What pension fund investors need to know about real assets

Written By: Pádraig Floyd LAPF Investments

Pádraig Floyd describes the different classes of real assets and explores their pros and cons as part of a pension fund investment strategy

A trend over recent years has been the growing interest investors have shown in real assets. On face value, one might imagine that is perfectly sensible – who would want to invest in something that was unreal?

After all, wonderfully fertile beans marketed by Jack, or a new Emperor clothing line have been sources of great amusement in the past.

Though there are those who would plough money into things like cryptocurrency and non-fungible tokens, that’s a story for another day.

Ain’t nothing like the real thing
Real assets are one of those quirks of the investment world that does make sense. Real assets are simply just that – real. They are physical assets that have an intrinsic worth due to what they are made of and what people want them for.

This includes precious metals, other commodities – including anything you eat or drink, cotton, lumber, and other things we burn or use to build our environment, such as gas and oil – property, land, equipment, and many other natural resources.

Some or all of these have been included in diversified portfolios because they have a relatively low correlation with financial assets, such as equities and bonds.

And because inflation, currency fluctuations and other macroeconomic factors influence real assets less than financial assets, they are often considered more stable.

During periods of elevated inflation, they will tend to outperform financial assets. Furthermore, cashflows generated from real assets like property, energy and infrastructure projects can provide predictable, steady income streams.

Real things take up space that has to be paid for
There is always a catch, naturally. Real assets are less liquid – sold or converted into cash – than financial assets. Not only does it take longer to sell them, but the cost of selling them is higher in terms of transaction fees.

As they are real – they actually exist – they take up real space. While £1 million worth of diamonds is more easily transported and stored than gold bullion, or even coal, gold needs to be stored in the proper facilities for which rent, insurance and security fees would be charged.

So, they’re attractive because they are needed by people everywhere. The fact that they are varied, are not isolated to a few geographies and have a reduced correlation with equities and bonds mean that they improve diversification of a portfolio, offer a hedge against inflation and secure income. What’s not to like?

Just because these assets have an “intrinsic” value, this can fluctuate. Commodities are traded on markets that rise and fall, just like property prices can.

However, prices generally rise with inflation, protecting against one particularly damaging force for pension funds.

Getting your hands on them
This is where the headaches start. Real assets are complex and often require considerable initial investments.

Though you can buy gold and solver coins, commodities are usually sold by traders in huge volumes through specialist instruments such as futures on financial markets.

Other real assets like property and infrastructure, are not so easily traded, so buying and selling them is time-consuming and costly. It also requires expertise.

And while some real assets like gold bullion will incur high storage costs, others, like property and infrastructure must be maintained and these maintenance costs can also prove expensive.

In the past, many institutional investors, in particular pension funds, have found it difficult to access certain assets, such as infrastructure projects.

When they can gain access, they have often felt the investments were structured for the benefit of those developing the projects, not the end investors. This misalignment between investment partners looking to get their money out of a project inside, say, seven years, rather than a long-term investor looking at a minimum horizon of five times that, can breed mistrust and dissatisfaction.

This was not helped by previous attempts by government ministers and agencies to encourage investment into projects that would originally have been considered the responsibility of government alone.

But the fact is that investing in infrastructure projects requires deep pockets and a lot of specialist advice and most funds have’t been able to justify the risk – asset or concentration – or had a sufficient governance budget to manage it. So many have satisfied themselves with nibbling at the vast amount of infrastructure debt to provide long-tail secure income.

And of course, short-term trading is possible with commodities. But things have changed.

It’s getting stronger every day
Pension funds – particularly open defined benefit (DB) ones – will be keen to future proof their portfolios, and are increasingly considering the potential of real assets, with exposure to new investment themes.

For instance, the transition from fossil fuels to renewable sources of power creates investment opportunities in new types of infrastructure. These match many funds’ preferences for sustainable investments, while the increasing use of online shopping is driving a need for logistics facilities.

Property is no longer “simply” an asset that delivers long-term inflation linked income. Through provision of affordable or social housing and regeneration of the built environment, it can satisfy a number of ambitions funds have today around environmental, social and governance (ESG) matters, but also using assets to deliver impact investing.

In fact, more than nine out of 10 (93%) of global institutional investors actively consider ESG and sustainability in their real assets investment decisions, according to research from Aviva Investors, with 17% considering it a critical factor.

