Alternative investments have doubled in terms of assets under management over the six years to 31 December 2011 to US$6.5 trillion1. This growth is seven times that of traditional assets.
Despite this increase, many investors still do not understand alternative investments. One reason is that they used to be any investment that was not one of the three traditional asset types of stocks, bonds and cash. Today, this is taken to include real estate (especially unlisted real estate), infrastructure, private equity, hedge funds, currency funds, commodities, managed futures, options and derivatives.
McKinsey & Company forecasts this “growth is expected to continue, fuelled by increasing allocations by institutional investors and the movement of alternatives into the retail investment mainstream”2.
Alternatives are not simply growing – they are becoming part of the investment management mainstream.
“Institutional investors expect, by the end of 2013, to increase their allocations to almost all forms of alternatives... to a simple average of 25% of portfolio assets”.2 In the US, they are expected to account for 28% of major institution portfolio assets. “100% of US participants in McKinsey’s research and 70% of those from Europe expect alternatives will grow faster than traditional asset management products”2.
A survey by Towers Watson found that alternative asset allocations increased to an average of 19% of portfolios collectively for the US, UK, Switzerland, Netherlands, Australia, Canada and Japan in 20123.
A focus on real assets
One of the fastest growing segments of alternative investments is the real assets class. One of the appeals of this asset class is the fact they are real which ensures a greater sense of security, in that there is a real asset that has tangible value.
A second appeal is that real assets’ typical performance bridges the gap between fixed income and equity. The stable, bond-like payment structure often provided by real assets also has the potential to deliver consistent mid- to long-term returns – absolute returns – and as such, can help institutional investors meet their desired rate of return.
They also offer the potential for equity-like upside and the ability to respond positively to healthy, growth-induced inflation. While bonds pay a regular fixed coupon until they reach maturity, real asset payouts can grow in line with cash flow growth.
One of the fastest growing alternative and real asset classes is infrastructure. It has been an asset segment since the 1980s, when investors used to view it as an extension of government bonds. Today, investors are beginning to discern that infrastructure is an asset class in its own right with its own characteristics.
McKinsey estimates that infrastructure has grown from less than 1% of institutional asset allocations in 2009 threefold to 3.5% this year2.
The World Bank estimates that more than $22 trillion needs to be spent on key global infrastructure over the next 25 years,while the Organisation for Economic Co-operation and Development estimates that an even greater $50 trillion is needed by 2030.4 In developed countries there is a need to replace ageing infrastructure, while in developing countries there is significant demand due to strong population growth, increasing wealth and growing demand for services. While the amount of infrastructure required is expanding, the supply of experienced infrastructure managers is limited. It is essential to use managers with a track record.
Infrastructure assets display characteristics such as strong, often dominant, market positions in their respective geographical regions and the ability to generate stable long-term cash flows.
Why invest in real assets?
Real assets have the following benefits for institutional investors:
Real returns – real assets focus on generating high cash yields from stable cash flows achieved by infrastructure businesses.
Diversification – real assets generally have a low to moderate correlation to traditional investments such as equities and bonds. This is largely a result of the oftentimes counter-cyclical forces driving real asset returns. Allocating to a diversified selection of real asset investments can thus increase a portfolio’s diversification and improve risk adjusted returns.
Hedge against inflation – real assets may also provide some effective inflation protection.
A survey undertaken by Pension & Investment magazine’s Research Advisory Panel in 2012 indicated that 46% of respondents plan to increase their asset allocation to real assets in the next three to five years. (The panel consists of executives at pension, endowment and foundation funds).
Using real assets to match liabilities
Separating return seeking and liability matching portfolios is a well-established practice among large defined benefit pension schemes. Rather than optimising risk-adjusted returns, matching portfolios seek to match the long-term cash commitments of a pension fund’s liability book with the long-term positive cash flows generated by an investment portfolio. The strategy is particularly important for investors with long-term liabilities that are directly linked to inflation, such as pension funds and insurance companies.
Core infrastructure assets, with their long-term, inflation linked cash flow profiles, are increasingly being considered as an alternative to traditional matching assets such as inflation-linked bonds. Investors are attracted by the idea that they might earn attractive, predictable, stable, risk-adjusted returns from long term assets, which are protected against inflation and help to diversify their portfolios.
As infrastructure is such a broad asset class, and infrastructure assets often have very different risk and return profiles, investors need to consider not just whether the infrastructure asset class is suitable for their purposes but which type of infrastructure sub-sector or assets can deliver the required cash flow profile to meet their liability requirements.
In determining which infrastructure assets best meet an investor’s needs, there are a number of factors that should be considered. These include the cash flow profile, risk profile and capital structure of the underlying asset. For example a regulated asset, typically a government mandated utility with extremely stable long term cash flows, will have a very different profile to a toll road asset, where cash flows may be impacted by fluctuations in traffic volume. Other considerations include the key risks applicable to the asset, including when refinancing is due, regulatory risks and economic risks.
1 Six years to end 2011. McKinsey & Company The Mainstreaming of Alternative Investments September 2012. There is no data for 2012.
2 McKinsey & Company ‘The Mainstreaming of Alternative Investments’ September 2012.
3 Towers Watson January 2013 Global Pensions Asset Survey.
4 www.worldbank.org 2011.
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