Q&A: Realities In Real-Asset Investing

Dec 2 2014 | 9:05am ET

Volatility in stock and bond markets is sending institutional investors towards real assets—but are some assets “more real” than others? Some 80% of institutions apparently think so, according to a recent Greenwich Associates report, with that proportion considering private real assets intrinsically superior to those that are publicly traded.

That finding prompted Vince Childers, senior vice president and portfolio manager at Cohen & Steers, to consider whether private assets are actually a better investment than listed ones. Childers is well placed to explore the matter—New York-based Cohen & Steers was the first investment firm to specialize in listed real estate. Today, the firm has offices in Europe and Asia-Pacific, an expanded list of investment offerings and $53.5 billion in assets under management. FINalternatives' Mary Campbell spoke recently with Childers about just how real real assets are.

Cohen & Steers' research finds that a portfolio of real assets, whether listed or unlisted, can play three main roles in an investment portfolio. The first is to provide “meaningful diversification benefits.” How do they do that?

There are a number of ways to tackle this problem. One is a very straightforward approach where you measure volatilities and returns and correlations and put things into an optimizer model and see what kind of outcomes you get. For the sake of argument let's say that a diversified portfolio of real assets has a long-term correlation to the equity market of something on the order of 0.7. The model will say, “Sell a lot of equities, sell a few bonds and get a lot of this in the portfolio.” It's okay to approach the world from a correlation standpoint if we understand that correlations are not meaningful in the absence of knowledge about risk and return as well.

Most investors think about stocks and bonds as having a zero correlation to each other, which is close to the mark. And what that tells us is that if two things are zero correlated, 75% of the time you're going to have something working for you. But what about that other quarter of the time? That period when you're getting simultaneous or joint stock and bond underperformance? From an overall portfolio perspective, diversifying against those periods should be something that investors find valuable.

We found real assets provide precisely that kind of outcome. If we focus on those periods when stocks and bonds are doing poorly at the same time, we tend to find that we get much better, much stronger returns out of real asset portfolio, whether they're in listed, liquid, exchange-traded real assets or in the private market categories. 

The second role is the potential to deliver attractive returns over a full market cycle.

The historical data tell us that you get something over full-cycle periods that looks a lot like equity returns, positioning real assets on the equity end of the risk/return spectrum. That’s important to understand the positioning of real assets; it wasn't that long ago I could go out and have conversations with investors under the illusion that an allocation to real assets is somehow dead money in the absence of a replay of the 1970s—some kind of inflation problem. What I've tried to communicate is that such a belief is completely at odds with the data. You can start in a period like the early 1990s, where we've had 2.5% inflation and very little volatility in inflation outcomes, and a portfolio diversified across the core real assets delivered something in the neighborhood of equity-like returns. 

Third, real assets can be expected to show higher sensitivity than stocks and bonds to unexpected inflation.

Over the long term, both stocks and bonds seem to exhibit this negative sensitivity to accelerating inflation or inflation surprises, whereas real assets tend to show positive sensitivity to unexpected inflation.

If you think about it from a hedging perspective, you'd like to have something that pays off better in those bad states of the world. One bad state is obviously something like a financial crisis but another would be a one where inflation accelerates, when you’d expect to get below-average returns out of stocks and bonds. You'd expect the converse out of real assets.

The Greenwich Associates survey found institutional investors think of private real assets as “more real” than listed real assets. Is there any basis for that?

Some people look at the return data from the private markets and find that they look very much like the listed assets, but with a lot less measured volatility and lower measured correlations. Now, I'm obviously not the first person to point out that there are serious problems associated with private market data series; one should not take the measured volatilities and the measured correlations at face value, because statistically they exhibit a lot of artificial smoothing and serial correlation. The academic literature has a bunch of suggestions and approaches and modeling techniques to try to adjust these private market data for those biases, and there are a lot of disagreements about how to make those adjustments, but one thing that everyone agrees on—or should agree on—is that the measured volatility and correlation statistics are not reliable and we can't expect to receive extra credit for not marking positions to market and injecting these smoothing biases into the portfolio.

There has to be some way to get a better handle on risk when it comes to the private real assets. It can't be done by just taking measured volatilities and correlations and throwing them into an optimizer. If you conduct that exercise, the results say, “Why would you hold anything other than this? Bond-like risk with equity-like returns? Sell everything in the listed liquid market—stocks, bonds, real assets—and load up on these things.” No one actually does that and there are good reasons why. Everyone intuitively knows those private market volatility and risk statistics can't be relied upon. 

A more useful basis for thinking about the risks associated with the private markets is to simply use what we have in the listed space as proxies for risks and correlations, recognizing that, to the extent that there are further diversification benefits in the private markets from the listed real asset markets, they're most likely to come from, and most likely to be legitimate, in terms of a more expansive opportunity set. If an investor wants exposure to farmland, typically they're going to have to go to the private market; there's very little farmland in the public markets. Timberland is a similar story—there are some timber REITs in the public markets, but, by and large, investors who want timber exposure are going to get that in the private markets.

One thing you are clear on is that no one real asset class will deliver all these benefits. Any thoughts on building a real asset portfolio?

There's not always a neat way to allocate or carve up that universe. In the listed space, I've said we can get you most of the way there if we think in terms of four major groups or categories—real estate, commodities, infrastructure and resource equities. Reasonable people can hold different views about where timber or U.S. MLPs or pipelines fall in those four categories but they're going in there one way or another. But if you think about the broader real asset allocation extended into the direct or private space, these things should be seen as complementary to each other. Private infrastructure and real estate look different than what you see in the listed universe and, of course, the same goes for private resource equities. And timber and farmland, as we discussed, are something a little bit different. And so my argument is that both listed and private should be seen as complements to each other and most investors, when they have the opportunity should have all of these things in their broader real asset allocation.

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