With target-date funds losing their appeal amid recent declines in both stocks and bonds, many fiduciaries are considering diversification options for their retirement plans. A blend of real assets may offer an attractive way to fill that need.
KEY TAKEAWAYS
- An essential allocation for a new market regime
With growth slowing and high inflation likely to persist, adding real assets to defined contribution (DC) plan investment menus may help participants better realize their financial goals. - A good fit for defined contribution plans
Put together, real assets offer the potential for some level of inflation defense, diversification and enhanced risk-adjusted returns, with lower historical volatility than individual real assets categories. - A blended solution to potentially enhance returns
By combining real assets together in a single multi-strategy, plan participants concentrated in
traditional equities and fixed income get a more balanced portfolio
while benefiting from a simplified investment menu that encourages sensible allocations.
An essential allocation for a new market regime
Investors today face a much more difficult return environment than they’ve experienced in recent decades, one that will likely be marked by sluggish growth and enduring inflation. In this environment, diversifying beyond stocks and bonds is likely to become increasingly important.
Yet defined contribution plan menus have historically been short on portfolio diversifiers, consisting largely of core equity and fixed income strategies (Exhibit 1). That’s especially true of target-date funds, the vehicle of choice for many retirement savers.
Inflationary pressures are expected to persist amid rising wages due to tight labor markets, a more active mindset among fiscal policymakers, and as commodities have transitioned from a decade-long period of secular oversupply and lack of investment in new production capacity to an undersupplied regime. We believe bonds are likely to be more volatile as this happens, making them less effective in counteracting the volatility of stocks.
Stocks face their own challenges. Geopolitical tensions, weak economic growth, rising input costs, and wages rising faster than productivity are all likely to impact earnings and share prices.
The result is that the traditional 60/40 equity/bond allocations that form the foundation of most target-date funds have come under significant scrutiny. The Wall Street Journal recently questioned whether target-date funds are appropriate for most investors, while Barron’s called target-date fund returns “mediocre.”(1)
One key challenge is the lack of diversification in target-date products. The goal of portfolio diversification is to own asset classes that tend to experience their above- and below-average returns in different economic and market environments—when one asset zigs, the expectation is that another will zag.
EXHIBIT 1
The need for diversifiers has perhaps never been greater
At September 30, 2022. Source: Callan Associates and FUSE Research.
Based on asset allocations of over 100 large defined contribution plans representing approximately $350 billion in assets, tracked in the Callan DC Index™. Diversifiers include Alternatives/Other, Real Estate, Real Return/TIPS and Specialty Equity. Stock funds include Emerging Markets Equity, Global Equity, Non-U.S. Equity, U.S. Large Cap and U.S. Small Cap. Bond funds include High Yield, Money Market, Non-U.S./Global Bond, U.S. Bond and Stable Value. See end notes for additional disclosures.
(1) “The Stock Market’s Drop Is Hitting Many 401(k)s Harder This Time,” The Wall Steet Journal, May 23, 2022; “Target-Date Funds Are Popular. But Mediocre Returns and Other Risks Warrant a Closer Look,” Barron’s, June 3, 2022.
Diversifiers historically have represented only a small fraction of DC plan assets
In recent years (2022’s price declines notwithstanding), an increasing number of investors have looked to solve this problem by carving out a portion of their portfolio for real assets. Today, the universe of listed real assets has grown beyond real estate to encompass other asset classes, including multi- strategy real assets portfolios (Exhibit 2).
EXHIBIT 2
Investments in real assets have risen sharply since 2007
At December 31, 2022. Source: eVestment Alliance.
See end notes for additional disclosures.
Institutional managers—including sovereign wealth funds, defined benefit (DB) plans, and endowments and foundations—frequently allocate as much as 20% to diversifiers such as real assets. By contrast, defined contribution plan weightings in real assets investments are well below institutional allocations, averaging around 1%.
