A REAL SOLUTION
Inflation, forecast to be transitory by many market observers earlier this year, has proved to be persistent. The possibility of stagflation looms. Both stocks and bonds have suffered. Real assets, defined as tangible assets that have intrinsic value, such as real estate, commodities and infrastructure, and that tend to offer inflation protection, are well poised for this environment, according to asset managers and index providers. Real assets also offer additional benefits, such as diversification and yield, leading many allocators to respond to the call for a long-term strategic allocation to real assets, and not just as a tactical one in response to the short-term spike in inflation.
“Inflation protection and diversification are at the forefront of institutional investor interest in real assets today,” said Jim Wiederhold, associate director of commodities and real assets at S&P Dow Jones Indices. “Real assets such as real estate, commodities and natural resource equities have historically tended to perform well during periods of high inflation and have demonstrated low correlations to major asset classes.”
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Wiederhold noted that commodities represented by the S&P GSCI Index and natural resources represented by the S&P LargeMidCap Commodity and Resources Index have performed better than other asset classes in 2022. “These are the assets with the highest historical inflation betas,” he said. A risk-off environment such as a recessionary or an inflationary environment can still negatively impact real assets, he said, but possibly to a lesser degree than other major asset classes: “This is because they tend to be better stores of value.”
This performance has led investors to realize this may be an opportune year for real assets. “With the macro backdrop of inflation, investors are looking for alternatives” Wiederhold said.
A diversified approach
“Inflation has motivated investors, and those that did not have an explicit exposure to inflation-sensitive assets in their portfolios are taking a hard look at real assets,” said Louis Basque, vice president and portfolio strategist at State Street Global Advisors’ Investment Solutions Group.
The reason that investors need real assets today is clearer than it has been in decades. “First and foremost, they are meant to be inflation-sensitive assets. Diversification, compelling risk-adjusted returns and a source of income are added benefits. Other assets don’t bring the inflation-sensitive piece to the puzzle. That’s what’s unique about real assets,” said his colleague, Robert Guiliano, vice president and senior portfolio manager at State Street Global Advisors’ Investment Solutions Group.
“The broad characteristics of this asset class argue for a diversified core allocation that can help meet investors’ risk and return objectives beyond expressing a short-term tactical outlook on inflation. Real assets always belong in a portfolio,” Basque said (see chart on real asset correlation and beta across asset classes).
Basque’s forecast: “The outlook for real assets, and especially commodities, remains firm.” He highlighted the attractiveness of infrastructure, which received a potential boost in the U.S. by the passing of the recent Bipartisan Infrastructure Law and the Inflation Reduction Act of 2022. Other asset classes for investors to consider are real estate, natural resource stocks and Treasury Inflation-Protected Securities, he said.
Investors can select specific real assets based on their own economic forecasts. “Real assets respond to different kinds of [economic] environments depending upon the assets being used,” Guiliano added. “Inflation has probably peaked, but it’s still high, and real assets like commodities, natural resource equities and real estate can make a positive contribution in keeping total portfolio returns elevated,” he said. “If we should move to a stagflation environment, real assets like precious metals and gold, inflation-linked bonds and, to a lesser degree, infrastructure, farmland and timberland can play key roles in supporting a diversified portfolio.”
“We encourage investors to invest in a broad variety of real assets. Our multi-strategy approach focuses on asset allocation using indexed underlying exposures. That’s an effective way to get the benefits of real assets and to provide diversification,” Guiliano said.
Real estate segments
“Inflation hedging, yield and diversification have long been the foundation of investor interest in U.S. commercial real estate,” said Martha Peyton, Ph.D., CRE, managing director and global head of real assets research at Aegon Asset Management. “Surveys of investors have mentioned these same factors, usually starting with diversification, but in recent months, inflation hedging has risen in priority.”
With the long investment horizon of commercial real estate, inflation hedging can be approximately measured by comparing returns to inflation over a rolling five-year period, Peyton said. “These metrics show that commercial real estate has been quite a good hedge against inflation over typical investment horizons.”
Beyond that, return considerations have been very attractive. “The performance over recent quarters has been astonishing,” Peyton said. Total return for the National Council of Real Estate Investment Fiduciaries’ NCREIF Property Index for the 12 months ending June 30 this year was 21.5% (see chart). These returns partly reflect GDP growth which led to increased demand throughout the economy, Peyton noted.
A number of sector-specific developments provided strong support for significant returns. “In the industrial sector, e-commerce took off as a result of COVID, accelerating the demand for warehouse space,” she said. These dynamics helped to support the 47.7% total return in the industrial sector for the 12 months ended June 2022.