The study discovered that two-thirds (64%) of institutional investors plan to increase their real asset allocations over the next two years, with 46% planning up to a 10% rise.

North America has the highest allocations, where almost a quarter have more than 20% of their portfolio in real assets, compared to 19% of European and 17% of Asia Pacific investors.

Diversification remains the primary driver for these investments for 57% of respondents, however, the ability to provide inflation-linked income is increasingly driving allocations.

The research shows that in just three years, the number of institutional investors allocating to real assets for inflation-linked income has grown to 53% from just 33%.

The positive ESG impacts are attractive to 28% of respondents compared with just 17% three years ago.

Daniel McHugh, chief investment officer, real assets, at Aviva Investors, said: “Inflation had an acute impact on the economic and investment landscape in 2022, making it increasingly expensive to hedge against through traditional asset classes, whilst rising interest rates have eroded returns.

“The ability of real assets to provide inflation-linked income has woken investors up to the attractiveness of these strategies beyond simply being a diversification play. They are now playing a meaningful role in overall portfolios, offering investors a broad menu of options with varying degrees of risk, and inflation protection built in.

“The study shows that demand is also being driven by the ability to assess the positive impact of these investments beyond returns, such as contributing to sustainability-related objectives.”

More than just returns
The study found that 67% of institutional investors feel it is their responsibility to invest sustainably. But while corporate values (61%) and risk management (59%) are both central tenets for pension funds, more than three quarters (79%) prefer a fund or strategy that prioritises financial returns that integrates ESG factors.

This returns based approach is the preference of 90% of North American investors, compared to 82% of Asian and 71% of European investors.

More than half (56%) believe that energy transition investments will provide the best financial returns, while delivering the best ESG impact.

Finding the right opportunities, transaction costs and valuations remain the greatest obstacles for more than half of respondents. But the biggest material risk has become greenwashing (52%), as recent events have shown the impact some lobbyist and investor groups have achieved through the power of social media, while regulators have made it plain that they will take an increasingly robust approach to anyone trying to pass off their work as something it is not.

For Aviva’s McHugh, climate-related obsolescence is identified by only 22% as the most material risk and as far as he’s concerned, “that has to change”.

“As the market looks at assets through a net zero lens, even prime assets could become vulnerable. Investors must be alive to how quickly – and to what extent – obsolescence could accelerate and the potential impact it could have on portfolios.”

Safe as houses? Maybe, maybe not
Property remains the most popular asset class, slightly less than in the previous study though expected to remain steady.

However, infrastructure equity is building momentum, with institutional investors most likely to increase allocations to this area, growing from 12% to 13% over a two year period and expected to grow 14% in the next two years.

Direct investment (46%) is the preferred route to market, followed by multi-asset pooled funds (40%) and single-asset class pooled funds (32%).

“It is clear real assets investors value the different access routes available to them. Gone are the days when allocations to each asset class within real assets would be looked at in isolation,” said McHugh.

“Instead, investors are often looking for a multi-asset and outcome-led approach, which can align with corporate values. With 81% of investors citing performance track record as being the most important criterion for selecting a real assets manager for a sustainable mandate, it is hugely important they choose an asset manager able to make relative value calls and who also understands the challenges involved in achieving long-term ESG objectives.”

Build it and they will… rent
Indeed, 2022 was a big year for real assets, AXA IM Alts confirmed, raising €15 billion of net new money in 2022. This reflects the strength of demand with more than half (€7.7 billion) of net new money from private debt and alternative credit strategies, and c.€3.5 billion for real estate debt, as investors seek strategies offering very good risk return profiles within the higher interest rate environment.

There are plenty of reasons to believe real assets will increasingly be considered as mainstream investments. They offer portfolio enhancement, offer secure attractive – often indexed – risk adjusted returns and meet their investment goals.

Build to rent – an asset for all seasons
Before the 1960s, a large proportion of the rental stock in the UK was provided by pension funds, but now it is almost entirely dependent upon a single business model – the developers who build themselves. What was needed was new business models to increase the supply of housing in the UK.

Dan Batterton, head of residential, Legal & General Investment Management, says: “Build to rent is different because it is build and hold. It is not about trying to make capital, but trying to generate a cash flow. So the rationale for investing into housing is different. And that changes a lot of thinking around location, build quality, environmental performance.”

