In creating the real assets portion of a portfolio, investors should consider several risk factors, such as the sensitivity of certain assets to inflation, interest rate changes (duration risk), or the continued availability of finance (illiquidity risk).
In a recent publication, Mercer, the world’s largest institutional investment advisor, explains how these and other factors that ought to come into play.
This paper, Building a Real Asset Portfolio, begins with a definition: real assets are those that provide exposure linked to physical assets where “the return is expected to come largely from the yield, income or income-generating potential.” The category includes real estate, infrastructure, timberlands, shipping, and natural resources. Each of these and subcategories of each of these, can be placed on a grid where one axis represents the maturity of the underlying assets and the other represents growth prospects. For example, fully leased properties and development properties are both subcategories of real estate. Definitionally, development properties are less mature and have greater growth potential than the leased properties. An operating toll road is a fully mature infrastructure property yet has continued opportunity for growth (by virtue of the increased traffic should there be a boom in the region it serves).
Risks and Subcategories
Let’s look at those subcategories in connection with the risks mentioned above. The report tells us that core real estate (which includes fully leased properties) has a medium linkage to inflation, a high duration risk (link to interest rates) and a medium illiquidity risk. Opportunistic real estate, on the other hand (development properties) has a low inflation linkage, a low duration risk, and a high illiquidity risk.
Core infrastructure has a high inflation link, a high duration risk, and a high illiquidity risk as well.
An investor should define its own position on a spectrum from defensive to growth oriented. Income oriented investments are defensive; examples include energy resource plays, established timberland, and agricultural assets, high-quality lease-oriented real estate; and established core infrastructure. Someone looking to balance a real assets portfolio as between income and growth might include the above, but might also include opportunistic real estate strategies, opportunistic infrastructure, and private equity mining/mineral strategies.
The Need for Liquidity and Balance
Looking at the same nest of issues from a somewhat different angle, the report says that it is important for investors building a real asset portfolio to seek a balance between tolerance for complexity on the one hand and the need for liquidity on the other. Fortunately for investors who value a wide array of choices, “the demand for real assets and the overall development of the asset class have led to the availability of more liquid alternatives for these investments,” the report says.
There are both unlisted and listed channels for the implementation of a real asset strategy. The unlisted channels include open-ended funds, debt strategies, or direct co-investment. The listed channels include listed natural property resources, listed property or infrastructure funds, and commodity futures.
One of the uses of the listed strategies is to serve as “placeholders.” They require a less extensive due diligence than the unlisted strategies, and this allows them to give an investor exposure in a rough-and-ready way while that due diligence moves forward on the unlisted options.
Meanwhile, Two Russian Scholars….
As Mercer was posting its views on real assets, summarized above, two Russian scholars have come out with a related and in its own right fascinating study of their “transactional asset pricing approach” to the value of illiquid income-producing assets.
The authors are Vladimir B. Michailetz and Andrey Igorevich Artemenkov. They contend that Modern Portfolio Theory has led to a dead end in valuation issues, and the TAPA offers a way out.
Michailetz and Artemenkov work from what they “the meta-assumption” that the unit of analysis for the valuation of illiquid assets is the particular transaction itself, or perhaps a small set of transactions such as might be used by assessors in a sales comparison approach, and not the “overall general market universe assumed in equilibrium (as in the MPT approach).” They invoke discounted cash flow (DCF) analysis in real estate as a special case. TAPA provides the broader framework that makes sense of DCF.
TAPA provides, they maintain, a working approach for “the majority of real assets participating in economic exchanges.”