“In apartments, several tailwinds came together, including the maturation of millennials and the surge in household formation. Supply was too tight to accommodate all the demand,” Peyton said. Total return for apartments was 24.4% for the 12 months ended June 2022.
However, despite the apparent consistency of strong returns in commercial real estate, the outlook for the sector is more muted. “Our expectations for real assets are in line with the Blue Chip [Economic Indicators] survey consensus, which [sees] U.S. GDP growth diminishing to 0.6% in 2023,” Peyton said. “That’s an enormous slowdown, but it is not a recession forecast for the U.S. economy. We expect the Federal Reserve will successfully manage an improvement in inflation. Commercial real estate performance will slow, but it will benefit if the U.S. manages a soft landing.”
Given that a major theme in Aegon AM’s forecast is one of uncertainty in a weakening economic environment, investors also need to carefully monitor specific sector developments. “The apartment sector is searching for an equilibrium by balancing availability, household formation and affordability. In response, investors are coming to the market with more uncertainty about the prices they’re willing to pay for new investments,” Peyton said.
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“The retail sector is responding to demographic shifts across the U.S. Some metro areas are losing population, while other metro areas are showing very strong population growth,” she said, noting that the Southwest and cities like Austin and Phoenix have strong demographic growth in contrast to the Midwest. “The question marks in demographics are the big coastal cities, like New York and San Francisco,” as their ability to recover from the shock of COVID and to grow again is highly uncertain.
“In the industrial sector, there is accumulating uncertainty about the demand for space,” Peyton said, noting Amazon’s announcement earlier this year that its appetite for more space has diminished significantly. In addition, she noted the office sector faces uncertainty around the return to work. “Forecasters across the board are assuming that COVID will not rear up again and impair growth. But is it really over?” That is the true unknown facing commercial real estate and the economy.
Long-term view on gold
When considering commodities, the World Gold Council has a long-term view on gold and its strategic position in investors’ portfolios. “Gold has a unique nature,” said Joseph Cavatoni, WGC’s chief market strategist for North America. “It’s a commodity and it’s a financial asset. Demand comes from many sources, including consumers, investors, technological [uses] and central banks.”
Inflation protection is just one of the many reasons for investor demand for gold today, Cavatoni said. “As investors look at which risk-mitigating assets could be added to their portfolios,” gold has offered average returns of 11% over the past 50 years and is a deeply liquid market, he said. Gold also provides diversification, as “it correlates positively with equities when they’re on the rise but negatively when they’re on the decline.”
“Pension funds, foundations, endowments and family offices are all talking with us about what role gold could play in a portfolio. Outsourced CIOs and consultants are also making a strong case for [gold], and the decision to add gold to portfolios is cascading through their systems,” Cavatoni said, noting some pension plans maintain a gold allocation range between 2% and 10%.
Gold as an asset class has been long supported by demand from jewelry consumption, technology applications and as central bank reserves. “Over the last three years, 20-plus central banks have added gold to their existing reserve portfolios, Cavatoni noted. Recent geopolitical risks have led more investors to flock to gold, though the recent rise in interest rates and the dollar have posed a headwind to inflows. “These are short-term headwinds. Gold is a global asset. The [gold] ETF market in Europe is holding its value because of dollar strength and geopolitical risks,” he said, which is offsetting the short-term headwinds.
Cavatoni said he encourages investors who may be assessing gold as an investment for today to take a long-term position. “Once inflation settles at a more moderate level, gold’s performance will recover and stabilize,” he said. “There are benefits from [owning gold], not only in terms of risk protection. but also [in terms of] growth,” Cavatoni said. Investors “try to find substitutes for gold. In reality, gold’s place in the portfolio, society and our world is here to stay.”
EMBRACING SUSTAINABILITY
Real assets have always been inextricably linked to broader environmental concerns and the growing issue of constrained resources. With the acceleration in demand from asset allocators for measurable progress on environmental, social and governance factors across all their investments — including real assets — asset managers across real estate and commodities have responded by making sustainability a central theme.
“Responsible investing concerns are critical for Aegon AM across its business,” said Peyton. “Aegon AM is a recognized leader in responsible investing. Across our real asset strategies, we work to employ responsible investing that seeks positive social and environmental impact.”