A good fit for defined contribution plans
Institutional investors have chosen to allocate to real assets partly because of their diversifying effects. In periods of rising and unexpected inflation, for instance, real assets historically have significantly outperformed stocks and bonds (Exhibit 3). Real assets’ ability to counter inflation offers potential benefits to portfolios in the short term, as prices climb, and in the longer term, should inflation rates continue to surprise to the upside.
EXHIBIT 3
Real assets have historically outperformed in inflationary environments
At December 31, 2022. Source: Barclays, Bloomberg, Dow Jones, FTSE, S&P, Refinitiv Datastream, Cohen & Steers.
Past performance is no guarantee of future results. Inflation measured as the year-over-year change in the Consumer Price Index for all urban consumers, published by the U.S. Bureau of Labor Statistics. Rising inflation measured as a positive year-over-year increase in the 12-month inflation rate. Unexpected inflation measured as a positive difference between the year-over-year realized inflation rate and lagged 1-year-ahead expected inflation, as measured by the University of Michigan survey of 1-year-ahead inflation expectations. The real assets blend is not representative of an actual portfolio and is for illustrative purposes only. The information presented above does not reflect the performance of any fund or other account managed or serviced by Cohen & Steers, and there is no guarantee that investors will experience the type of performance reflected above. See end notes for index associations, definitions and additional disclosures.
Real assets can help to counter the ravages of inflation.
Real assets’ distinct economic sensitivities further differentiate them from traditional risk assets such as stocks and bonds.
The historical benefits of real assets’ differentiated economic drivers can be seen in their “beta,” i.e., their sensitivity to the broad global equity market (Exhibit 4). A beta of less than one indicates that the asset class (over the analyzed timeframe) exhibits less volatility than the broad equity market. The low market beta of real assets suggests significant diversification potential, which may help to reduce portfolio volatility—and, we believe, improve risk- adjusted returns.
EXHIBIT 4
Low market beta suggests significant diversification potential
At June 30, 2022. Source: Barclays, Bloomberg, Dow Jones, FTSE, S&P, Refinitiv Datastream, Cohen & Steers.
Past performance is no guarantee of future results. The information presented above does not reflect the performance of any fund or other account managed or serviced by Cohen & Steers. The real assets blend is not representative of an actual portfolio and is for illustrative purposes only. There is no guarantee that any historical trend illustrated above will be repeated in the future, and there is no way to predict precisely when such a trend will begin. Beta measures an investment’s relative volatility compared to a standard market index. A market index will always be equal to 1.00. An investment with a higher/lower beta, more/less than 1.00, is more/less volatile than the market index. See end notes for index associations, definitions and additional disclosures.
A real assets blend can be an important portfolio diversifying element, on top of the attractive inflation sensitivity.
Historically strong returns with less volatility
Real assets have historically generated strong returns over full market cycles, with all but commodities delivering performance in line with or better than global stocks over the past 30 years (Exhibit 5).
The long-term average for commodities was depressed by a decade-long bear market in commodities from 2008 to 2018, driven by China’s orchestrated downshift in demand, significant technological advances in oil and gas drilling, and a decade of low interest rates and cheap access to capital. These unusual factors led to a prolonged commodity oversupply cycle. Commodities have since experienced substantial improvements in supply/demand fundamentals, including strong global post-Covid reopening demand, tight inventories (exacerbated by the Russia-Ukraine war) and a more supportive macroeconomic backdrop, providing potential catalysts for a sustained multi- year recovery.
There are significant potential benefits of combining an array of real assets within a single portfolio. Individual real assets categories can be quite volatile. But across full economic and market cycles, the desynchronized payoffs of the different categories mean that in a diversified framework, a strategic allocation to real assets may offer utility to investors, historically delivering competitive returns with significantly less volatility than global stocks.
EXHIBIT 5
An illustrative real assets blend has delivered strong returns with less volatility than individual asset classes
At December 31, 2022. Source: Barclays, Bloomberg, Dow Jones, FTSE, S&P, Refinitiv Datastream, Cohen & Steers.
