What is a ‘real asset’? And why would an investor want it.

The strict definition – a physical asset whose substance has value, as opposed to a financial asset, a contractual claim on an underlying asset – isn’t much help to practitioners. Commodities are clearly real assets and commodity futures, as cash-collateralised derivatives, are clearly financial assets. But how many pension funds are buying steel warehouses or grain silos? Equities are clearly financial assets, but they equally clearly confer ownership rights over the capital stock of corporations – which are undeniably real assets. Leaving aside all of those non-deliverable derivatives that net each other out in the financial ether, it’s obvious that all the value in this world resides in real things being used to make real things.

This might seem a bit academic. But when a pension fund allocates to ‘real assets’ it tends to define that term in a pretty fuzzy way. Basically, it seems to mean real estate, infrastructure, timber or farmland and commodities. When ‘commodities’ is used to mean ‘commodity futures’ that’s not so problematic, as these contracts confer the right to take delivery of a physical amount of a real asset. But ‘real estate’ and ‘infrastructure’ are increasingly accessed via debt instruments. The coupons are often index-linked, because the debt issuers often enjoy an inflation-linked cash flow from the underlying real assets.

That certainly makes them real-income assets. Furthermore, debt becomes a claim on real assets in the case of bankruptcy, when an issuer has to pay its obligations, if necessary, by liquidating capital stock. But hold on a moment: that claim is for a cash-value share of real assets, not an absolute share. In extremis, infrastructure and real-estate debt are not real assets in the way that the common stock of a corporation is.

So maybe it’s the real income that pension funds are truly looking for. Many face index-linked cash-flow obligations. And if they seek inflation protection, as our first article on real estate suggests (page 57), this comes from the income component of the total return – which is often erased completely by the volatile capital-value component. This might explain why Martijn Cremers and his colleagues from Notre Dame University found so little evidence for inflation protection from most real assets (page 62). Here is the supreme irony, then: if it’s inflation protection you want, dump the real asset and, instead, buy income strips – pure financial derivatives.

And there is more to it than this. Greater discrepancy between the income and capital-value components of total return denotes greater illiquidity. That suggests that analysis of historical returns from a real asset must take account of the extent to which any positive real total return has come, not from some inflation link, but from an illiquidity premium priced-into its capital value at the time of purchase; and further, the extent to which illiquidity risk in the capital value will correlate with equity risk, destroying the diversification benefits of the real income.

Diversification and inflation-protection are the most widely-cited reasons for allocating to real assets. But as our report indicates, many real assets – as opposed to financial income from real assets – seem to jeopardise rather optimise those two things. That makes clarifying terms and objectives crucial in this fast-developing area of institutional investment.