James Mee explains how real assets can offer multi-asset portfolios both return enhancement from differentiated sources and risk mitigation due to the broadly uncorrelated nature of the underlying risks
Real assets sit within the investment universe as return-seeking 'alternatives' to traditional asset classes.
They comprise an increasingly diversified universe of both tangible, asset-backed investment opportunities and capitalisable cashflow streams that can be valued with some level of confidence.
Broadly, real assets can be defined as property, infrastructure (including renewable energy infrastructure), asset finance, commodities and specialist lending.
As already suggested, real assets have a place in multi-asset portfolios as diversifiers of return - however, each of the five real assets we identify also have structural investment tailwinds supporting their respective outlooks.
The rest of this article will outline some of the long-term trends underpinning a subset of the real assets opportunity: infrastructure, renewables and commodities.
In 2016, the McKinsey Global Institute published Bridging Global Infrastructure Gaps, a paper in which it noted "the world invests $2.5trn a year in transportation, power, water and telecom systems" before highlighting that "this amount continues to fall short" of what the world needs in order to maintain its historic growth rate.
Indeed, according to the report, roughly 3.8% of Global GDP, or $3.3trn (£2.55 trn), needs to be invested in economic infrastructure per year just to support expected rates of growth to 2030, with a focus on power, roads, telecoms and water infrastructure.
For its part, the American Society of Civil Engineers believes $4.6 trn needs spending in the US alone, and ranked the country's infrastructure a 'D+' in its '2017 Infrastructure Report Card'.
In developed markets, aggregate spending on infrastructure has been declining since the global financial crisis while government spending has also fallen as a proportion of GDP, reflecting an austerity-led approach to economic recovery.
With government debt levels touching 100% of GDP in the US and UK, questions need to be asked as to how any future critical infrastructure spend will be financed in these and other similar economies.
It seems likely private capital will form at least part of the solution - indeed, this has already been the case in some geographies.
The UK leads the developed world in public-private partnership (PPP) projects, for example, while the US lags, despite reports of poor quality of existing infrastructure.
US infrastructure is now aging - the country saw a significant increase in transportation and water investment between 1980 and 2001 only to see a decline since the early millennium.
This may be about to change, though - in a presently confrontational political landscape, infrastructure investment offers the potential for some bipartisan relief.
Notwithstanding the necessary investment in developed market infrastructure, a significant opportunity also lies in developing markets all over the world. Catch-up potential is substantial, with road, rail and airport density still a fraction of the G7 average. Today, China spends more on economic infrastructure annually than North America and Western Europe combined, reflecting a likely shift of investment dollars from developed into developing markets.
Indeed, China's 'Belt and Road' initiative (BRI) is likely to spearhead a growth in investment in essential infrastructure across developing regions, subject to geopolitical complexities. China has already spent $434bn on construction (both BRI and non-BRI) since the 'One Belt One Road' strategy was announced in 2013. Two thirds of Chinese investment and construction in BRI countries has taken place in Asia, according to Citi, while the majority of spending has been on the energy and transportation sectors, with real estate and logistics also featuring prominently.
Renewables investment is a growing subset of infrastructure investing. With global warming and the climate in general gaining increasing traction among global policymakers, demand for renewable infrastructure is set to grow significantly over the coming decades.
The United Nations' Sustainable Development Goals specifically mentions "addressing climate change" as one of its central objectives, while the Paris Climate Conference in 2015 saw 195 countries adopt the "first ever universal, legally binding global climate deal", according to the European Commission.
Many respective signatories of the deal have since set targets for themselves to meet in order to keep the globe from warming by more than 2% of pre-industrial levels.
The EU, for example, has set targets for both 2020 and 2030, as well as publishing a long-term goal of cutting emissions by 80% to 95% of 1990 levels by 2050.
Private investment in renewable infrastructure in developed markets has historically been supported by government subsidy - in the UK, for example, most solar and wind projects benefit from historically-agreed 'feed-in tariff', 'renewable obligation certificate' or contracts for difference subsidies.
As investment in renewable technology has increased significantly and the cost of wind turbines and photovoltaic cells (solar panels) have fallen exponentially over almost four decades, however, subsidy-free investment is now economically viable.
An increasing proportion of renewable infrastructure deals completing today are being structured as 'power purchase agreements' (PPAs), where corporate entities (rather than governments) pay for power provided by the renewable energy providers for a fixed, often inflation-linked fee.
In order to achieve the UN and Paris Agreement goals and targets without significantly disrupting power prices, energy storage will likely need to be part of the solution.
Happily, battery technology is improving and it is becoming increasingly economical to have a battery storage facility adjacent to a solar park or wind farm.
This mitigates the 'intermittency' risk to national power grids by spreading out the provision of electricity rather than sending all electricity produced all at once (in the middle of the day when it is sunny, for example).
Battery storage could in time enable renewable energy to become part of a country's 'baseload' power make-up. Importantly, by spreading the energy provision over time, the renewable company will also improve the average price received, thus improving its own economics.
Undoubtedly there are risks - when subsidy periods roll-off, investors are then subject to power prices, which will result in a more volatile revenue stream, almost by definition.
Then there are assumptions surrounding asset depletion and useful life, operating cost assumptions and counterparty risks in the case of PPAs.
Batteries meanwhile are nascent in their use alongside renewable projects, while UK-listed companies are increasingly looking overseas for investment opportunities, increasing country and currency risk within their own asset portfolios.
Consequentially, a deep due diligence needs to be conducted on the specific investment opportunities available.
Despite a committed pursuit of sustainable development, the world continues to rely heavily on commodities for its energy - according to Energy Production & Changing Energy Sources, 87% of global primary energy consumption is made up of coal, crude oil and natural gas.
Looking beyond energy, hard commodities such as iron, steel and copper also remain essential inputs to the increasing infrastructure spend discussed above, while new sources of demand - and battery storage in particular - are generating demand for copper, lithium, cobalt and palladium.
On the supply side, meanwhile, miners and producers of industrial metals have significantly reduced capital spending, preferring to return cash to shareholders. Should this continue, we could see an undersupply of hard commodities to the global economy.
The asset class is unloved, as reflected in the performance of the S&P GS Commodity index relative to the equity market, thus providing a potentially interesting entry point into an undoubtedly cyclical real asset.
After an extraordinary run of performance - in both absolute and risk-adjusted terms - traditional asset classes face structural headwinds that will very likely limit the risk and return outlook for a traditional balanced portfolio of equities and bonds.
Real assets offer multi-asset portfolios both return enhancement from differentiated return sources and risk mitigation due to the broadly uncorrelated nature of the underlying risks.
The portfolio rationale for an allocation to real assets is that an inclusion can improve risk-adjusted returns through the cycle; the investment rationale is that certain real asset sub-classes are the beneficiaries of what could be multi-decade, structural tailwinds.
Each real asset sub-class carries its own risk and return dynamic, which must be fully understood before investing.
That said, infrastructure, property, commodities, asset finance and specialist lending opportunities provide a diversified and growing opportunity set to invest in.
James Mee is co-manager of the Waverton Real Assets fund
This article first appeared in the June issue of Professional Adviser's sister title Multi-Asset Review, which is now out. To make sure you receive your own copy of the next issue, please do register your interest here
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