Past performance is no guarantee of future results. Return reflects compound annualized return. Risk reflects annualized standard deviation of monthly returns. Standard deviation, also known as historical volatility, measures the dispersion of a set of data from its mean and is used by investors to gauge the amount of expected volatility. Sharpe ratio is a measure of risk-adjusted return, calculated by subtracting the risk-free rate from a return and dividing that result by the standard deviation. The higher the Sharpe ratio, the higher the risk-adjusted return. The information presented above does not reflect the performance of any fund or other account managed or serviced by Cohen & Steers, and there is no guarantee that investors will experience the type of performance reflected above. See end notes for index associations, definitions and additional disclosures.
A blended solution to potentially enhance returns
Implementing real assets in DC plans
Given their attractive investment attributes, we believe adding real assets to retirement plan investment lineups can be an effective way for fiduciaries to help plan participants diversify their portfolios and improve potential outcomes.
Historical analysis shows that including a blend of real assets in an illustrative portfolio of stocks and bonds offers the potential to reduce volatility and improve risk-adjusted returns (Exhibit 6). We attribute these results to the distinct return drivers of the underlying assets and their individual sensitivities to the business cycle, which provide potential diversification benefits.
The potential diversification benefits of real assets are likely going forward given the increasingly challenging return environment for stocks and bonds.
EXHIBIT 6
Real assets offer the potential for improved risk-adjusted returns without sacrificing growth
At December 31, 2022. Source: Barclays, Bloomberg, Dow Jones, FTSE, S&P, Refinitiv Datastream, Cohen & Steers.
Past performance is no guarantee of future results. The information presented above does not reflect the performance of any fund or other account managed or serviced by Cohen & Steers, and there is no guarantee that investors will experience the type of performance reflected above. Return reflects compound annualized return. Volatility (risk) reflects annualized standard deviation of monthly returns. Sharpe ratio is a measure of risk-adjusted return, calculated by subtracting the risk-free rate from a return and dividing that result by the standard deviation. The higher the Sharpe ratio, the higher the risk-adjusted return. There is no guarantee that any historical trend illustrated above will be repeated in the future, and there is no way to predict precisely when such a trend will begin. Stocks represented by MSCI World Index. Bonds represented by ICE BofA U.S. 7-10 Year Treasury Index. Real assets blend composed of 27.5% global real estate securities, 27.5% commodities, 15% natural resource equities, 15% global listed infrastructure, 10% short-duration fixed income and 5% gold. The real assets blend is not representative of an actual portfolio and is for illustrative purposes only. See end notes for index definitions and additional disclosures.
The active advantage
Cohen & Steers’ multi-strategy approach to real assets provides diversification at the asset level while also seeking to further enhance returns through bottom- up stock selection and a top-down asset allocation process. Each asset class in the portfolio is managed in-house by a dedicated investment team, providing separate opportunities to add value through over- and underweights relative to the respective benchmark. Because each underlying strategy has its own investment process, this spreads the impact of active management across the sleeves of the portfolio.
From the top down, instead of using a simple, equal-weighted blend of real assets, we take a strategic approach to portfolio design, setting a target allocation range for each asset class according to its investment characteristics. We then adjust these allocations dynamically based on our current market view, providing an additional lever for both risk management and the enhancement of return potential.
For the retirement plan participant, we believe this approach is superior to owning individual real assets funds, as it helps to reduce menu clutter while potentially providing stronger and more consistent results.
Conclusion
In our view, a diversified multi-asset-class approach to real assets not only offers distinct advantages from an investment perspective but is also consistent with the objectives of plan sponsors and participants. To summarize:
- A diversified multi-asset-class strategy effectively addresses the three objectives of diversification, long-term return potential and inflation sensitivity.
- For the sponsor seeking to minimize menu clutter, a single real assets option can provide a streamlined solution that encourages sensible asset class diversification.