“In our U.S. multifamily impact capability, we are finding improvements to the environmental aspects of a property — insulation, heating systems, solar power, smart thermostats and LED lighting — that are particularly valuable to investors. Research shows that energy retrofits on older properties will have more impact on reducing CO2 emissions than building new properties with zero-operating emissions because of the embodied carbon that new construction requires. We believe these energy-efficient improvements can be both cost effective and financially beneficial,” Peyton said.
The push toward responsible investing in real assets is coming from allocators too. “Prospective investors express a tremendous amount of interest in our responsible investing policy. It is not only about telling a story, but also [about] showing how you are measuring ESG impact, the metrics you use and that you are targeting improvements,” Peyton added. While investors continue to be focused on risk-adjusted return, many take the stance that progress on ESG factors also contributes positively to investment return, she noted.
ESG tilt in indexes
“ESG principles are touching many types of asset classes. We’re now seeing this trend [across] real assets,” said Wiederhold at S&P Dow Jones Indices. Though many commodities are carbon intensive, “there are new methods of more environmentally-friendly production which emit less and use less land and water.”
In April 2021, S&P Dow Jones developed new real estate indexes with an ESG tilt in response to investor interest. “We have rolled out an ESG version of our standard Dow Jones Global Select Real Estate Securities Index, using data from GRESB, the Global ESG Benchmark for Real Assets,” said Michael Orzano, senior director of global equity indices at the firm. “[The index] tilts to better performing companies along ESG lines while maintaining similar regional and sector characteristics of the benchmark.”
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The application of ESG strategies in real estate assets has driven investor interest. “We have seen continued adoption of these strategies, more so in Asia and Europe than the U.S.,” Orzano said, adding that U.S. client interest is increasing as well. The rapidly evolving developments in the use of ESG approaches in real estate bring the potential for the development of new indexes that focus on more specific ESG attributes such as green building certifications, carbon emissions and energy efficiency. “We started with a baseline ESG real estate index offering and are now working on more nuanced strategies,” he said.
ESG and gold
ESG is as important for the gold industry as it is for any other asset class, said Cavatoni, who added, “We are taking the lead with our members to be ahead of the ESG curve.” Among several initiatives that the WGC is engaged in is an ESG framework for the gold-mining sector known as the Responsible Gold Mining Principles, which are mandatory for all of its large-scale gold-mining members, he said.
The organization is also conducting original research into climate change and the gold industry. “Our research demonstrates that gold can reduce the overall carbon footprint of a portfolio without [negatively] impacting overall performance,” Cavatoni said. Gold doesn’t generate scope 3 emissions in the way that other mined minerals do. “It sits in a vault and can have a favorable impact on your portfolio over time.”
In addition, the WGC has partnered with the London Bullion Market Association on the Gold Bar Integrity program, which is “currently a pilot project with a number of participants representing the entire gold supply chain that are using blockchain technology to trace gold bars across the ecosystem,” Cavatoni said. “This will become the foundation for improved supply-chain integrity and will be extended to other products in the future.” The program also “provides market participants with additional confidence that their gold is authentic and has been responsibly sourced and produced,” he added.
DRIVERS OF SUCCESS
The attractiveness of real assets in today’s inflationary environment is clear. With many investment managers specializing in real assets, how should asset owners go about selecting those who can deliver on their portfolio objectives?
An all-weather strategy
“What establishes a good manager is creating an all-weather strategy for the investor,” said Guiliano at State Street Global Advisors. “Real assets belong in the portfolio all the time. In a broad core [real assets] allocation, the critical pieces are the components and how you build and allocate to them.”
State Street Global Advisors takes a comprehensive approach to building the components of a real asset portfolio. “We look at several attributes: desirability, investibility and suitability,” Guiliano said, adding that transparency and ease of understanding for investors are important components as well. “Combining these things together with a thoughtful approach to portfolio construction and day-to-day management creates a successful real asset manager.”
At Aegon Asset Management, “what differentiates a successful real assets manager is a combination of long-term expertise and relationships, robust research and a focus on providing customized solutions that seek to provide relative value and meet clients’ changing needs,” Peyton said.
Breadth and depth
When it comes to selecting a real assets index provider, “a multi-asset approach is a differentiator which is not common in the market,” said Wiederhold at S&P Dow Jones Indices. Though breadth is critical for diversification purposes, so is depth, particularly when it comes to real estate with its many different sub-sectors. “Having offerings that cover different segments and with innovative, interesting themes such as ESG [is critical],” added Orzano at S&P Dow Jones Indices. “Investors are asking for all of these types of indices in the real estate space. It is important to have complete offerings.”
