Alex Farlow: Real assets and their role in multi-asset portfolios

A key attraction of multi-asset solutions is the potential diversification benefits they can offer. By investing in a portfolio with exposure to a range of securities across equity and fixed income markets, investors can spread their risk and capture the potential upside from a variety of difference sources. 

Differing asset classes typically exhibit distinct characteristics and this lack of correlation can potentially provide a buffer to investors during times of market duress. Whilst historically multi-asset portfolios favoured a mix of equities and bonds to achieve this diversification, funds giving access to real assets are increasingly part of the overall blend.

Real assets comprise a spectrum of very different investments, which have quite distinct characteristics. One trait they have in common, however, is the exposure they offer to a physical, tangible asset. 

Property is possibly the most widely understood of these, but other examples of real assets might include infrastructure projects, forestry and agriculture, or commodities such as oil or gold. The sector also includes funds that invest in debt secured on tangible assets, or asset backed securities.  

In addition, there are a number of fund structures that offer access to these assets, including open-ended and closed-ended vehicles, REITs in the case of property, and funds that invest in the shares of businesses linked to the underlying assets - mining companies, for instance.

The benefit of diversification is not the only attraction of real assets. Multi-asset funds have increased their allocations to many of these vehicles in recent years as a means of generating a high level of income in an environment where it has been difficult to secure it from more traditional sources given the low interest rate environment. 

This form of income, which is frequently linked to contractual obligations - an obligation to pay rent in the case of property - can provide a good hedge against inflation. However, not all real assets produce income. Gold for instance has an intrinsic value and is often viewed as a safe haven asset, which may be helpful in a portfolio in falling markets.

The fund structure is an important consideration for those allocating to real assets. A key drawback of investing in open-ended funds that hold physical assets is the illiquidity of the underlying holdings, particularly at times of market stress. 

The managers of these funds are not able to dispose of these holdings to meet redemptions in the same way that an equity or bond manager can. In particular, ‘bricks and mortar' funds, which buy physical properties such as commercial units or offices, have come under scrutiny on a number of occasions. 

Following the surprise result of the EU referendum in 2016 there was a run on these funds, which led to many of them gating. Investors have also not been able to access their money in these funds during the market crisis accompanying the current coronavirus pandemic.

This latest development has been the result of material uncertainty over the valuation of property assets and not a result of liquidity for the vast majority of funds. Ultimately, both of these actions were made to protect the interests of existing investors in these funds. While all open-ended property funds hold cash buffers, which can be drawn on to meet some level of redemptions, these are not always sufficient to meet demand.

Some point to the advantages of a closed-ended structure in gaining exposure to illiquid asset classes as a means of addressing this liquidity mis-match. This is because investors dispose of the shares of the vehicle at a price another investor is willing to pay, removing the potential for the manager to be a forced seller of the underlying assets. However, these structures are not without their disadvantages. 

At times of market stress, investors frequently dispose of their most liquid investments first.  This means that listed vehicles can be more closely correlated with other equity holdings than anticipated. During the market sell-off in the last quarter of 2018, certain listed infrastructure funds, for example, held up much better than global equities. 

However, during the market crash accompanying the current Covid-19 crisis there was indiscriminate selling across all asset classes, including listed real asset funds. Under these circumstances, when all assets correlate towards one, their behaviour can be more closely aligned with broader equities and their role as a diversifier of risk can be reduced significantly. 

Real assets can play a valuable role in a multi-asset portfolio both as a means of diversifying risk or providing an alternative source of income. However, understanding the underlying characteristics and behaviour any real asset exposure brings to a portfolio is key. Not just in normal conditions but also during a stressed environment. 

An investor's time horizon is also an important consideration. While retail investors might need to redeem their holdings at relatively short notice, institutional investors tend to have a much longer-term mindset enabling them to weather short-term volatility and fluctuations in valuations. 

As with all aspects of multi-asset investing, it is essential to have a clear view of a portfolio in its entirety and the position of real assets within it to avoid watering down their perceived benefits and inadvertently skewing its overall risk profile. 

Alex Farlow is head of risk based solutions research at Square Mile Investment Consulting and Research

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