Adding portfolio ballast with core global real assets
The intense market volatility of the last four months serves as a reminder to investors of the need to maintain exposure to effective sources of portfolio ballast. For local authority schemes that can tolerate higher liquidity risks, core real assets may provide access to attractive sources of uncorrelated, inflation-protected returns.
High quality assets (including high quality property) and assets that are less sensitive to the global economy, such as infrastructure, have held up well in the Covid-19 crisis. This performance underlines the importance of focusing on the highest quality real assets that are able to provide a true safe haven through a wide variety of market conditions.
Rather than restrict themselves to their domestic markets, our research also suggests schemes should consider globalising their exposure to gain access to a wider choice of attractive high quality assets, and to take advantage of the even greater diversification benefits that a global portfolio can provide.
Focus on the true core
Today’s ultra-low bond yields mean that de-risking by shifting from equities to bonds may come into conflict with long-term funding goals. Although government bonds remain the core source of risk mitigation in portfolios, reallocating to a global portfolio of high quality core real assets could be a more attractive option in the current environment, with our forecasts suggesting that the reduction in risk provided by real assets is without detriment to long-term performance.
As the Covid-19 crisis has demonstrated, the stable cash flows generated by real assets can act as an effective portfolio stabiliser in the event of a market downturn. However, recent experience has also demonstrated the importance of focusing on the highest quality assets that should provide the safe haven attributes that investors require, while avoiding those that are more sensitive to a downturn in the global economy.
While some investors may have drifted to lower quality and riskier assets in the later stages of the last cycle as they stretched for a higher yield and return, it has been the highest quality core property assets that have largely held their value through the crisis. Lower quality property, by contrast, continues to suffer from huge uncertainty. Also, it has been the less economically sensitive assets, such as infrastructure, that have continued to produce the most attractive risk-adjusted returns.
An attractive risk-return profile
It’s important, therefore, to ensure that safe haven portfolio exposure is focused on the highest quality core real assets. However, the potential advantages of switching some equity exposure to these assets, in our opinions, remains compelling. Based on our 2020 Long-Term Capital Market Assumptions, we find that the average LGPS asset allocation* could benefit from a small increase in expected return by switching 10% of its current equity exposure to a globalised portfolio of core real assets, including infrastructure.
While increasing expected returns, an allocation to global real assets would also be expected to deliver much of the volatility reduction achievable by switching to fixed income. Notably, this globalised exposure to a broad range of real assets we believe is also more effective than switching solely into a portfolio of UK property, or into global property.
Impact on LGPS of switching 10% from equities to fixed income, real assets or UK property
Go global to maximise opportunities
We find that maximum benefit can be gained by de-risking into a globally-diversified portfolio of core real assets, rather than sticking with the traditional home bias of LGPS real estate exposure (local authorities have an average 9% allocation to UK property).
Although it may not be a reliable guide to the future, past experience shows that UK real estate has been more volatile than global core real assets. A portfolio that switched 10% from its equity allocation to UK property would have fared considerably worse through the global financial crisis, for example, than the existing portfolio. Similarly, it is the lower quality property assets that are suffering from the greatest uncertainty in the current crisis.
An allocation to a high quality portfolio of global core real assets provides strong diversification benefits to both global equity and global bonds, allowing schemes that are willing to invest globally to access larger markets and a broader range of investment opportunities than they could achieve in a domestic allocation.
Globalised portfolios can also provide an effective hedge against UK inflation. Global real estate, for example, has provided a better hedge against UK inflation than investing in UK property alone, which at least serves to question the belief that UK property is a good long-term hedge for UK inflation.
Correlation of rolling one-year return, June 2006 – December 2017
Our paper, “Going Global in Pension Real Estate Portfolios”, looks in more detail at how pension schemes can take advantage of increased diversification benefits and a greater scale of investment opportunities by globalising their real estate holdings.
If you would like to discuss allocating to global core real assets in more detail, please don’t hesitate to contact your usual J.P. Morgan Asset Management representative.