Vince Childers thinks DC schemes should take a look at real assets.
After a 35-year run of strong returns, bonds now face an uphill climb, offering little yield to 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.
We believe 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 centers, 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 Greenwich Associates survey of US institutional investors showed that 97% of respondents had dedicated investments in real assets.
In contrast, DC plans have been relatively slow to incorporate real assets. A 2014 Greenwich Associates survey of U.S. institutional investors 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. In our view, this dynamic is likely to be similar here in the UK and Europe.
We believe DC plans should consider greater adoption of real assets in line with institutional investors, such as DB plans. Our analysis examines the attributes of real assets based on three primary objectives, diversification, total returns and inflation sensitivity.
Diversifying, inflation-sensitive returns
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.
Implementing real assets in DC plans
While different real assets offer attractive attributes, they can be volatile on their own and may not excel equally across all three criteria noted above. By combining real assets together, plan participants get a more balanced portfolio. Additionally, we believe the potential for added value through active stock picking 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 60/40 portfolio of global equities and diversified bonds served to improve total returns and reduce volatility. This resulted in higher risk-adjusted returns, as measured by the Sharpe ratio, see chart below. We attribute these results 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.
A diversified, multi-asset-class 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. In our view, 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
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