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Improving portfolio diversification with uncorrelated market exposure
- In the face of market volatility, lower-for-longer interest rates, and return expectations for equities and bonds that are well below historic averages, institutional investors are considering real assets to help meet investment objectives.
- Private investments in relatively illiquid categories of real assets — farmland, timberland and commercial real estate — have exhibited low or negative correlations to stocks and bonds, diversifying portfolio risk. For the past two decades, real assets have generated higher returns than traditional investments, with significantly lower volatility.
- Portfolio optimization using 28 years of returns demonstrated private real assets’ potential to improve the risk-adjusted returns of traditional stock-bond portfolios, and to diversify risks associated with publicly traded commodities and real estate investment trusts (REITs).
- Results supported combining multiple categories of real assets and constraining overall allocations within practical limits, such as 10% or 20%.
In search of alternativesSince the global financial crisis, interest rates have been anchored at unprecedented lows. At the same time, stock and bond investments have produced positive returns along with bouts of significant volatility. This has left many investors questioning long-held return expectations for these asset classes as well as long-held beliefs on the diversification power of a traditional balanced portfolio. These questions persist in 2020, amid a global pandemic in which stock markets dramatically sold off and government borrowing looks set to reach new record highs.
Against this backdrop, increasing numbers of institutional investors are seeking sources of uncorrelated returns, with many finding real assets playing a role in that pursuit.
This paper focuses on private real assets, which we define as private, direct investment in farmland, timberland and commercial real estate. They belong to a category of alternatives that many institutional investors have not fully explored.
In addition to explaining potential benefits, we provide guidance on the impact of combining real assets with stocks and bonds in portfolios representing different investor risk preferences. We address the impact of real assets’ illiquidity and limited availability — factors that require constraining allocations within practical limits. We also include a case study of one of the world’s largest institutional investors — the TIAA General Account — and their experience of investing in real assets.
How real assets can improve traditional portfoliosResults of our analysis support the long-term investment thesis that real assets have potential to improve the performance of traditional portfolios in multiple ways:
- Diversification: Real assets are powerful diversifiers, with low or negative correlations to traditional stocks and bonds — and to each other (Figure 1). Private investments rarely move in lockstep with traditional assets or commodities in part because they are relatively illiquid; they are not traded in public markets.*
- Higher risk-adjusted returns: For the past 28 years, real assets have provided similar or higher returns than stocks with much lower volatility, resulting in higher risk-adjusted returns, or Sharpe Ratios (Figure 2). Despite higher volatility, real assets provided similar or higher risk-adjusted returns than U.S. and global bonds. Among publicly traded counterparts, REITs and timber product companies had returns higher than or similar to real assets, but with more than double the level of volatility, resulting in lower risk-adjusted returns.
- Liability-matching characteristics: Real assets have potential to provide bond-like current income from contractual lease obligations and from revenue from selling commodities. Long-term capital appreciation from rising land values may also help meet future liabilities.
- Inflation hedging: Real assets have provided a strong hedge against inflation for two reasons: 1) long-term returns have far outpaced the inflation rate; and 2) many commodities, such as foodstuffs and raw materials, are components of inflation measures, such as the Consumer Price Index (CPI). Driven by global demand trends, rising commodity prices increase the profitability of timberland and farmland, causing land values to rise and providing a long-term hedge against inflation. Since 1992, timberland and farmland returns have averaged 9.6% and 11.4%, respectively — more than double the inflation rate of 2% to 4% during the same time period. Their positive correlations with inflation, 0.38 and 0.20, respectively, were higher than for government bonds or stocks. Similarly, real estate hedges inflation through annual lease escalations, and the rising value of buildings and land in desirable locations.
