Real assets, such as property and renewable energy, are evolving into a mainstream asset class as institutional investors look for alternative investments post-financial crisis, says Stuart MacDonald, of Aquila Capital.
The decimation of bond and equity markets in the global financial crisis spurred many institutional investors to look for alternatives. This has been reinforced by the financial repression, with widespread projections of lower returns from traditional investments, as well as fears in some quarters of resurgent inflation.
Many institutional investors have stuck with hedge funds or even invested in them for the first time, since their aggregate performance in the crisis showed that there were clear benefits on the downside to incorporating such investments in their portfolios. Others have taken up the smart beta theme, which is reflected in the proliferation of risk parity strategies and exchange-traded funds, two of the ways in which this can be harvested. It is also clear that real assets are evolving into a mainstream asset class that will feature increasingly in investors’ portfolios alongside other alternative investments. Our own experience supports this trend, as we are seeing a continued rise in enquiries from investors in our real assets products, such as agriculture and renewable energies. So what are the drivers?
The basic case for real assets is generally well understood. They can generate income streams and act as an inflation hedge, while offering opportunities for capital appreciation, low correlations with other asset classes and an opportunity to harvest a liquidity premium. At Aquila Capital, our recent real assets survey of more than 50 institutional investors across Europe was illuminating. It is clear real assets are evolving into a mainstream asset class that will increasingly feature in investors’ portfolios alongside other alternative investments. The majority (60%) of the investors surveyed expect to see institutional allocations to real assets increase over the next three years. Of these, one in five (21%) expect the rise to be “significant” while only 7% expect institutions to reduce their exposure.
It is interesting to compare investors’ current holdings with their longer term views.
Of the respondents, 90% said that they had some exposure to real assets and 44% had more than a 10% exposure.
Property was the most popular asset, with 74% of investors having exposure to it, followed by infrastructure (37%), commodities (26%), renewable energy (21%), timber (18%), shipping (7.9%) and farmland (2.6%).
WINNERS AND LOSERS
In the future, however, there will be some winners and some losers. More than four times as many respondents are positive on the investment outlook for the asset class (41%) compared with those who are negative (10%).
In this context, property was ranked as the real asset type offering the greatest investment opportunities over the next five years (33%), followed by infrastructure (18%), commodities (15%), farmland (15%) and renewable energy (15%).
Aquila’s study also identified the key drivers behind institutions’ increasing appetite for such investments. These are long-term positive cashflows (56%) and protection against inflation (56%). Portfolio diversification (thanks to real assets’ low correlations to other asset classes) is also a major consideration (42%). There is, as well, the perception of a continuing need for investments with attractive risk/return profiles, as well as their growing familiarity with the asset class because of existing allocations.
Several factors are considered to support the case for real assets over coming decades. The front runners are: The increasing global population (55%); increasing standards of living, especially in emerging markets (51%); out-of-date infrastructure in need of modernisation, located mainly in OECD countries (50%). Others that feature prominently are: increasing industrialisation and urbanisation, particularly in emerging markets (44%); and long-term supply/demand imbalances, which have a bearing, for example, on demand for agricultural and renewable energies investments (41%).
This positive picture does have some blurring at the edges. Notwithstanding a widespread grasp of the basics, the variation between different investors’ knowledge levels is wide, even though so many have real assets investments. It is interesting that fully one-third say that a barrier to engagement is a lack of understanding, while 41% cite a need to have a clearer understanding of the risk-reward profiles involved. Equally, one-fifth said that they are unwilling to commit to what they see as “untested” investment sectors. Combine this with concerns about managers’ often limited long-term performance histories and one sees a widespread conservatism of approach that may militate against innovation except by the most established providers. It may also mean that first-mover advantages where they exist could continue to be harvested by those who have achieved a deeper understanding of the different options available.
In summary, there is a growing appreciation among institutional investors of real assets. In the coming years, we can expect to see a narrowing of the gap between actual and desired levels of investment. The survey’s findings and our own contact with investors show that institutional investors are broadly aware of the opportunities. This is supported by views of long term macro trends and real assets’ ability to deliver strong, inflation-protected income with high levels of investment security, manageable risk and inflation protection, as well as limited correlation to traditional asset classes.
For many investors, however, a knowledge gap persists and many are not yet able to distinguish clearly between different types of real assets. For example, there is direct investment in farmland according to an owner/operator model (in which title is taken to the underlying land as well as responsibility for the extraction of value from the farms above it). This has very different characteristics to investment in renewable energies, such as solar, wind or hydro power, which are themselves differentiated. Equally, we sometimes encounter a lack of understanding of the implications of the different forms that an investment can take, whether direct ownership, specialised investment funds, closed-ended funds, club deals/co-investments and managed accounts.
From an investment manager’s standpoint, however, the most significant challenge in attracting institutional capital to real assets is not necessarily an educational one. While innovation does not go unrewarded, there is a need to demonstrate a strong and long established track record, as well as suitable scalability. In this regard, real assets are no different to other parts of the investment management industry.
Stuart MacDonald is a managing director at Aquila Capital
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