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Do not put all your eggs in one basket is a common phrase that resonates among investors worldwide. The errand of such a famous saying is simple, diversify! However, how to diversify, if in the crisis, everything seems to be highly correlated? Last week, we wrote a blog about the Macro Factor Risk Parity, but it certainly is not the only option. Real assets such as REITs, various commodities, and the ever-popular gold are commonly added into portfolios as diversifiers. However, Parikh and Zhan (2019) research examine a much bigger set of real assets than the aforementioned evergreens. Real assets like Timberland, Farmland, Infrastructure, Natural Resources and many others are presented in the paper. All those assets have different sensitivities to inflation, GDP growth, equities or bonds. Therefore, real assets could have a value in the portfolios to protect an investor from inflation, stagnation, or simply distributing the eggs mentioned above in many baskets. All these strategies are presented in the paper and compared to equities, bonds and traditional 60/40.
Authors: Harsh Parikh and Wenbo Zhang
Title: The Diversity of Real Assets: Portfolio Construction for Institutional Investors
What is the role of real assets in institutional portfolios? To answer, we first identify the major real asset classes, both public and private, review their salient features, and measure their performance since 1996. We focus on estimating real asset sensitivities to both macroeconomic variables (e.g., growth and inflation) and traditional financial market performance (e.g., stock and bond returns). We present a regression framework that addresses the low reporting frequency issues when estimating these sensitivities, especially for private real assets. While our analysis is US-centric, due to greater data availability, our methodology is applicable for non-US investors. We find that real assets are heterogeneous in their macroeconomic and financial market sensitivities. In addition, we find that the estimated sensitivities are time varying. These findings support a diversified portfolio approach to real asset investing or active management of real asset portfolios. Using the estimated sensitivities, we construct three real asset strategies – Diversification, Inflation-Protection and Stagnation-Protection. We show that the strategies’ sensitivities to macroeconomic variables and financial market are more stable. We then show how these strategies perform in different economic environments: ideal, overheating, stagflation and stagnation. Finally, we evaluate how these three real asset strategies might fit within a US pension plan. We show that these strategies can help improve funded ratios or lower surplus risk, especially in economic environments such as stagnation or stagflation that are of concern to plan sponsors. This analysis can also be applied to non-US plans.
As always the results are best presented through charts and tables:
Notable quotations from the academic research paper:
“What is the investment role of real assets? A real asset has a total return sensitivity to inflation and/or economic growth that differs from those of traditional financial market assets (e.g., stocks and bonds). Consequently, real assets may offer useful inflation protection, stagnation protection and portfolio diversification properties unavailable from traditional assets. Investors often lump together assets like real estate, infrastructure and timberland into a “real assets” category. However, we show that there is significant diversity across real assets in terms of their sensitivities to macroeconomic factors and to traditional asset performance. Identifying and measuring these sensitivity differences is key to successfully incorporating real assets into an overall portfolio.
We estimate the exposure of various real assets to the inflation rate (CPI) and inflation surprises (i.e., unexpected inflation). If actual inflation matches expected inflation, assets such as nominal bonds, whose prices reflect expected inflation, should adequately compensate for inflation. However, if actual inflation deviates from expected inflation only real assets, whose performance tracks actual, not expected inflation, may provide inflation protection. We also evaluate the exposures of real assets to the real growth rate (i.e., real GDP) and growth surprises (i.e., unexpected growth). Investors may look to real assets for stagnation protection (i.e., provide robust performance in low growth environments). Finally, we measure the sensitivity of real assets to financial market returns, such as stocks and bonds.
We illustrate the salient features and economic and financial market exposures of a variety of real assets. Our study accounts for some measurement challenges, especially for private asset returns. We find wide diversity in real assets’ sensitivities to inflation and growth, and stocks and bonds, and that these sensitivities vary between the subsample periods analyzed. In fact, the economic betas for some real assets may flip signs. Investors can try to mitigate this time-varying exposure risk by holding a portfolio of real assets or actively managing their real asset portfolios. Based on an investor’s investment objective, we construct three real asset strategy portfolios – Diversification, Inflation-Protection and Stagnation-Protection. While the portfolios’ market sensitivities were still time varying their macroeconomic sensitivities of these strategies were more stable. Across the various economic environments, the three strategies had lower 3y return dispersion compared to equity, suggesting less variability in outcomes for portfolios with a real asset allocation.
The Diversification strategy is a portfolio of real assets that is expected to have performance uncorrelated with traditional stock and bond returns. This ensures a diversification benefit regardless of the market cycle. For this strategy we select the diversifying real assets whose performance is least correlated to stock and bond returns (i.e., low R2s for both subsample regressions): farmland, gold, natural resource, real estate and timberland.
The Inflation-Protection strategy is designed to have higher returns when inflation and inflation surprise are higher. It is a strategy for investors with inflation-linked liabilities or a concern about overheating (high inflation and high growth) and stagflation (high inflation and low growth) economic scenarios. For this strategy, we select the inflation-protection real assets that have significant and positive exposure to both inflation level and inflation surprise: commodity, energy equity, gold, infrastructure, TIPS and natural resource.
The Stagnation-Protection strategy portfolio is expected to perform better than cash in economic environments with below average growth. This is a strategy for investors concerned about stagnation (low inflation and low growth) scenarios. For this strategy we include the stagnation-protection real assets that have a sensitivity to both the real growth level and growth surprise that is lower than corresponding sensitivities for cash: farmland, gold, real estate debt and TIPS.”
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