Important differences in the sizes of investable marketsSignificant differences in the sizes of investable markets across real assets have important implications for investors. The NCREIF indexes used as proxies for U.S. markets represent only a fraction of the total investable markets for farmland and timberland, which are far less institutionalized than commercial real estate. (We relied on U.S. market indexes due to the absence of indexes representing markets for non-U.S. real assets.) Total assets included in the NCREIF indexes represent $11.4 billion for farmland, $23.4 billion for timberland and $683.5 billion for real estate, as of 31 Dec 2019 (Figure 3). In contrast, we estimate the overall size of the U.S. farmland market alone is about $2 trillion, with around $560 billion available to institutional investors. The NCREIF Farmland Index represents only the assets owned by institutions — the vast majority of the assets are held by individual farmers in a highly fragmented market with high barriers to entry. Differences in historical returns among real asset categories may partly reflect different levels of market development, contributing to higher returns for the less developed farmland and timberland markets, compared with commercial real estate. Rising institutional interest in farmland and timberland may produce return compression in the future in developed markets but emerging and frontier economies remain largely untapped. In the near term, demand is likely to exceed available investment capacity, posing challenges for investors seeking exposure to farmland and timberland. Predictably, mean-variance optimization specifies extreme allocations to asset classes with more attractive risk/return profiles. We have therefore chosen to constrain allocations to real assets in several exhibits to reflect real-world capacity constraints and liquidity concerns facing institutional investors.
Structuring a portfolio of real assetsWhile the case for real assets is compelling, they raise difficult implementation questions: How should investors structure a portfolio of real assets? How might allocations change for different investor risk and return preferences?
No single optimal allocation fits all risk profiles. Allocations should reflect individual investment objectives, risk tolerance, and liquidity needs. We used mean-variance optimization analysis to show the potential impact of real assets on a range of portfolios representing different risk profiles and constraints. Portfolios shown in this analysis are designed to provide an analytical framework and illustrations and should not be considered investment recommendations. The analysis is based on the following scenarios:
- Adding real assets individually — and as a group — to a portfolio of stocks and bonds
- Comparing real assets with publicly traded commodity stocks and REITs
- Structuring a real asset portfolio for different investment objectives
- Constraining real asset allocations within practical limits in conservative and aggressive portfolios
Observations from mean-variance optimization analysis
Observation 1Real assets improved the risk-adjusted returns of a portfolio of traditional stocks and bonds
Institutional investors are posing a basic question: How do private real assets impact the risk and return attributes of a portfolio of stocks and bonds? In Figure 4 (next page), efficient frontier charts show the impact of adding farmland, timberland and real estate individually to a stock/bond portfolio. In the table we also show the impact of combining all three categories. In this example, we constrained real assets to 15%, divided evenly at 5% in each.
- Each category of real assets increased returns, with similar or lower levels of risk, resulting in higher Sharpe Ratios.
- Farmland had the greatest impact on returns and received the largest allocation in an unconstrained portfolio at 43%. Real estate at 31% had the second biggest impact on returns, followed by timberland at 24%.
- Diversifying a stock/bond portfolio with a 5% allocation to each of the three real assets increased annual returns by 36 basis points and reduced risk by 70 basis points, producing a higher Sharpe Ratio.
Overall, results support the case for diversifying traditional portfolios with multiple categories of real assets even when constrained within realistic limits. The constraints reflect supply limitations, the relative illiquidity of real assets, their relatively high transaction costs, and the limited history contained in the analysis.
Observation 2Private real assets provided higher returns with lower volatility than publicly traded commodities and real estate stocks
We compared private real assets with publicly traded commodity stocks and commercial REITs to assess diversification benefits against the illiquidity of private assets. Since many institutional investors already have exposure to REITs and commodities, such as metals or oil and gas, we also compared the impact of combining private real assets with public stocks. This analysis used fixed allocations and constrained alternatives to 15% of the portfolio, consistent with realistic limits.
Figure 5 compares three portfolios consisting of a fixed 85% in stocks and bonds in a 60/40 ratio, and 15% in alternative assets. Portfolio 1 adds three categories of private real assets, divided evenly at 5% each. Portfolio 2 adds three categories of publicly traded commodities and REITs, divided evenly at 5% each. Portfolio 3 combines private and public assets, split evenly at 2.5% each.
- Private real assets increased portfolio returns and reduced volatility, resulting in a higher Sharpe Ratio, versus publicly traded commodity stocks and REITs. This can be seen by comparing the performance of Portfolio 1 and Portfolio 2 in Figure 5.
