The case for diversified liquid real assets

We believe that in a diversified liquid assets portfolio, the combination of underlying real assets with growing cash flows offers a compelling investment opportunity over long-term economic cycles.

A diversified real assets portfolio can achieve an investor’s objective of inflation protection with low relative volatility. And a combination of real assets with growing cash flows offers a compelling investment opportunity within the economic and business cycles. We find that the following distinguishing features make a diversified liquid real assets strategy an attractive choice for accessing the asset class:

Use of Real Estate Investment Trusts (REITs) — Potential anchor of a diversified liquid real assets strategy as a component to deliver growth and higher yield as well as liquidity.

Diversified, both in a total portfolio and within real assets — Low correlative investing through the use of diverse real asset classes, including Energy Infrastructure (or Midstream), Utilities, REITs, infrastructure and Treasury Inflation Protected Securities (TIPS) can result in consistent cash flow throughout market cycles. The intent is to deliver lower relative volatility than individual real assets alternatives and the overall U.S. equity market.

Transparent framework — The ability to rely on the use of exchange-traded securities across asset classes. This transparency allows investors to more easily assess valuations and other components of volatility and total return.

Use of Real Estate Investment Trusts (REITs)

REITs provide a more liquid way to invest in real assets, while retaining the potential for high-dividend income and high total return.

Though it may be common for some investors who are unfamiliar with publicly traded REITs to avoid them, REITs can provide relatively consistent total returns over market cycles. In fact, in 13 out of the last 19 years REITs have outperformed the S&P 500® Index.

Diversified, both in a total portfolio and within real assets

At Securian AM, our experience with real asset classes has been that investing directly in commodities often does not provide an adequate approach to inflation protection that many investors seek without also introducing significant volatility.

By focusing instead on a structure where the underlying real assets can generate growing cash flow with the capability of distributing a growing dividend over time, we find that the reinvested cash flow can smooth the inherent volatility. Growth in dividends received on an absolute basis also can help to offset inflation erosion. We also suggest in periods of high inflation expectations, to include highly liquid commodity ETFs as an alternative to direct commodity exposure.

According to the National Association of Real Estate Investment Trusts’ (NAREIT) 2017 outlook, equity REIT total returns have exceeded inflation 69 percent of the time during extended periods of high inflation.¹ NAREIT notes this performance has only been matched by the “energy-heavy” Goldman Sachs Commodity Index (GSCI).

However, when inflation has been high, the total returns on REITs and commodities have both been strong (averaging 13.7 percent per year and 17.6 percent per year, respectively), but when inflation has been low the total returns on REITs have outperformed commodities by a substantial amount (11.95 percent per year vs. -7.34 percent). We believe the dividend income component, particularly the compounding effect of reinvestment, plays a critical role in the outperformance by REITs during periods of low inflation.

In our view, Energy Infrastructure provides similar inflation protection due to its dividend/distribution income component. In fact, over the past 20 years, both Energy Infrastructure dividend/distribution and REIT dividend growth have exceeded the Consumer Price Index (CPI) on average. Recent restructuring of the Energy Infrastructure business model has improved the quality of the dividend/distribution, as these companies have improved their balance sheets and improved their capital allocation decisions.

The comparison in the chart from the National Association of Real Estate Investment Trusts (NAREIT) below depicts the growth of distribution and dividends annually versus CPI, not the Energy Infrastructure/REIT yield. Underlying price returns are not considered in this analysis and could add additional return.

For Utilities, the defensive nature of the sector can smooth the volatility of a diversified real asset portfolio when introduced as a component. In our opinion, this is partially due to the market’s recognition of the Utilities sector’s history of consistent dividend income. The resulting lower correlation can help diversify a portfolio. Infrastructure investments in the portfolio, primarily companies that focus both domestically and internationally on large scale, capital-intensive long-lived physical assets, are often comparable to Utilities. They can also incorporate other global real asset exposure with an income component. Preferred securities and Treasury Inflation Protected Securities (TIPS) can be valuable components of a real asset strategy. Both provide the low relative correlation with the rest of the portfolio, which can dampen portfolio volatility, while also providing current income and inflation protection. Corporate bonds can also be part of the fixed income equation, leveraging off the security selection process utilized in the common/preferred equity investments.

In addition to current income, having the right combination of assets, those that have historically demonstrated a low correlation of relative performance against each other, can lead to relatively lower volatility than a specific asset or commodity over long-term economic cycles.

Transparent framework

Diversified liquid real assets strategies are designed using publicly traded, liquid securities as an alternative to direct real asset and commodity investing. Many times, the direct asset investment can lock an investor’s capital beyond a market cycle.

Using exchange-traded REITs, Energy Infrastructure and Utilities priced daily with limited transaction fees may reduce risk by providing liquidity within an investor’s holding period. The benefits of using exchange-traded securities versus owning specific physical assets, such as gold or an apartment building, can improve valuation transparency, provide efficient transaction executions, and lower operating expenses and carrying costs.

The case for diversified liquid real assets

We also believe experienced, active management across asset classes is crucial to delivering a competitive total return that reflects a combination of inflation protection, high current income and low relative volatility. Familiarity with each asset’s relative performance during stages of the macroeconomic cycle (particularly with real estate and energy) is crucial and built into our process. On a micro basis, experience with real estate, energy infrastructure, infrastructure and utilities management teams, demand/supply dynamics, industry M&A environment history and technological advancements are some of the considerations used in positioning within a diversified liquid real assets strategy.