With liquidity sloshing around the financial system, inflation may not be a matter of ‘if’, but ‘when’. Miranda Schoutsen asks whether real assets will help protect fragile nominal pensions from the relentless erosion of value

Over the past few years the pensions industry has seen a surge in interest for ‘real assets’: relatively new alternative assets with an inflation link, such as infrastructure, farmland, forestry and sustainable energy.

APG Asset Management invests approximately €8-10bn in infrastructure and natural resources, about three quarters of which is invested in infrastructure, says Ronald Wuijster of APG. According to Wuijster, inflation protection is a secondary objective. “We invest in infrastructure because of the returns and relatively stable cash flows, while diversification of our commodities portfolio is the main driver of investments in natural resources.”

Natural resources such as oil wells or gold mines offer an alternative to regular commodity investments and may complement an existing commodities portfolio, he says. “Physical holdings are an alternative source of returns besides commodities futures.” APG has a preference for production-unit investments – the country that grows the wheat or the actual oil well. “This affords you access to price developments while you can add value by the way the enterprise is run,” he comments. Investing in natural resources is riskier and APG therefore expects a higher reward than from infrastructure.

Over the past five years APG has made an annual return of approximately 15% on infrastructure, significantly more than the 6% on equities over the same period (due in part to the disastrous year of 2008). Semi-monopolies, such as toll roads, offer inflation protection to investors “according to the same mechanism as equities, only the effect is more pronounced as toll roads work with price contracts, while with equities an investor has to wait and see if the companies in question are in a position where they can afford to raise their prices.”

On the whole, the best inflation protection is to be had from well-regulated investments – but these involve the least business risk, “and we believe that economic developments are such that we expect to be rewarded for those entrepreneurial risks,” says Wuijster. “Given the return objective, that’s why within infra we tend to gravitate to investments that are less tightly regulated and offer the most business risk.”

APG is expanding its investments in real assets. “As a rule of thumb an allocation has to be at minimum 5% of the total portfolio to achieve any meaningful diversification. But these are illiquid assets and you can’t just add a couple of percentage points in a single day. We are gradually expanding our holdings. We are at 3% now. Some Canadian pension funds have been earning steady returns from infra for years and have allocations of 10% and even up to 15%.”

Infra according to APG
APG has been investing in infrastructure since 2008, opting primarily for direct investments. The asset class has a return expectation of around 10%, says Wuijster. “Like with private equity there is the J-curve effect to take into account: investors don’t receive cash flows while the gas pipe is being built. A large part of our infra portfolio has moved out of the construction phase and besides we also invest in existing assets.”

The manager invests €600-700m annually in approximately five projects, out of some 200 potential investments APG considers each year. “There are plenty of opportunities. Governmental bodies increasingly turn to the private sector while corporates wish to maintain a healthy balance sheet, so institutional investors can play a useful role.”

APG’s infra portfolio includes gas pipes, sustainable energy, public buildings, toll roads, ports, telecoms and public-private joint projects. While PGGM, the Dutch manager for the healthcare industry pension funds, started investing in infrastructure funds in 2004, APG prefers direct investments to funds. “Direct investments may require a lot of expertise and energy, but infra funds demand a management fee of at least 1% and on top of that a 20% performance fee over a hurdle rate of 8%. That amounts to 2-3%. Applied to a €3.5bn infra portfolio such as ours, that is a lot of money,” Wuijster says. “Besides, by investing directly we get to select the projects we want to get involved in. We aim for low-risk projects while funds tend to select higher-risk projects because of the performance fee.”

Wuijster concedes that scale is crucial to be able to afford a strategy of direct infrastructure investments. “Smaller pension funds have no choice but to use funds.” In light of the recent appeal to pension funds by the Dutch Labour Party leader Diederik Samson to invest more in the Dutch economy, some experts are calling for the government to facilitate direct infrastructure investments. “The government should launch a platform enabling smaller pension funds to invest directly in infra,” Anton van Nunen of Syntrus Achmea said in July.