LGIM expects to own these build to rent properties 40 years from now, says Batterton. “It is highly likely that we will live in a world where carbon is regulated in 40 years’ time, so LGIM is building schemes that can be lived in in a zero carbon lifestyle. Residents could have a net zero carbon footprint living in our buildings. We are not focused on development profit, we’re focused on long-term income. I’m looking at how can we reduce long term operating costs rather than day one construction costs. This strategy is appealing for pension funds, as it sits well within the ambitions they have for decarbonisation, social impact within ESG investment and social engineering through improvements to the built environment”, said Batterton. “It also does not rely on the economy booming. Even when it is struggling, we shouldn’t see big negative movements in value or in cash flow in the rental sector. “That is because if interest rates are going up, mortgage availability reduces, and people must rent for longer,” said Batterton. “So during times of economic difficulty that demand for rental increases and that creates a floor in falling rates.”

“This has been the pattern of the last 12 months,” says Batterton, “with strong rent increases as demand surged. Yields have moved out, but by not as much as the rents have increased, however, asset values are still going up and there has been very low volatility in returns. So, consistent, stable, boring cash flows is what we’re trying to deliver.”

Continued opportunities
Three key themes offer further confidence that real assets will become a core element of pension fund investments.

The first theme is population growth: larger populations and more concentrated population densities and their specific needs. That population is also ageing rapidly, which brings its own deep and wide-ranging implications.

The United Nations has predicted that the global population will rise by over two billion people over the next 30 years, with most of this growth coming from emerging markets. The UN also forecasts that, by 2050, one in six people in the world will be over the age of 65, an increase from the 2019 figure of one in 11.

These population and demographic changes are already causing housing shortages, public healthcare spending and public infrastructure causing social and economic challenges, some of which may be addressed by real assets investment.

The second theme is climate change, which is finally rising up the political and economic agenda, resulting in significant investment opportunities. The rate of progress in renewable energy is one such example.

The UK is a leader in offshore wind, largely thanks to former government subsidies. This is an exciting opportunity, as wind and solar power are set to generate close to half (50%) the world’s electricity supply by 2050.

New technologies such as “whole wind farm optimisation” and “digital twins” are improving output and extending the lives of the assets themselves, which is a bonus for investors.

Reducing an organisation’s carbon footprint can begin with the way it produces and/or consumes energy. Decentralised energy can reduce generation, transmission and distribution losses from around 65% to around 15%.

It also provides a cleaner, lower carbon, lower cost power supply with more security thanks to its independence from the grid. Investing in companies that are at the forefront of such technology could ultimately pay huge dividends.

Finally, the pace of technological advancement is our third theme and has been identified as the fourth industrial revolution. The convergence of virtual reality, augmented reality, the so called “internet of things” (IoT, consisting of billions of connected devices) and 5G will transform the ways in which we interact with our homes, workplaces, schools, transport and healthcare, quite possibly in ways that we simply haven’t imagined, yet.

But demand for online shopping and fast home delivery has transformed logistics which requires large warehouses and distribution centres to support today’s retail businesses.

This means good facilities near major road networks and large populations offering investors the security of longer leases and the potential for positive rental growth.

Demand for digital storage is also growing so quickly that data centres are being built all around the world. These make good investments as they’re not easily moved, and are best located close to major internet nodes.

Custom-built centres can command leases in excess of 10 years, providing investors with longer-term, reliable returns.

The role of government
Governments have a role to play in helping to finance or facilitate the kinds of real assets projects that investment solutions for pension funds will be based upon.

In recent months, politicians seem hellbent on telling pension funds how and where they should be investing their money. It started last year, with the government’s levelling up project indicating public sector funds should dedicate 5% of their portfolios to these types of projects.

This was followed this year with the chancellor, Jeremy Hunt suggesting this might go further as part of deeper and more rapid consolidation of the pension fund investment pools.

Since then, the shadow chancellor Rachel Reeve has outlined how pension funds might be forced into a series of regional sovereign wealth funds, while the lord mayor of London, Nicholas Lyons, outlined an idea to use money from defined contribution (DC) schemes to fund a £50 billion private equity fund for tech startups.

All these schemes were met with a mixture of derision and genuine interest, but most warned against the government going as far as dictating where money should be invested.“Our view is that the government can act as an enabler, it can remove barriers, costs and unduly restrictive legislation, but it should be wary of mandating schemes’ investment policies,” says Ed Wilson, partner at pensions advisory firm, Isio.

Ultimately, the fiduciary duty remains unchanged, and no scheme will surrender that for a fashionable political idea, however well planned.