History shows that secular changes in the investment environment force dramatic changes in asset allocations.
Low bond yields, along with outsized equity market volatility and modest equity returns, have brought us to a new asset allocation “tipping point.”
Global real assets—real estate, infrastructure, transport and natural resource assets that can provide higher income than bonds and superior risk adjusted returns to equities—will increase in size and importance in investor portfolios.
In the next decade we believe real assets will move from an alternative to a mainstream asset class. Portfolio allocations could rise from roughly 5%–10% today to as much as 25% in the next decade.
Investors are at various stages of what we call the Realization, a structural shift toward higher real asset allocations.
Those investors who recognize, embrace and act on this Realization in their portfolio allocations are likely to have better investment outcomes than those who do not.
The traditional mix of equities and bonds has long held unchallenged sway within pension fund and private investor portfolios, with fixed income offering yield and lower volatility and equities delivering earnings-driven capital appreciation. Recent shifts in allocation have largely been tactical (i.e., cyclical) moves between the two or, more recently, a gradually increasing strategic (i.e., structural) tilt to alternatives, including real estate, infrastructure and private equity.
But a convergence of slowly emerging trends and rapidly changing realities has given rise to concern over the ability of equities and bonds to realize the absolute and/or risk-adjusted investment performance necessary to cover liabilities for pension funds or meet wealth creation targets for other investors. Fixed income sectors are generally offering yields that are at or close to historic lows just as debate rages over whether stimulus will ultimately push inflation up from its current levels. The March 2012 yield-to-worst for the U.S. Barclays Aggregate Bond Index was 2.2%—and future returns are not likely to exceed the coupon by much, if at all. Equities have lagged over the most recent ten years, with an annualized total return of 2.9% (as of December 2011). Uncomfortably elevated volatility implies a decline in the prospects for attractive risk-adjusted returns as expectations for the U.S. economy have plunged—during the most recent decade (2000–2009) GDP growth averaged just 1.7% per year.1
WHAT ARE GLOBAL REAL ASSETS?
Real assets are characterized typically by investments in tangible “hard” assets that provide a blend of stable income, equity-like upside potential, inflation hedging, lower volatility and, in general, low correlations to the two current “traditionals”—equities and fixed income. For the purposes of this discussion, we focus the bulk of our discussion on global real assets that include investments in real estate (including REITs), infrastructure and shipping, as well as commodities and related investments such as timber land, farm land and natural resources. However, we acknowledge that many investors consider real assets to include any investment that is designed to provide a “real return” and frequently achieve higher allocations to the overall real assets category by including financial instruments such as TIPS, inflation-managed bonds and other inflation-sensitive investments. These instruments can certainly be considered within the scope of real assets and can be helpful in achieving a globally diversified real assets allocation.
The tectonic shift in standard asset allocation
A new normal? A new world of uncertainty, heightened volatility and slower growth? Perhaps, but investors are beginning to search out and invest strategically in alternatives that can deliver when the Big Two traditionals, bonds and equities, cannot. “Real assets” is one category that is fast gaining acceptance as an essential portfolio component, a third traditional alongside equities and fixed income. Real assets encompass a wide variety of tangible investments that give investors “optionality” in a world of uncertainty—the ability, that is, to serve as a stable source of income in weak markets and to participate in the capital appreciation associated with strong markets.
Global real assets' typical performance bridges the gap between fixed income and equity
Global real assets’ typical performance bridges the gap between fixed income and equity. First, they generate yields that are competitive with other fixed income alternatives. Their stable bond-like payment structure can serve as a reliable base for stable mid- to long-term total returns by contributing to price appreciation in up markets and offsetting losses when values decline. Second, as a higher yielding, non-bond complement to fixed income, real assets also offer the potential for equity-like upside and the ability to respond positively to healthy, growth-induced inflation. While bonds pay out a regular fixed coupon until they reach maturity, real asset payouts can grow in line with cash flow growth. Global real asset investments also provide geographic diversification, and, perhaps most importantly, they come, in most cases, with total return targets that range from competitive—8%–11% (net of fees) for core (less risky) strategies—to compelling—14%–20% (net of fees) for more opportunistic strategies.
A select group of investors, including some high-profile public plans, has already grasped global real assets’ potential. This Realization has tilted their current allocations toward real assets, which now approach 15%–25% of their overall funds. These investors are at the vanguard of what, we believe, is a rare, structural shift in pension fund/investor allocations to a new mix in which global real assets will migrate from being an “alternative” to being a “traditional,” playing an equally critical role in asset allocation as today’s traditionals of fixed income and equities.
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