The new mainstream

Oldrik Verloop, co-head of hydropower investments at Aquila Capital, explains why real assets have become an attractive core category for institutional investors.

The economic situation that now prevails following the extreme market turbulence of 2008 to 2012 is often described as the ‘new normal’. It implies steady – but anaemic – growth and consequently, low returns from bonds and equities for some time.

Indeed, a new paper published by Aquila Capital and entitled Real Assets – The New Mainstream, includes calculations that show the Dow Jones Index will deliver total returns averaging just 4 percent per annum over the next 10 years, based on its current Shiller Price/Earnings Ratio and 114 years of data, while German 10-year government bonds are set to produce negative real returns even if interest rates were to reach 4 percent by 2024.

Faced with such a difficult investment climate, a growing number of institutional investors struggling to meet their long-term commitments are re-evaluating their asset allocations. Prompted by the lessons of the financial crisis and new regulations that are forcing a de-risking of portfolios, investors are increasingly turning their attention to real assets.

The term ‘real assets’ refers to a broad range of potential investments that have intrinsic value. They serve as the foundation for the delivery of goods and services that are necessary to support the global economy and encompass a number of sub-asset classes, including renewable energies/infrastructure, agriculture/farmland, timber and real estate.

A recent survey of European institutional investors by Aquila Capital found that the majority (60 percent) expect to see institutional allocations to real assets increase over the next three years. Of these, one in five expects the rise to be ‘significant’ while only 7 percent expect institutions to reduce their exposures.

This increased investor appetite for real assets is likely to be accompanied by strong growth in the supply of investment opportunities. Several macroeconomic trends point to this. First, according to the United States Census Bureau, the global population is more than seven billion and rising, with most of the growth taking place in emerging and developing countries. According to the United Nations, the world population is expected to grow to 9.6 billion by 2050.

From an agronomic viewpoint, this is a challenge, as demand for food rises and land as well as water become increasingly scarce. According to the OECD, calorie production would have to be raised by at least 60 percent in the next 40 years to meet the extra demand for food.

Second, the economic growth accompanying population expansion will fuel demand for commodities. This process will be highly energy-intensive. With concerns over global warming, this signals further growth in regenerative energy sources and translates into a huge demand in investment requirements to build renewable energy infrastructure, beyond the reach of public financing alone. This will create a significant opportunity for the investment of private capital.

Third, there is increasing scope for investments in existing real asset structures. As financial deficits remain high in the developed world, a number of governments have chosen to privatise and dispose of mature government-owned infrastructure assets, such as airports and toll-roads, in the quest for liquidity. This is providing investors with more opportunities to invest in existing infrastructure assets.

The appeal of real assets is that they are supported by long-term macroeconomic trends and can deliver a strong, inflation-protected income with high investment security, manageable risk and a limited correlation with the traditional investment asset classes of equities and fixed income.

Importantly, real assets have the potential to provide stability and growth in a range of market conditions. In a recessionary environment, they can provide invaluable downside protection to a portfolio thanks to the generally stable nature of their cash flow streams. At the same time, they can participate in the upside during periods of growth.

As such, real assets are uniquely positioned to provide value and enhance overall risk-adjusted returns in a broad range of market environments. This combination makes them an attractive core holding for institutional investors worldwide.