The asset class known as ‘real assets,’ which includes real estate, infrastructure, transport and natural resource assets, is not only gaining in popularity among institutional investors, but it also is moving from an alternative investment to a more mainstream one. In fact, a recent report by JPMorgan Asset Management predicts that, over the coming decade, pension plans’ allocations to real assets could rise from a range of 5 percent to 10 percent spread among the individual component assets to a consolidated allocation of up to 25 percent of total assets.
According to the JPMorgan report, “a convergence of slowly emerging trends and rapidly changing realities has given rise to concern over the ability of equities and bonds to realise the absolute and/or risk-adjusted investment performance necessary to cover liabilities for pension funds or meet wealth creation targets for other investors.”
Joseph Azelby, JPMorgan’s head of global real assets and a co-author of the report, said in an interview in the June issue of PERE: “We need to move investors from thinking 5 percent real estate and 3 percent infrastructure to 25 percent in real assets. Therefore, we are going to make that collection of assets as broad as possible to deliver it.”
Furthermore, Michael Hudgins, the report’s other co-author and a real estate strategist at JPMorgan, told PERE: “Over the last year or so, we’ve seen signs that these real asset sectors have really come to the fore. Investors are looking for solutions, and bonds won’t get investors to where they need to go.” He added that, given that investors are looking for solutions, JPMorgan is seeing a structural shift from the ‘big two’ asset classes (bonds and stocks) to the ‘big three’ (bonds, stocks and real assets).
Historically speaking, during the first half of the 1900s, the ‘big two’ investments didn’t amount to much more than the ‘big one’: bonds. It wasn’t until the late 1960s and 1970s that pension allocations gradually moved from 80 percent or more in fixed income to the current standard of 60:40 stocks and bonds.
Real GDP growth from the end of 1929 through 1975 suggests that growth before the 1950s and 1960s was volatile. Growth-oriented investments like equities languished, while fixed income attracted investors. In addition, the 1950s and 1960s delivered two decades of stable and sustained economic expansion. While the negative experience of the 1930s and 1940s would have taken time to loosen its hold over investor psychology, the 1950s and 1960s laid the foundation for what JPMorgan calls ‘the growth case’.
With less volatility and more dependable economic and market fundamentals, the case for moving from ‘risk free’ to riskier investments with higher inherent return potential finally made sense. Despite the real GDP expansion of the 1950s and 1960s, investors nowadays face diminished prospects. This is where alternative investments, such as real assets, come into play.
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,” the report stated.
Second, as a higher-yielding complement to fixed income, real assets 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, in most cases, come with total net return targets that range from 8 percent to 11 percent for core strategies to 14 percent to 20 percent for opportunistic strategies.
Already, there are signs that pension plans are moving in this direction. A small group of North American institutional investors already have tilted their current allocations toward real assets, which now approach 15 percent to 25 percent of their total assets. Among those with a significant allocation to real assets are the Dallas Police & Fire Pension System, the Ontario Teachers’ Pension Plan, the Austin Police Retirement Fund and Yale University’s endowment.
According to Hudgins, over the course of conducting its research, JPMorgan looked at approximately 2,500 plans managing a total of roughly $8 trillion. “If all of those plans went to an allocation of about 20 percent to real assets, that would bring another $715 billion to the market,” he said.
Such an inflow of capital would likely drive up valuations. “The early movers are only going to benefit moving forward,” Hudgins added. “You needed to get in early and aggressively, as we’re going to see positive pricing for these assets.”
Another early adopter
A Pennsylvania pension has consolidated its alternative investments into real assets
The Pennsylvania State Employees’ Retirement System (PA SERS) is another institutional investor to recently adopt the strategy of investing in real assets. Indeed, the $24 billion pension plan agreed to a new strategic plan that includes real assets on 13 June.
Under the plan, the new asset class structure recognises real estate as a sub-asset class within the real assets class, rather than as its own primary asset class. Moving forward, instead of investing separately in real estate, commodities, timberland, energy and natural resource equities, PA SERS will allot 12 percent to real assets, which includes all of those subcategories.
A spokeswoman for the pension told PERE that, as a result of the strategic shift, PA SERS will be reducing its investment in real estate from roughly 10 percent during its last fiscal year to 6 percent going forward.
Documents from the state pension reveal that the move was made to increase liquidity options, increase returns and reduce fees. “SERS will reduce the pace of new real estate opportunity fund investments, which have high fees, lock up capital for extended periods and duplicate strategies offered by its separate accounts.”
The Caisse for separation
Though investing more in real assets, the Quebec plan is still separating its portfolios
While some investors are changing their investment strategy by establishing a real assets portfolio, others are looking to beef up their real assets investments while not changing their allocation structure. For example, the Caisse de dépôt et placement du Québec is planning to increase its investments in real assets such as real estate, infrastructure and private equity in order to accommodate its investors’ desire to maintain a rate of return of approximately 7 percent.
Bernard Morency, executive vice president and chief operations officer, told PERE that the Caisse is looking to up its total allotment to the three alternative investment classes from approximately 25 percent to 30 percent. However, it is not putting the investments into one ‘real assets’ portfolio.
Currently, the second largest pension fund in Canada allots approximately 12 percent to real estate, 10 percent to private equity and 3.6 percent to infrastructure. Morency said the decision as to how the additional 5 percent will be distributed to the three asset classes has not yet been made. “We need to discuss that with our investors,” he added.