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The last couple of years have been a wild ride and a divergent path within real assets: an allocation in client portfolios that aims to provide protection against unexpected inflation, real growth of capital over the long-term and diversification benefits. On one hand, it has been a Goldilocks scenario for income-producing investments such as REITs. Low and falling interest rates, steady economic growth and supply constraints have supported valuations. On the other hand, commodities have suffered through a steep and prolonged cycle trough that led to acute distress for natural resource producers.
With inflation still relatively muted and the Fed reaching the limits of monetary policy stimulus, what opportunities and risks are present in real assets? Let's walk briefly through the major segments of this asset class.
Real Estate Investment Trusts (REITs)
Relative to other opportunities within real assets, publicly-traded REITs are generally less attractive. Fundamentals remain strong with solid net operating income growth and constrained supply. However, with capitalization rates (net operating income divided by property value) near historical lows and price multiples of funds from operations (P/FFO) similarly stretched, these favorable fundamentals won't necessarily translate into attractive forward-looking returns.
In the context of overall objectives of the real assets portfolio, REITs have also become less compelling from a diversification standpoint. Correlations to equities have been steadily increasing over time and REITs are now well-represented within equity portfolios. At the end of August, S&P and MSCI implemented the creation of a new real estate sector, moving it out of the broader financial sector. There are select opportunities in private real estate, but exposure to REITs has been de-emphasized in portfolios until the margin of safety improves with more attractive valuations.
Master Limited Partnerships (MLPs)
Investors were rudely reminded of the risks associated with MLPs beginning in mid-2014. Once a reliable play on yield, MLPs became an oil proxy as the collapse in oil prices cascaded through the energy complex. Investors began to have doubts about the viability of strong distribution growth implied in the lofty expectations. This was especially true in higher-cost areas where producing rigs were shutting down en masse. As a result, units were re-priced at much higher yields and distribution cuts occurred for several highly-leveraged, commodity-sensitive MLPs. The yield advantage of MLPs relative to other securities did little to buffer the volatility.
Beginning in March 2016, MLPs started to re-establish a positive relationship with bond prices as oil markets stabilized. MLP unit prices have retraced some of the decline and have been a positive contributor to 2016 performance after a difficult 2015. Looking forward, MLPs offer reasonable value and one of the few attractive income opportunities – a 7% current distribution yield for the Alerian MLP Index. Even after a meaningful recovery from trough lows, valuation multiples are still below average and offer some cushion against the prospect of rising interest rates. As oil markets continue to balance, we expect the tight linkage to oil prices to moderate and MLPs to reestablish a more uncorrelated return.
Treasury Inflation Protected Securities (TIPS)
TIPS are not technically a real asset, but we consider them an important tool in pursuing the objectives of the allocation. Breakeven inflation (nominal Treasury yield – TIPS real yield of equivalent maturity) is currently 1.3% for 5 years and 1.5% for 10 years. This implies the market is pricing inflation to run below the Fed's stated target of 2% for the next 10 years. With such modest expectations, there is some risk that inflation can surprise to the upside – a positive outcome for TIPS investors relative to other fixed income. Despite low expected returns, TIPS continue to be utilized in many portfolios, especially those that are more conservative with preservation of purchasing power as a primary objective.
Commodities / Natural Resource Equities
Broad commodity exposure is captured in two primary ways: commodity futures and commodity producers. Our efforts and capital allocation have been solely focused on commodity producers for the last four years due to structural issues with commodity futures. Without devoting too much space here on the subject, the low interest rate environment and the negative roll yield (selling a futures contract close to expiration and buying another one with an expiration date a month or more out) translate into total returns that significantly trail the actual spot price change of commodity prices over time.
Natural resource equities (commodity producers) have consistently delivered strong outperformance over commodity futures strategies in various market cycles. The combination of attractive valuations and commodity prices that were below the long-term marginal cost of supply led us to increase exposure to this segment of real assets in early 2015. In retrospect, that decision was made too early. Oil and other commodity prices continued to plummet throughout 2015 and the prices of natural resource equities moved from cheap to historically cheap by early 2016. It was painful to live through. At this point, we've experienced a sharp recovery in prices from lows in mid-January and believe most commodities still trade at or below the long-term cost of marginal supply. Like past commodity price cycles, the damage inflicted on the industry and the collapse of capital spending during the downturn could set the stage for the next upswing of the cycle.
Though the various real assets investments have common properties that align with the overall objective, the unique aspects of each of these segments allow us to position the portfolio with the most attractive combination based on our assessment of risk and reward. This process had led us away from the comfort of strong recent performance and toward areas where volatility has revealed opportunity. The timing of these decisions within the market cycle is of course unknown, but for investors with a long-term horizon we believe this approach will be rewarded.
The above commentary represent the opinions of the authors as of 9.29.16 and are subject to change at any time due to market or economic conditions or other factors.Print