In Newton Investment Management's latest DC column, Paul Flood considers the role of liquid real assets in default strategies
Constructing a portfolio with diversified sources of return is an important consideration for strategies that form a key building block of a defined contribution (DC) default solution. However, while diversification may be a sound principle, achieving a reward for it requires a disciplined approach. Government bonds may offer a place to hide during periods of financial distress, but the impacts of extraordinary monetary policy have left prospective returns on bonds and cash wallowing well below inflation. Last year also saw a number of occasions when bonds and equities sold off in unison, just when investors needed their negative correlations to hold up. This illustrates the importance of having a framework to assess the benefits of diversification and identify opportunities early.
At Newton we use investment themes to identify long-term global trends and help us assess the future diversification potential of assets, rather than just relying on historical correlations. This helps us allocate members' capital into areas we believe are more likely to generate attractive returns and avoid areas that may be more prone to risks. For example, our Earth matters theme led us to avoid the catastrophe bond market, as we believed its reliance on historical data to price risk could be impaired as changing weather patterns result in certain regions becoming more prone to extreme weather events. However, the theme has also helped us identify areas of opportunity, such as operational renewable-energy assets. With fixed, inflation-linked revenues representing up to 50% of these firms' overall earnings and power prices making up the rest, their sensitivity to the economic cycle is very limited.
Just five years ago, renewables were a nascent market, and investors continue to question the ability to access scale. However, to decarbonise the world's power generation will require up to $50trn of capital over the next 30 years1, which in our view should provide support for the asset class as companies compete for access to that capital. Of course, careful analysis of the business models and structures of these companies remains essential.
Renewables are just one example of what I would define as liquid real assets, which can also include operational infrastructure, aviation financing and property. While investors with lower liquidity requirements can access unlisted and direct investments in real assets, the investment trust structure provides access for smaller schemes and those with daily liquidity requirements. The other benefit of the listed space is the ability to adjust portfolio positioning quickly when more attractive opportunities present themselves.
We have deployed liquid real assets in our multi-asset and absolute-return strategies for several years, as we seek to achieve a more predictable risk and return profile for our clients. While liquid real assets are not without risk, they can provide uncorrelated returns, benefiting those pursuing fundamental diversification. Such attractive characteristics could be advantageous for DC schemes looking to inflation-proof members' portfolios against a backdrop that remains challenging for more traditional assets.
Paul Flood is portfolio manager, multi-asset team, at Newton Investment Management
1 Source: Bloomberg New Energy Finance
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