REFINING THE MENU
Institutional investors today have a greater variety of approaches for real asset allocations, as well as multiple investment vehicles to consider. Building a real assets portfolio involves several decisions, including the size of the allocation, the segments to invest in and the choice of an active, passive or combination strategy.
A core approach
“Indexed exposures are an effective way to gather much of the return and benefits from inflation-sensitive assets,” said Guiliano at State Street Global Advisors, adding that active exposures can also play a role for some investors. The firm works with asset owners to complement their existing allocations of private real assets with a liquidity sleeve of public real assets.
“We also consider the question of how to combine different indexed building blocks tactically to add value,” said Basque, noting that State Street Global Advisors uses this flexible approach in its real assets ETF.
“In the [real assets] ETF space, there are few options other than targeted ones. [We see] increased demand for our [core] ETF — ticker RLY — as investors are looking to fill a gap in their portfolio for inflation-sensitive assets. This core holding allows investors to then take tactical positions in particular themes they see unfolding,” Guiliano said.
Passive paths to consider
S&P Dow Jones Indices offers real estate, infrastructure and commodities indices for all different types of objectives for index-based allocators. “Historically, during periods of high inflation like in the 1970s and mid-2000s, a 10% to 15% allocation of real assets generated real returns of 2% to 3%,” said Wiederhold.
“In the real estate space, listed REIT indices incorporate diversification, liquidity and transparency,” said Orzano at the firm. “One index can represent exposure to an entire cross section of the global real estate market and can be used to create a single index fund,” he said.
However, Orzano acknowledged that REITs, compared with private real estate, have been criticized for their volatility and correlation with equity markets. “This [distinction] is largely a mirage,” he countered. “There is no transparent pricing in private real estate. The appraisal process lags and smooths out price changes,” he said. In contrast, Orzano pointed to the liquidity and other characteristics of REITs.
The advantages of an index-based approach extend to performance, Orzano said. “For U.S. real estate funds, the evidence shows it is difficult for active managers to beat indices, particularly over the long term. In real estate, the ETF market has been expanding. REITs have historically tended to benefit from inflationary periods over the long run.”
S&P Dow Jones Indices segments the REIT market into distinct categories, such as data center REITs, cell tower REITs and REITs with short-duration leases that tend to be less interest-rate sensitive. “There [can be] broad exposure through global listed real estate, and there are newer, more nuanced exposures to specific segments, providing more options to investors,” Orzano said.
On the commodities side, S&P Dow Jones Indices’ broad commodities index is diversified across real assets and includes gold, energy, industrial metals, precious metals like gold, agriculture and livestock.
Accessing Gold
“There are many ways to get exposure to gold, [ranging from] owning the precious metal directly to using investment vehicles like futures or swaps contracts, [to] investing in mining companies’ equity,” Cavatoni said. There may be a very good reason to buy the latter, but “investors have to understand mining companies represent not only a precious metal, but also a management company with its own performance.”
With the huge growth in gold ETFs, now at 85 funds worldwide, the WGC has responded to the retail surge. Its Responsible Gold Mining Principles also provide retail investor guidance on evaluating gold investment options, he said.
“One challenge facing investors is how to model the price of gold as they can for other asset classes,” said Cavatoni. The WGC has developed short-term and long-term models for expected returns, which are available on its website. “The Gold Return Attribution Model tracks short-term movements in gold driven by interest rate moves and opportunity costs,” he said, adding that the Qaurum model tracks longer-term expected return using investors’ own capital market assumptions as inputs. “We are empowering people to make the right decision around an investment in gold and to understand what drives returns,” Cavatoni said.
Bringing real assets into DC
Until more recently, defined contribution plans have provided limited exposure to real assets, despite the potential benefit to participants as an inflation hedge. That has been changing over the past five years and now has a new sense of urgency, given the current elevated inflationary environment.
“The DC space is a growth area [for real assets] in two ways. One is in target-date funds and the other is as a stand-alone option on the [DC] menu,” said Guiliano at State Street Global Advisors. Real assets can play a particularly important role in the later stages of a target-date glidepath because they help with purchasing-power protection as participants get closer to retirement, he said. The firm introduces TIPS, commodities and real estate into its target-date glidepath allocations, he noted.
DC investment options outside of target-date funds often do not include real asset strategies, Guiliano pointed out. The firm’s approach is a bundled, multi-strategy solution that “keeps the lineup short and clean for plan participants,” he said. “A bundled approach goes beyond simple diversification. It brings in our value-add as a manager and uses our know-how and long-term strategic asset class forecasts,” added Guiliano’s colleague, Basque.