The Observer


Private Real Assets - Alternative Income for Enhanced Total Return

by Patrick Murray and Johnny Yong, Manulife Asset Management

Executive summary
Interest rate normalization continues apace in North America. Just since the summer of 2017, the Bank of Canada has doubled its interest rate to 1.5%, and the U.S. Federal Reserve has raised its federal fund rate on multiple occasions from historic lows. Expectations are that rate normalization will continue in the years ahead—especially if both the U.S. and Canadian economies continue to expand at the current pace. For instance, the unemployment rate in both countries is near historic lows, lending further credence to the belief that more rate hikes will be forthcoming.
What does this mean for investors? We believe returns from traditional fixed income will likely remain elusive. Based on historical data, we know that a diversified portfolio of real assets has provided attractive returns versus the FTSE Canada Universe Bond Index and the FTSE Canada Long Bond Index, with much less volatility.
We examined how various real assets typically behave in an environment characterized by rising interest rates and rising inflation. We found that this group of assets lived up to its reputation as being an effective hedge against higher rates while providing a steady stream of income. Critically, we believe real assets have low correlations with most liquid asset classes and have low historical drawdown compared with traditional asset classes.
Plotting asset performance: change in 10-year yields vs. real asset performance (%)

Source: Manulife Asset Management, July 31, 2018.

This paper outlines how a diversified portfolio of real assets focused on strategic assets can provide attractive returns relative to traditional fixed-income benchmarks, with potentially much less downside risk from higher
interest rates.

Anchoring and enhancing fixed-income portfolios with real assets

Bond yields have been falling since the early 1980s. The FTSE Canada Universe Bond Index has returned 8.8% annualized in the last 37 years; the level of return, however, has nearly halved, to 4.7%, in the past 10 years—low, in our view, and it could get much lower. In addition, volatility levels for long-term bonds have increased recently: In the last two years alone, we saw two of the biggest negative quarterly returns since 1994.1 This development has given many pension fund sponsors and managers even more reason to turn to nontraditional assets in their quest for yield and returns stability. An asset class that has become increasingly popular? Private real assets.
Asset class expected return components, Q2 2018 (%)

Source: Bloomberg, Manulife Asset Management, as of June 30, 2018.
A significant portion of private real assets’ total return is income, which is often directly linked to economic growth: It typically rises in times of inflation and heightened levels of economic activity and falls when the reverse happens. In some instances, the income generated is contractual in nature, which can serve to not just enhance total returns, but protect asset owners from the negative impact of economic changes. For example, infrastructure such as toll roads typically have built-in inflation clauses allowing toll operators to charge more under certain conditions. Similarly, leases for commercial properties can be rolled over with higher rates to reflect higher levels of economic activity. In short, real assets can provide a form of long duration exposure sought by investors without exposing them to the potential capital losses stemming from rising interest rates or inflation.

Real assets: limited drawdowns when compared with traditional public indexes
In terms of drawdowns, defined as the percentage change between the peak achieved by an asset (class) and the lowest level it sank to during a specific period of time, it’s fair to say that real assets have historically fared better than traditional public indexes. Farmland has never experienced a drawdown, while the NCREIF Timberland Index has only had a couple that can be considered noteworthy: one in 2001 and the other during the U.S. housing crisis in 2009. Incidentally, the two commonly benchmarked fixed-income indexes for core fixed-income and liability-driven investment (LDI) mandates—the FTSE Canada Universe Bond Index and the FTSE Canada Long Bond Index— experienced their maximum drawdown during the same quarter, Q4 2016, during the U.S. elections.1

Cumulative returns across asset classes, December 2003–March 2018 (%)

Source: Bloomberg, Manulife Asset Management, March 2018.

