When investing for the 12-percent-plus return bucket, investors target higher return investments knowing that some will not work out. Thus, the winners have to achieve very high returns so that investors do not end up averaging down with returns below 12 percent.

 

Stephen Blum, founder and president, Strategic Wealth Planning

Constructing portfolios that have a good chance of performing well over the next 10 years has become much more difficult. Because both stocks and bonds have been running near all-time highs, investors have become skittish and quick to unload positions, thus creating sporadic periods with sharp volatility spikes and rapid market declines. Prolonged low interest rates have made it necessary to take on more risk to meet target income requirements. Including alternatives and real assets with limited liquidity in portfolios can help long-term returns, reduce volatility and increase yield.

Our typical target allocation to alternative and real assets is one-third of the portfolio. We break these investments down into four categories: private equity, private real estate, private credit, and “other.” We tend to shy away from the multibillion-dollar funds as they are required to deploy large amounts of capital quickly and cannot be as selective as smaller funds. We also try to minimize the correlation between the investments we select. Ultimately, it is hard to know what will turn out to be a profitable investment, so we focus on funds with lower investment minimums to keep position sizes small and achieve greater diversification.

Conducting proper due diligence on nontraded alternative and real asset investments is a serious undertaking. It is necessary for advisers to look past the slick presentations, steak dinners and entertaining events. Networking with other advisers experienced in this space can help guide you through the due diligence process, leading you to better investment selections.

 

Marty Bicknell, president and CEO, Mariner Wealth Advisors

When considering the utilization of any asset class, we urge clients to consider many client-driven variables that should weigh in the decision.  These variables include:

  • Time horizon
  • Needed return
  • Risk allowance (return variance)
  • Needed income
  • Needed liquidity
  • Taxation considerations

The utilization of real assets in a portfolio mix can positively impact a number of the factors mentioned above, specifically, return/risk allowance and income. In other words, the inclusion of real assets in a portfolio can impact three of the four true “financial” variables.

In addition to the mentioned variables, over the long run we urge clients to consider the inclusion of assets in their decision process that can lower portfolio exposure to “deep risk” pressures.  These deep risks are not what Benjamin Graham, the father of “value investing,” called short-term “quotational risks” but are fundamental risks that can, over a long period, negatively affect a family’s financial health.  “Deep risks” we include in this analysis are:

  • Inflation
  • Deflation
  • Destruction risk (war)
  • Confiscatory risk (rising punitive taxation rates)

The inclusion of real assets has historically had the ability to positively impact inflation and confiscatory risk exposure in portfolios due to the inherit nature of real asset returns and pricing as compared to financial asset characteristics. It is this ability of real asset exposure in a portfolio to help meet various types of client fundamental needs combined with deep-risk management tendencies that justifies the utilization of real assets in many client portfolio structures.

When considering real assets for a client’s portfolio, we generally recommend an allocation of 12 percent to 20 percent, depending on risk tolerance and comfort with an illiquid investment.

 

Steve Gruber, global co-head of real assets, Hamilton Lane

When investors typically think of portfolio construction, they think of modern portfolio theory and, specifically, mean variance optimization and its formulation of an efficient frontier. Given the return, volatility and correlation of distinct asset classes, mean variance optimization seeks to construct an “optimal” portfolio that maximizes return for a given level of risk.  However, the tools for mean variance optimization that are typically involved in asset allocation decision making have limitations when applied to private real assets. Portfolio construction within real assets is especially difficult. Whereas many investors include private equity in a portfolio primarily for alpha generation, institutions may include real assets for any or all of the following reasons:

  • Alpha generation
  • Income generation
  • Inflation protection
  • Volatility reduction

Each of the subsectors within real assets can achieve those objectives depending on the specific strategies pursued. In addition, under the real assets umbrella sits a collection of related but distinct subsectors and investment strategies. Diversity in the portfolio requires effective selection and diversification across managers. Private equity may provide sufficient diversification, as these managers often invest across sectors or are agnostic to sectors as generalist investors.

Using a triangulation approach, we develop forward-looking assumptions on how we expect subsectors to perform over a long-term time horizon (usually 10 years). It’s important to keep in mind though, that these are just assumptions. The exercise of developing these assumptions forces us to think about each of the subsectors, and how they fit together in a diversified real assets portfolio.

 

William Platt, partner, Momentum Advisors

Real assets can play a real role in reducing risk by further diversifying risk, income, returns and liquidation events for clients. While not for everyone, the allocation to real assets should be determined by liquidity needs above all else, and then understanding and appetite for the asset class.  Though most firms have percentage caps on how much a client should invest to any particular investment, we believe that total net worth and income required from those assets is as large a factor. Someone worth $2 million should be subject to restrictions that someone worth $20 million should not be. Because of the lowering of minimums in this asset class, diversification across multiple real asset vehicles for someone with $2 million or $3 million is possible.

When building the portfolio, we are specifically looking for asset classes that contain as little correlation to each other as possible. This may include fast-food restaurants, REITs, investor-owned life insurance, oil and gas development projects, and medical device companies. A mix of these strategies can make sense whether the client priorities are income or tax-deductible solutions. Some vehicles have a lower risk profile, such as private fixed income, and some have a higher risk profile, such as an equity share in new technology companies. Some strategies may have themes that resonate with certain clients, such as a client who is concerned about the environment and is presented a green energy investment. We recently had a client who made investments in solar and wind — a tangible, impact investment — specifically because he wanted a positive return while making a difference in the world, that latter meaning more to him than dollars and cents.

Ultimately, the right mix depends on the risk tolerance, liquidity needs, desired return profile, and priorities of how the clients want their money to impact the world.

 

Vince Annable, founder and CEO, Wealth Strategies Advisory Group and The Household Endowment Model, LLC

The gold standard for constructing a client’s real assets portfolio has been established by David Swensen, CIO of the Yale Endowment Fund. A review of his fund’s allocation and performance demonstrates the need to use real assets in an individual’s personal portfolio. Obviously, an individual’s portfolio must take into consideration a different time horizon, risk tolerance and need for current income. But, based on a client’s profile, an endowment-style portfolio is one that will suit them in pursuing all that’s important to them in pursuit of their personal goals and objectives.

The question to ask is, what exactly is a real assets-backed portfolio? The answer is a portfolio with assets that are backed by “real assets” (i.e., different types of real estate equity such as buildings (whether industrial, retail, office, multifamily, etc.), farmland or debt, as well as energy assets such as natural gas or oil reserves. These assets can be obtained through private equity transactions or publicly traded. We believe, like Yale and David Swensen, this type of portfolio should be predominately private investments with a smaller portion in publicly traded entities, allowing investors with a long- term time horizon the opportunity to capture the alpha and illiquidity premium associated with private investments.

Factors including time horizon, risk tolerance, need for current income and other personal considerations must be taken into account when determining the proper balance of allocations to private and public investments.

 

 

 

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