Ahead of the Curve: A real asset in DC plans
Vince Childers says that in today’s environment, real assets can provide diversification, long-term return potential and inflation protection
After a 35-year run of strong returns, bonds face an uphill climb, offering little yield offset the potential impact of higher interest rates in a strengthening economy. At the same time, stocks are trading at demanding valuations despite uncertainty around fiscal policy, rising protectionism and shifting global currents.
These dynamics are likely to shape global financial markets for years to come, positioning real assets to play a critical role in helping investors diversify risk, improve return potential and preserve the purchasing power of investment dollars.
Real assets include toll roads, shopping centres, pipelines, grains, crude oil and fertiliser – the structures and raw natural resources that support the basic functioning of the global economy. Many real assets investments are highly illiquid, but can be accessed through liquid, publicly traded securities and commodities futures.
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 survey of US institutional investors by Greenwich Associates, a market intelligence firm, showed that 97% of respondents had dedicated investments in real assets.
In contrast, defined contribution (DC) plans have been relatively slow to incorporate real assets. The Greenwich Associates survey showed that the average allocation to real assets in DC plans was just 4% – half the allocation of corporate DB plans, less than a third of public DB plans, and less than a quarter of endowments and foundations. This dynamic is likely to be similar in the UK and continental Europe.
DC plans should consider greater adoption of real assets in line with institutional investors, such as DB plans. The attributes of real assets can be analysed on the basis of three key objectives – diversification, total returns and inflation sensitivity.
As a result of their different performance drivers, real assets have historically exhibited modest correlations with each other and with stocks and bonds. Going a step further, listed real assets have generally performed well when both stocks and bonds have underperformed at the same time, providing a potential defence against otherwise challenging market environments.
Real assets have shown the potential to provide attractive returns across full-market or economic cycles. Since 1991, global real estate and infrastructure stocks have outpaced the global equity market and produced higher risk-adjusted returns, as represented by the Sharpe ratio. This equal blend of real assets produced solid returns despite a challenging environment for commodities, with less volatility than stocks or individual real asset categories.
Real assets may not depend on high inflation to deliver attractive full-cycle returns, but they generally exhibit a positive association with unexpected increases in inflation, compared with the generally undesirable impact of inflation surprises on stocks and bonds.
While different real assets offer attractive attributes, they can be volatile on their own and might not excel equally across all three criteria noted above. By combining real assets, plan participants get a more balanced portfolio. Additionally, the potential for added value through active stockpicking and dynamic asset allocations can be an important factor in achieving investors’ return objectives.
For example, adding 10-20% of a diversified equal-weighted real assets blend to a classic 60% equities/40% bonds portfolio served to improve total returns and reduce volatility, resulting in higher risk-adjusted returns, as measured by the Sharpe ratio. These results should be attributed to the distinct characteristics of the underlying assets and their individual sensitivities to the business cycle.
A diversified multi-asset-class approach to real assets not only offers distinct prospective advantages from an investment perspective, but it is typically consistent with the objectives of plan sponsors and participants.
Such a strategy can effectively approach three objectives – diversification, long-term return potential and inflation protection. 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.
Vince Childers is senior vice-president and portfolio manager of real assets strategies at Cohen & Steers