- Private real assets helped to diversify the volatility risk of publicly traded commodities and REITs. This can be seen by comparing the performance of Portfolio 2 and Portfolio 3 in Figure 5. The combination of private and public assets in Portfolio 3 increased returns by 23 basis points and reduced volatility by 74 basis points, resulting in a higher Sharpe Ratio, compared to Portfolio 2.
Observation 3Farmland dominated a portfolio consisting only of private real assets
The next analysis shows how different asset categories work together in a portfolio consisting only of private real assets. We examined how the structure can change based on different investment objectives. An efficient frontier using farmland, timberland and real estate allowed comparison of three portfolios producing the highest efficiency, lowest risk and highest return (Figure 6).
- The most risk-efficient portfolio was dominated by farmland at 63%, but also included 20% timberland and 17% real estate, benefitting from low correlations among the categories.
- The lowest-risk portfolio reduced farmland exposure to 40% and increased timberland and real estate to 26% and 34%, respectively, reflecting relatively low or negative correlations between categories.
- The highest-return portfolio consisted of 100% farmland, reflecting higher returns and lower volatility compared to timberland and real estate.
- Overall, the most efficient real asset portfolio generated much higher risk-adjusted returns than the most efficient combination of traditional stocks and bonds. The real asset portfolio produced an additional 395 basis points of return and only increased standard deviation by 133 basis points.
Observation 4Constraining real assets within practical limits still improved performance
How much real assets exposure is reasonable for institutional investors? Real assets are expected to continue their recent steady growth, with current portfolio allocations generally estimated at 5% to 10%, and endowments ranging up to about 15%. Overall, real assets represent more than $10 trillion out of $27 trillion of global institutional assets under management in 2019, or nearly a third. Additionally, institutions are increasing their exposure to alternatives in efforts to increase current income and risk-adjusted returns, dampen volatility, and meet specific needs, such as inflation protection.
As noted earlier, mean-variance optimization outputs may suggest extreme allocations to individual asset classes based on returns for the time period used as inputs. For most institutions, allocations exceeding 25% to individual real assets categories would be unrealistic. Most portfolios would lack sufficient liquidity to meet near-term spending obligations, and investors would have difficulty accessing enough farmland and timberland. Moreover, questions about the limitations and relatively short history of index data would argue against such large holdings in real assets.
There is no single optimal allocation to real assets, which will differ based on the investor’s specific risk profile. The next analysis considers two model portfolios representing a conservative allocation of 20% stock and 80% bonds and an aggressive allocation of 80% stock and 20% bonds. We limit the combined real asset allocation to 10% (3.3% per category) in the conservative portfolio and 20% (6.6% per category) in the aggressive portfolio.
- Despite the allocation limits, real assets reduced volatility compared to only stock-bond portfolios — resulting in higher risk-adjusted returns (Figure 7).
- Overall, results show that, based on historical performance, investors could improve portfolio risk-adjusted returns with allocations that were fractions of the unconstrained allocations, but realistic for institutional investors.
Investment implications — and conclusionsThis analysis shows private real assets offer institutions compelling potential to enhance risk-adjusted returns. As long-term investments, their benefits provide some compensation for their relative illiquidity. They can combine bond-like income from asset leases and equity-like returns from long-term appreciation in land values. These features can support asset-liability matching, with potential for improved long-term portfolio returns to meet future obligations, and lower volatility of returns to meet current liabilities.
Our analysis provides directional guidance for incorporating private real assets in institutional portfolios:
Adding private exposure to any single category — farmland, timberland or commercial real estate — increased portfolio returns and reduced risk, resulting in higher Sharpe Ratios.
Private real assets offered superior risk-adjusted returns compared with publicly traded commodity stocks and REITs. In combination, private real assets helped to diversify the volatility of publicly traded commodities and REITs, resulting in higher portfolio risk-adjusted returns.
Unconstrained, farmland tended to dominate timberland and commercial real estate, based on historical returns reflecting farmland’s limited availability and less-developed institutional markets. The resulting large allocations suggested by mean-variance optimization require practical constraints to address availability, prudent diversification, and liquidity needs.
