Real assets—which range from listed securities, to direct real estate and infrastructure, to timberland and farmland— can be a valuable tool in the pension investor’s tool kit.
But positioning an allocation to a real asset isn’t the same as allocating to stocks or bonds, noted Emmanuel Matte, senior managing director, global head of investment solutions, Manulife Asset Management. He was speaking at the 2015 Risk Management Conference held this past August in Muskoka, Ontario. “First, publicly available indices on some of those assets classes may not be investable and could mislead the asset allocation process. In addition, correlations are not stable in the real asset world,” he explained.
Typical investors choose real assets for two reasons, he said: to reduce risk or to enhance yield. On the risk side, real assets provide an interesting source of stable income which could be of help in interest hedging strategies: for example, in an LDI context. Real assets also provide interesting inflation hedging characteristics.
Finally, in this prolonged low interest rate environment, “everybody’s looking for some sort of fixed income substitute…and clearly, real assets are a very appealing asset class to add,” said Matte.
Some consultants suggest buying direct real assets such as real estate instead of bonds—which makes sense, since “real estate can easily be seen as a long equity, long bond-like exposure,” he noted. The challenge lies with the allocation model. “If you start looking at correlations among real assets, you can get all sorts of results, as they may not be representative of the actual investment that will be made,” Matte said.
And even the definition of risk might need an overhaul, he suggested. Traditionally, risk has been associated with volatility, “but in the context of real assets, I’m not 100% sure this is the best way to quantify the risk investors are actually facing,” he noted. For instance, due the nature of private placements, it may be more appropriate to separate risk from the two sources of return: income and capital gain.
Matte proposed a different way of looking at risk in the allocation decision by understanding that income and capital gains have different short- and long-term return, interest rate and inflation sensitivities.
How to allocate to real assets
When determining how much to allocate to any asset class, the typical approach is to model the efficient frontier. But this may not work the same way for real assets, Matte cautioned.
He also suggests building real assets into your LDI strategy. “There’s big interest right now in moving toward new sources of alpha within an LDI mandate,” he explained. “Many plan sponsors have explored the use of core plus or active LDI as a way to enhance the LDI portfolio yield. Real assets can play a very interesting role in this case because the income component of direct real assets is less impacted by rising interest rates, unlike traditional long bonds.
“In the real asset world, you do have some stable income you can use for matching liabilities,” he noted. But if you’re not taking this into account in your LDI framework, “you may be understating how much hedging you really have,” he added.