The right balance

Investment in real assets such as renewable energies, farmland and timber can help with portfolio diversification, say Detlef Schön and Susanne Wermter of Aquila Capital.

Institutional interest in the possibilities of investing in real assets is growing. With fixed income accounting for the largest share of portfolios by far, and core central banks applying ultra-low interest rate policies accompanied by low yields, many institutional investors have gone in search of alternatives as a way to meet the flow of payment obligations which they have little means of influencing. In the past, other asset classes such as direct investments in equities have frequently culminated in unsatisfactory returns given the unacceptably high volatility of this asset class.

In this context, investments in real assets represent an interesting alternative for institutional investors. The segment encompasses productive assets such as land, including farmland and forest, and infrastructure. Real estate, ports, bridges, conventional power plants and renewable energies would all be included in the latter category.

A number of features make real assets attractive: they are powered by long-term macro trends which are not dependent on capital markets. At this point in time global population is more than seven billion and rising; most of the growth taking place is in emerging and developing countries. According to the Deutsche Stiftung Weltbevölkerung (German Global Population Foundation), the population is expected to grow in these regions from 5.7 billion to nearly 8 billion in the next 40 years alone.

From an agronomic viewpoint, this is a challenge as demand for food rises and land and water will become increasingly scarce. According to the OECD, food production would have to be raised by at least 60 percent in the next 40 years alone if the growing demand for food is to be met. What is more, the economic growth accompanying population expansion will fuel demand for commodities, part of a change process which will be highly energy intensive. With concerns over global warming, this signals further growth in regenerative energy sources.

A survey commissioned by Aquila Capital and carried out by TNS Infratest among institutional investors in Europe in the second half of 2012 revealed that nearly one-quarter of those questioned plan to raise the share of real assets in their portfolios. The reasons for this are obvious: Renewable energies such as photovoltaics, wind and hydropower as well as agricultural and forest investments are attractive fixed-asset investments.

They offer an appealing risk/return profile, i.e. attractive returns with comparatively high investment security, manageable risk and inflation protection. Real assets also display only a slight correlation with the traditional asset classes of equities and fixed income. This diversification aspect, combined with the ability of these investments to generate long-term stable cash flows, makes real assets the ideal asset class for the asset-liability management of insurance companies and pension funds.

Advantages of diversifying across various real assets

An investment in real assets has a diversifying effect on the portfolio as a whole since the earnings flows are not impacted by market movements in the way that bonds and equities are. The diversifying effect can be enhanced if investors focus on a number of real asset segments simultaneously, as exposure to differing cycles allows them to be combined for maximum effect.

One example of this is renewable energies: investments in photovoltaic and wind power plants correlate negatively in terms of their return profile, while hydropower investments show virtually no visible correlation with the two other segments. Thus, by combining various real asset segments, clear diversification advantages can be gained in the form of lower volatility and generally enhanced returns.

The global macro trends which will drive investments in farmland, photovoltaics, wind energy and hydropower in the decades ahead suggests a predictable growth of demand, albeit complicated by politically determined background conditions. A portfolio of investments in these segments is diversified per se and boasts an optimised risk-return profile.

The integration of real assets into an existing portfolio helps to diversify it, helps to balance and perpetuate returns, and thus mitigates the risk of the portfolio as a whole.

*By Detlef Schön, managing partner of farm investments and Susanne Wermter, senior fund manager renewable energies at Aquila Capital