The second in a new Insight series covers how investors can consider portfolio positioning to assets other than equities.
Our first insight series article discussed how an allocation to selective alternative assets across the real asset and absolute return universe could help investors navigate the uncertain outlook and improve portfolio risk adjusted returns. Within this second article, we focus on real assets in particular, analyse how these have performed historically, what investors may expect from exposure to each real asset class and how an allocation to real assets can aid portfolio construction in a variety of market environments.
Our contention is that an allocation to real assets can help investors meet the challenge of the low interest rate environment and bring portfolio diversification benefits. We believe that real assets should be considered as a core allocation within investment portfolios over the long term. As this article will detail, real assets have proven their value over time by providing reliable long-term total returns, inflation protection and the ability to offset the volatility of equity and fixed-income investments.
The universe of investment opportunities is broad, but can exhibit return sensitivity to inflation and / or economic growth that differs from traditional financial market assets, such as equities and fixed income. We have categorised the universe across five real asset classes, Property, Infrastructure, Commodity, Asset Finance and Specialist Lending.
Historical Real Asset Performance
The chart below helps explain the role of real assets within investment portfolios. We have assigned market indices to represent each of the five core real asset classes and plotted the return on the Y-axis versus risk, expressed as the standard deviation of returns, on the X-axis. Many of the real asset classes, in particular Property, Infrastructure and Asset Finance, have exhibited very attractive risk adjusted returns, versus traditional assets such as global equities and global fixed income, as confirmed by the Sharpe ratios detailed in the bottom right of the chart.
December 2003 to September 2019
Source: Morningstar *The Real Asset Index are defined by the following benchmarks: IPD UK All Property TR (Property), Morningstar Global Multi-Asset Infrastructure (Infrastructure), 50:50 ICE BofAML US Mortgage Backed Securities and DJ Transportation (Asset Finance), S&P/LSTA U.S. Leveraged Loan 100 TR (Specialist Lending), S&P GSCI (Commodity). MSCI AC World (Equity), BBarclays Agg (Fixed Income). TR in GBP.
The real asset composite index, constructed using an equally weighted basket of these five core real asset classes supports the case that a diversified portfolio approach to real asset investing can improve risk adjusted returns versus traditional equity and fixed income indices.
The outlier in this analysis is the commodity market, which has delivered significant volatility but little realised return. What is the benefit of an allocation to commodities at this juncture? As the chart below indicates, displaying the ratio of the S&P GS Commodity index to the Dow Jones Industrial Average, commodity markets are trading at extremely attractive levels versus financial assets. While timing any change in this trend has proved challenging to date, markets may be offering an interesting entry point to opportunities across the energy, mining and industrial commodity markets.
Ratio of S&P GS Commodity Index to Dow Jones Industrial Average
1917 – current
Source: Goehring & Rozencwajg Associates as at 27.11.19
How can investors expect an allocation to real assets to perform in particular market environments?
Assessing the broader universe, real assets share a number of common characteristics. Firstly, many investments are linked, to varying degrees, with the global economic cycle. They are, therefore, more likely to post stronger returns in a positive growth environment. Secondly, much of the universe offers inflation linked cash flows and thus protection from rising inflation. Thirdly, these cash flows, whether delivered via a coupon or a dividend, provide an attractive level of income. Given this, how can investors expect an allocation to real assets to perform in particular market environments?
Using the previously defined indices to represent the five real asset classes, we have analysed the performance in periods of rising or falling interest rates, as defined by how each asset class performed in periods where 10-year US treasury yields either fell, representing a falling interest rate environment, or rose, representing a rising interest rate environment over 1 year periods, rolling quarterly.
We have firstly shown how these assets perform during a falling rate environment, in the chart below:
Unsurprisingly, during these periods fixed income has outperformed equities. Secondly, certain parts of the real asset universe, in particular Infrastructure and Specialist Lending, performed strongly in a falling interest rate environment. Indeed, should the global economy remain within a subdued inflation and interest rate environment, many real assets offer better return potential than large sections of the fixed income market, given the more attractive current starting valuation.
Our final chart, shown below, displays the performance of the same selection of assets, during periods of rising interest rates.
In this scenario, equities substantially outperformed bonds. However, importantly, certain real assets, in particular those within asset finance, commodity, infrastructure and property delivered attractive returns. Should we enter a more inflationary environment, with resultant risk that interest rates may rise, an allocation to real assets can provide investors with a means to hedge this interest rate risk, generate positive risk adjusted returns, in conjunction with an attractive inflation linked income stream.
As we have highlighted, real assets may respond differently to varied economic environments; some are more tilted to the economic cycle, while others more correlated with inflation, while others specifically take on cyclical commodity risk. Given this, we believe there is a strong argument for how an allocation to a diversified portfolio of real assets can reduce specific risk inherent in certain individual real asset investments and provide a consistent attractive risk adjusted return profile over time.
Investors are looking for what real assets offer; steady, predictable and growing income, potential gains and capital preservation in an uncertain global environment. In our next Insight instalment, we delve a little deeper into each real asset class and detail the analysis underpinning a number of existing portfolio holdings in the Waverton Real Assets Fund.
The views and opinions expressed are the views of Waverton Investment Management Limited and are subject to change based on market and other conditions. The information provided does not constitute investment advice and it should not be relied on as such. All material(s) have been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy of, nor liability for, decisions based on such information.
Changes in rates of exchange may have an adverse effect on the value, price or income of an investment.
Past performance is no guarantee of future results and the value of such investments and their strategies may fall as well as rise. Capital security is not guaranteed.