Real Assets: Potential Alternate Source of Growth and Income?

By Sloan Smith, MBA, CAIA, CPWA®

In 2020 the Federal Reserve and the US Congress took aggressive monetary and fiscal action. The COVID-19 outbreak caused not only the US but also the global economy to shut down in order to hinder the spread of the virus.   The short-term federal funds rate approached 0%, which was the lowest since 2008. Also, the yield curve shifted lower with the 10-year treasury yield dropping to less than 0.75%. After their March 2020 lows, equities rebounded to new all-time highs, bringing some valuations to above their long-term averages. The combination of low bond yields and above-average equity valuations point to the difficulty of how a stock and bond portfolio generating robust future returns while mitigating downside risk.

This dilemma has caused investors to look for alternative asset classes meet their objectives.  Investing in real assets may provide a potential solution. Real estate, commodities, and the energy sector often come to mind when considering real assets. However, additional sub-asset classes that merit consideration include infrastructure, timberland, and farmland. These investments offer the opportunity to improve a portfolio’s risk/return profile, access attractive cash flows, participate in equity-like capital appreciation, and help to hedge against inflation risk.

Potential Real Asset Investments and Their Advantages

1.       Infrastructure

Infrastructure assets include toll roads, airports, railways, wireless towers, and data centers.  These investments offer relatively stable and predictable income through long-term fixed contracts. These investments provide some monopolistic characteristics with high barriers to entry. The key return drivers for infrastructure are the free cash flow yield, inflation escalators, organic growth, and leverage. Further, the historical correlations between the MSCI Global Infrastructure Index and the S&P 500 Index and the Bloomberg Barclays Aggregate Bond Index are quite low at around 0.01, showing the diversification benefits of infrastructure. 

2.       Timberland

Timberland assets include pulpwood (for paper and packaging materials), softwood, (for building materials), and precious hardwood (for furniture and remodeling). The key return drivers for this asset class include income from harvesting, inflation from the value of the timber land, and biological tree growth. Timberland has historically provided a hedge against inflation, and the correlations of the NCREIF Timberland Index between the S&P 500 and the Barclays Aggregative Bond Index are also quite low at around 0.04.

3.       Farmland

Farmland assets are comprised of row crops (corn, soybeans, cotton, rice, vegetables, wheat, and potatoes) and permanent crops (almonds, walnuts, pistachios, apples, wine grapes, cranberries, and macadamia nuts). The key return drivers come from the income received from selling the crops, inflation of land value, productivity growth, and crop price growth. Farmland is a highly fragmented market with minimal institutional ownership, which creates numerous opportunities for potential investors. Farmland productivity has historically increased by approximately 2% a year, which is a further benefit of the asset class. Also, population growth and a reduction in arable land are strong secular trends for farmland.

4.       Additional Portfolio Advantages

Diversified real asset funds often target annualized returns of 5% to 7%, significantly higher than bonds, yet with a volatility profile closer to bonds than stocks. Also, real assets could appreciate in value should inflation accelerate in the coming years due in part to the massive increases in the global money supply from the COVID stimuli.

The Potential Drawbacks of Real Asset Investing

1.       Illiquidity

When investing in the real assets, especially in the private space, liquidity is usually limited. Infrastructure, timberland, and farmland are physical tangible assets that require time to transact. Therefore, redemptions from this asset class may take three months or a year in some cases. This scenario is significantly different than what is experienced in fixed income where the market is highly liquid. However, limited liquidity is a potential trade off in the search for greater income and higher total return.

2.       Fees

When allocating to fund of real assets, the fees are usually higher relative to an equity or fixed income strategy. The median expense ratio for an active equity and fixed income manager is between 0.60% and 0.90%, while fees are typically above 1.00% for a real assets manager. As real asset funds attempt to access the best opportunities in farmland, timberland, and infrastructure, they usually demand a higher fee for not only identifying but also managing these investments. Also, in rare cases strategies may charge a performance fee if a return hurdle is achieved. 

3.       Track Record

Historically, real asset funds have targeted only one specific type of investment using a structure entailing capital calls and a long-term time frame. Allocating to real assets can be beneficial especially if an investment strategy offers is broad diversification among infrastructure, timberland, and farmland in one portfolio. However, these diversified real assets strategies are limited in number and usually do not have long-term performance track records.  Therefore, it is important to perform thorough due diligence on these diversified real asset managers that may be relatively new to the space. Investors’ interest in real assets continues to grow. The environment of stretched equity valuations in some areas, the future sparse returns in fixed income, and the potential for rising inflation point to merits of real assets. Naturally, the advantages and disadvantages of real assets need to be reviewed carefully before pursuing an allocation.  Overall, we believe that an allocation to diversified real assets could enhance the probability of meeting long-term return objectives while enhancing portfolio diversification and continuing to manage downside risk.

Figure 2 (Global Investment Universe) [2]

Figure 1 (Trailing Risk Reward Chart from 1/1/1993 to 12/31/2019) [1]

[1] Source: Versus Capital Research, Morningstar Direct, NCREIF, JP Morgan, MSCI.

[1] Source: JP Morgan 2018, WFE 2018, LaSalle ISA 2018, McKinsey GI 2016, Hancock 2017, Versus Capital 2018