Let’s look at an example within the farmland space, where the recent peaks of the market occurred in 2012/2013. Prices for almonds, pistachios, cranberries, walnuts, and row crops, such as corn, soybeans, and wheat, dropped between 40% and 60% from their respective highs; however, the value of farmland continued to increase during the period. An investor who buys into these asset classes isn’t buying the underlying crops, but a diversified portfolio of properties through a pooled vehicle. In a sense, these long duration assets with stable income streams are akin to a long bond portfolio, where an investor can clip coupons and ride out the shorter-term moves in rates. With real estate, the diversity of buildings, regions, and economies, backed by strong and consistent cash flow from long-term leases, can provide the same type of stability and long duration sought by investors.

Private real asset returns and characteristics

Private real assets have always been attractive to long-term investors who value stability and the asset class’s ability to act as a diversification tool as well as an inflation hedge. However, critics have questioned the validity of applying risk metrics such as volatility and Sharpe ratio to this group of assets, noting that infrequent valuation exercises can make these readings less meaningful.
Private assets: 14-year annualized returns (%)

Source: Bloomberg, Manulife Asset Management, as of December 31, 2017.
While these criticisms may have some merit, we note that the income component of real assets does provide a great deal of stability to its respective return profile. For example, our calculation shows that the correlation between the income component and total return component within agriculture is 0.9, indicating that income represents a very high proportion of the total return. Similarly, many other private assets exhibit a high income component as a percentage of total return.
Historical income component, total returns
 Time periods for income breakdown Number of years Since From income (%)
 Canadian mortgages 8.0 July 2008 91
 U.S. private placement debt 6.0 January 2011 86
 U.S. mortgages 10.0 July 2006 82
 Canadian real estate IPD 30.0 January 1985 80
 Canadian private placement debt 8.0 July 2008 73
 Agriculture/farmland 21.5 October 1995 63
 Timber 29.5 January 1987 43

Source: Manulife Asset Management, as of June 30, 2016. Canadian mortgages: 8 years to June 30, 2016, is represented by Manulife's internal commercial mortgage composite/representative account. U.S. private placement debt: 6 years to June 30, 2016, internal composite. U.S. mortgages: 10 years to June 30, 2016, internal composite. Canadian private placement debt: 8 years to June 30, 2016, is represented by Manulife's internal Canadian private debt composite/ representative account. Canadian real estate IPD: REALpac/IPD Canada Quarterly Real Estate Index, Q1 1985–Q4 2015. The REALpac/IPD Canada Quarterly Real Estate Index tracks the performance of real estate in Canada. It is not possible to invest directly in an index. Agriculture/farmland: Q4 1995–Q4 2016, internal composite. Timber: Q1 1987–Q4 2016, internal composite. The table shows data from different time periods to illustrate the percentage of income that comes from the total return while using the maximum amount of historical returns possible. For example, Canadian mortgages, U.S. private debt, and U.S. mortgages have between 6 and 10 years of history, while the timber and agriculture/farmland components, managed by John Hancock, have history going back to 1987 and 1995, respectively. The income component is divided into the total return component to derive the percentage of income return generated out of the total return.

Exposure to a diversified group of infrastructure, timber, agriculture, private debt, mortgages, and direct real estate, wrapped in the same vehicle, can appeal to smaller pension plans, endowments/foundations, and high-net-worth investors, helping them gain access to what could be seen as a turnkey solution within private markets. An optimal asset allocation within a total return- or income return-based approach that’s consistent with their needs and philosophy could then be constructed. A diversified fund of real assets could also be an effective means to de-risk via diversification, rather than increasing the hedge ratio.

1 Bloomberg, as of June 30, 2018.

 Patrick Murray, CIM, FCSI
 Managing Director, Specialist
 Multi-Asset Portfolio Management

 Manulife Asset Management

 Johnny Yong, CFA
 Director, Global Asset Allocation

 Manulife Asset Management


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A rise in interest rates typically causes bond prices to fall. The longer the average maturity of the bonds held, the more sensitive a portfolio is likely to be to interest-rate changes. The yield earned by a portfolio will vary with changes in interest rates.
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