Overall, results support the case for diversifying traditional portfolios with multiple categories of real assets within realistic limits. A combined allocation of only 10%, evenly divided among the three categories, significantly improved portfolio risk-adjusted returns.
These results should be considered broadly illustrative — not specific investment recommendations. As noted previously, data limitations — relatively short time series, self-reporting, and a “smoothing” effect from periodic appraisals — are likely to understate actual volatility of private real assets returns. Traditional mean-variance optimization has well-known drawbacks that are not tied to a specific asset class, including the assumption that returns are normally distributed and reliance on historical returns that cannot predict future results. While these limitations are important to acknowledge, they do not undermine the potential for real assets benefits to persist in the future. First, long-term capital appreciation depends on inexorable global trends — population growth and urbanization — that drive steadily rising demand and diminishing supplies of food, wood products and high-quality commercial real estate. Second, real assets’ low correlations and capacity to diversify risk are primarily a function of their being private, relatively illiquid, and not subject to public markets and speculative trading.
Challenges of investing in private real assets
- Lack of transparency. Sophisticated due diligence capabilities are essential to analyze the potential profitability and cash-flow profile of assets in diverse regions around the globe.
- Capital requirements. Deep financial reserves are necessary to achieve scale economies, provide geographic diversification, and invest in technology and infrastructure.
- Operational risks. Investing in farmland and timberland involves a range of operational risks that include weather, pest damage, marketing perishable crops and complying with local regulations. Expertise in local markets and access to a network of local operators can allow investors to transfer operational risk and gain steady income through leasing contracts. Commercial real estate requires investment scale for diversification and large staffs to acquire and oversee holdings.
Addressing these challengesInstitutional investors seeking the potential benefits of this alternative asset class should identify asset managers with specialized expertise, strategic partners, global scale and a track record of investment success.
Case study: Putting real assets to work supporting insurance products
Insight from TIAA General Account
Improving the risk/return profile of a conservative fixed-income portfolioCalifornia vineyards, U.S. Pacific Northwest timberland and New York City commercial real estate might not come to mind as potential holdings of a conservative insurance portfolio. But private real asset investments like these represent a small but growing portion of the TIAA General Account, supplementing investments largely in high-quality bonds.
Why would relatively illiquid alternative investments make sense for a statutory portfolio with about two-thirds of its assets in low-risk, fixed-income investments supporting contractually guaranteed payments? The answer lies in the powerful diversification and inflation hedging potential of private real assets that can help to reduce overall portfolio risk. Direct investments in real assets represent $17.9 billion, or about 7%, of the $271 billion General Account (Figure 8).
Real assets provide three potential benefits to the General Account: current income, long-term capital appreciation, and low correlations with traditional investments.
- Income generation: While most traditional fixed-income investments recently have offered low yields, real assets have generated relatively attractive and stable levels of current income. Expected annual income returns range from about 3% to 6%, depending on asset category. Mainly, this income comes from leases — acreage leased to farmers, commercial real estate rented to tenants, timber sales and infrastructure leased to municipalities or agencies.
- Capital appreciation: Expectations of the increasing value of land and natural resources over time act as a hedge against inflation — protecting the General Account’s future purchasing power. Projected annual total returns range from 7% to 10%, depending on asset category.
- Low correlations: Real assets tend not to move in lockstep with traditional investments. Their correlations to stocks and bonds are low and sometimes negative, providing diversification that is especially desirable when correlations between traditional assets converge during periods of market volatility.
Advantages of private real assets over publicly traded commodity stocks
- In seeking to diversify the General Account, TIAA chose direct investments in real assets over publicly traded commodity stocks for important reasons. Real assets tend to be much less volatile because they are not subject to market speculation, such as options trading. At times when the commodity price cycle is unfavorable, we have flexibility to leave real assets in the ground to await better prices. Unlike bonds that mature or may be called, we can hold real assets indefinitely, selling appreciated property as needed to help meet the General Account’s long-term liabilities.
Managing risks inherent in real assetsTIAA has developed solutions to address illiquidity and other risks inherent in holding real assets. The General Account holds appropriate amounts of liquid assets and other liquidity sources. Real assets investments can be structured in ways that reduce exposure to operational risks, such as growing, harvesting and selling crops or timber. In many cases, Nuveen can avoid these risks by leasing farmland or creating wood supply agreements with local mills.
