Why invest in real assets?
Author: Steve Bonnyman
August 22, 2019
A conversation with Steve Bonnyman, Co-Head of North American Research and Portfolio Manager, AGF Investments Inc.
What is a real asset?
Real Assets are generally defined as physical or tangible assets that derive their value from their own substance and properties, including precious metals, commodities, real estate, agricultural land and oil and renewable energy.
What is the objective of investing in a real asset?
In a financial context, real assets are often identified by their relatively low correlation with traditional equity markets and other financial assets. The goal of a real asset strategy is to invest in long-term physical assets that generate attractive, risk-adjusted returns as a cushion against business cycle volatility with a focus on controlled risk and industry diversification.
What does a real asset investment add to an equity portfolio?
The assets in the real asset universe tend to be less correlated to the broader market indices and therefore offer a broader source of diversification. They also tend to be more highly correlated to inflation, offering an improved hedge, or protection against inflation.
How might a real asset fund be structured?
The investment universe could include investments in global materials, energy, real estate and Infrastructure industries. This could include everything from airports and highways (infrastructure) to power generators and distributors (utilities), miners, gold miners, smelters, chemical producers, fertilizer and streel companies ( materials), all varieties of global real estate REITS ( residential, office, specialty ), global integrated oil companies, oil exploration and production companies, pipelines, service companies and petroleum refiners.
A fund might also consider associated businesses, where there’s a strong link to a core investment sector. For example, this might include pipe providers to drilling companies, or a technology company focused exclusively on mining applications.
How do you find the right asset allocation of real assets to invest in?
Asset managers would want to evaluate the relative risk/return opportunity in each sector in light of the broader economic and market outlook by looking at potential sector/equity returns and return volatility, as well as the correlations (or lack thereof) between sectors to evaluate the net impact to the portfolio.
The equity selection is the dominant driver of portfolio construction, with sector allocation being utilized as a risk monitoring/management tool.
How do you evaluate these holdings? Is it different than evaluating stocks?
The selection portfolio process starts with an initial screening to reduce the universe to a narrower selection of possible assets. This would be followed by a fundamental analysis with economic/market forecasts applied to seek out the best risk/reward opportunities in the group.
Asset managers would also look for unique investment opportunities which may not have registered using the screens already applied. This may provide other opportunities in the portfolio. Broadly, the portfolio will contain the following assets: firstly, those “core holdings” which are the businesses and companies that we are likely to hold through a full, economic cycle; secondly, “macro plays” where we have sought exposure to a broader macro theme; and thirdly, “opportunistic” investments, where the thesis is unique to the equity selected.
The portfolio assembly process examines the relative correlations across the equities and sectors to balance our risks and exposures to broad market variables.
Where do the best opportunities lie at the moment?
It’s especially difficult to predict in this period of higher volatility where making decisions based on both the short and long-term pose both risks and opportunities. The commodity producers appear to be unduly discounted based on our assessment of their longer term cash flow generation capability, but remain out of favour due to the perception and risk of a near-term economic slowdown. Meanwhile, businesses participating in the growth of the global LNG market are well positioned for long-term growth and aren’t expensive. I believe there may also be interesting opportunities in global integrated energy firms given that cash flow generation is being unduly discounted.
What is the biggest challenge at the moment?
From my perspective, the global investment landscape is as fluid as it has ever been with an increasing presence of “known unknowns” in the market. Additionally, it feels like we are on the cusp of a marked change in what’s driving markets. More specifically, for more than a decade, the market has been driven by momentum and growth whereas there’s potential for a ‘’regime’’ change whereby future markets may be driven by price. And that could get messy.
There are probably three key risks that I am spending the most time thinking about ( or are keeping me up all night), and to an extent, they are related:
Economic cycle risk: It has been a long economic cycle with a rotating series of drivers, and it’s not clear how the next few years will play out. We have not had to invest before in a period of such low interest rates and inflation at the later part of an economic cycle.
Geopolitical Risk (which links to the point above): Brexit, conflict in the Persian Gulf, sanctions against Iran, trade disputes with China—all of these conflicts are difficult to assess and forecast, and in many cases, have bimodal outcomes. In other words, the outcome won’t be neutral—it will be either positive or negative.
Meanwhile, there are a number of potentially interrelated factors to consider that could also meaningfully impact global trade flows and commodity supply.
Investor Perception Risk: The recent market has been very “thematic”–relative valuations for much of the market have been driven by longer-term themes or expectations rather than nearer term cash flows and earnings that include themes such as electric vehicles, battery technology, carbon reduction, Cryptocurrency.
In the real asset space, this has induced exceptional volatility in commodities associated with EV’s (lithium), for example. This has left the broader commodity space largely unloved.
A question we’re currently asking is: Have valuations for commodity producers been permanently devalued/contracted? Is this just part of the normal cycle or, with the evolution of demographics and changing public perception, is the group now posed to trade below historical normal valuations?
The commentaries contained herein are provided as a general source of information based on information available as of August 12, 2019 and should not be considered as investment advice or an offer or solicitations to buy and/or sell securities. Every effort has been made to ensure accuracy in these commentaries at the time of publication however, accuracy cannot be guaranteed. Investors are expected to obtain professional investment advice.
The views expressed in this blog are those of the author and do not necessarily represent the opinions of AGF, its subsidiaries or any of its affiliated companies, funds or investment strategies.
AGFiQ is a collaboration of investment professionals from Highstreet Asset Management Inc. (a Canadian registered portfolio manager) and AGF Investments LLC (formerly FFCM, LLC). This collaboration makes-up the quantitative investment team.
AGF Management Limited (“AGF”), a Canadian reporting issuer, is an independent firm composed of wholly owned globally diverse asset management firms. AGF’s investment management subsidiaries include AGF Investments Inc. (“AGFI”), AGF Investments America Inc. (“AGFA”), Highstreet Asset Management Inc. (“Highstreet”), AGF Investments LLC (formerly FFCM LLC) (“AGFUS”), AGF International Advisors Company Limited (“AGFIA”), AGF Asset Management (Asia) Limited (“AGF AM Asia”), Doherty & Associates Ltd. (“Doherty”) and Cypress Capital Management Ltd. (“CCM”). AGFI, Highstreet, Doherty and Cypress are registered as portfolio managers across various Canadian securities commissions, in addition to other Canadian registrations. AGFA and AGFUS are U.S. registered investment advisers. AGFIA is regulated by the Central Bank of Ireland and registered with the Australian Securities & Investments Commission. AGF AM Asia is registered as a portfolio manager in Singapore. AGF investment management subsidiaries manage a variety of mandates composed of equity, fixed income and balanced assets.
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