Diversification across global regions and asset types helps to address other risks. Agricultural investments, for example, are spread across four continents — Australia, North and South America, and Europe — reducing exposure to drought, pest damage, commodity pricing and other market-specific risks. In real estate, the size and scope of the U.S. market provide ample geographical diversification across regions and metropolitan areas, along with property-type diversification. Nuveen Real Estate has offices across the globe providing opportunities to diversify in the U.S., Europe and Asia. Across its range of real asset management capabilities, Nuveen has embedded responsible investment practices, adding a further layer of risk management for environmental, social and governance concerns. With real assets investment experience dating to 1934 in real estate, 1998 in timber, and 2007 in agriculture, Nuveen has a first-mover advantage in establishing scale and developing expertise ahead of most other asset managers.
Real asset exposure in the TIAA General Account already provides important contributions to risk-adjusted returns. In continuing efforts to diversify the portfolio and hedge inflation, TIAA expects to maintain healthy allocations to farmland, infrastructure, real estate and timberland. Investments in real assets offer the potential to combine steady current income and long-term capital appreciation, making them a good fit with the General Account’s current and long-term liabilities.
About the authors
The statements contained herein are based upon the opinions of Nuveen and its affiliates, and the data available at the time of publication of this report, and there is no assurance that any predicted results will actually occur. Information and opinions discussed in this commentary may be superseded and we do not undertake to update such information. This material is provided for informational or educational purposes only and does not constitute a solicitation in any jurisdiction. Moreover, it neither constitutes an offer to enter into an investment agreement with the recipient of this document nor an invitation to respond to it by making an offer to enter into an investment agreement. This material may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections, forecasts, estimates of yields or returns, and proposed or expected portfolio composition. Moreover, certain historical performance information of other investment vehicles or composite accounts managed by Nuveen has been included in this material and such performance information is presented by way of example only. No representation is made that the performance presented will be achieved by any Nuveen funds, or that every assumption made in achieving, calculating or presenting either the forward-looking information or the historical performance information herein has been considered or stated in preparing this material. Any changes to assumptions that may have been made in preparing this material could have a material impact on the investment returns that are presented herein by way of example. This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The information and opinions contained in this material are derived from proprietary and non-proprietary sources deemed by Nuveen to be reliable, and not necessarily all-inclusive and are not guaranteed as to accuracy. There is no guarantee that any forecasts made will come to pass. Company name is only for explanatory purposes and does not constitute as investment advice and is subject to change. Any investments named within this material may not necessarily be held in any funds/accounts managed by Nuveen. Reliance upon information in this material is at the sole discretion of the reader. They do not necessarily reflect the views of any company in the Nuveen Group or any part thereof and no assurances are made as to their accuracy. Past performance is not a guide to future performance. Investment involves risk, including loss of principal. The value of investments and the income from them can fall as well as rise and is not guaranteed. Changes in the rates of exchange between currencies may cause the value of investments to fluctuate.
Risks and other important considerations
This material is presented for informational purposes only and may change in response to changing economic and market conditions. This material is not intended to be a recommendation or investment advice, does not constitute a solicitation to buy or sell securities, and is not provided in a fiduciary capacity. The information provided does not take into account the specific objectives or circumstances of any particular investor, or suggest any specific course of action. Financial professionals should independently evaluate the risks associated with products or services and exercise independent judgment with respect to their clients. Certain products and services may not be available to all entities or persons. Past performance is not indicative of future results.
Economic and market forecasts are subject to uncertainty and may change based on varying market conditions, political and economic developments. As an asset class, real assets are less developed, more illiquid, and less transparent compared to traditional asset classes. Investments will be subject to risks generally associated with the ownership of real estate-related assets and foreign investing, including changes in economic conditions, currency values, environmental risks, the cost of and ability to obtain insurance, and risks related to leasing of properties.
Real Asset investments may be subject to environmental and political risks and currency volatility.
The TIAA General Account is an insurance company account and does not present an investment return, and is not available to investors.
Nuveen provides investment advisory solutions through its investment affiliates.
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