- For participants, access to real assets may help to increase confidence in their ability to achieve their financial goals at a time of uncertainty for stocks and bonds. In our view, portfolios that are actively managed may provide an important advantage in achieving sufficient growth potential.
We believe a multi-strategy real assets option can provide an efficient way to diversify and align portfolios for the investment challenges that lie ahead.
Appendix: What are real assets?
Real assets are the structures and raw materials that allow for a productive economy—the properties where you live, work and shop; the infrastructure assets that provide power and water or enable transportation and communication; and basic natural resources such as food and heating oil. These tangible assets typically come early in the supply chain and tend to be sensitive to changes in inflation—either driving inflation themselves (as higher energy prices do) or given cash flows and asset values that may have direct or indirect links to inflation.
ABOUT THE AUTHORS
Vince Childers, CFA, Senior Vice President, is Head of Real Assets Multi-Strategy and a portfolio manager for Cohen & Steers’ real assets strategy.
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Index definitions and important disclosures
An investor cannot invest directly in an index and index performance does not reflect the deduction of any fees, expenses or taxes. Index comparisons have limitations as volatility and other characteristics may differ from a particular investment.
Real assets blend: 27.5% real estate, 27.5% commodities, 15% infrastructure, 15% resource equities, 10% short-duration fixed income and 5% gold. Real estate: Datastream Developed Real Estate Index through 2/28/05; FTSE EPRA/NAREIT Developed Index thereafter. The Datastream Developed Real Estate Index encompasses listed real estate companies in developed markets and is compiled by Refinitiv Datastream. The FTSE EPRA Nareit Developed Index is an unmanaged market-weighted total return index consisting of many companies from developed markets that derive more than half of their revenue from property-related activities. Commodities: S&P GSCI Index through 7/31/98; the Bloomberg Commodity Total Return Index thereafter. The S&P GSCI Index is a composite index of commodity sector returns representing an unleveraged, long-only investment in commodity futures that is broadly diversified across the spectrum of commodities. The Bloomberg Commodity Total Return Index, formerly known as the Dow Jones-UBS Commodity Index, is a broadly diversified index that tracks the commodity markets through exchange-traded futures on physical commodities, which are weighted to account for economic significance and market liquidity. Infrastructure: 50/30/20 blend of Datastream World Gas, Water & Multi-Utilities, Datastream World Pipelines and Datastream World Railroads through 7/31/08; Dow Jones Brookfield Global Infrastructure Index thereafter. The Datastream World Index Series encompasses global indexes of companies in their respective sectors (World Gas, Water & Multi-Utilities; Materials; Oil & Gas; and Pipelines) and is compiled by Refinitiv Datastream. The Dow Jones Brookfield Global Infrastructure Index is a float-adjusted, market-capitalization-weighted index that measures the performance of globally domiciled companies that derive more than 70% of their cash flows from infrastructure lines of business. Resource equities: 50/50 Blend of Datastream World Oil & Gas and Datastream World Basic Materials through 5/31/08; S&P Global Natural Resources Index thereafter. The Datastream World Index Series encompasses global indexes of companies in their respective sectors (Datastream World Oil & Gas and Datastream World Basic Materials) and is compiled by Refinitiv Datastream. The S&P Global Natural Resources Index includes 90 of the largest publicly traded companies in natural resources and commodities businesses that meet specific investability requirements, offering investors a diversified, liquid and investable equity exposure across three primary commodity-related sectors: Agribusiness, Energy and Metals & Mining. Short-duration fixed income: The ICE BofA 1–3 Year U.S. Corporate Index tracks the performance of USD-denominated investment-grade corporate debt publicly issued in the U.S. domestic market with a remaining term to maturity of less than 3 years. Gold: Gold spot price in USD per Troy ounce. Global stocks: MSCI World Index, a market-capitalization- weighted index consisting of a wide selection of stocks traded in 24 developed markets. U.S. Treasury bonds: The ICE BofA U.S. Treasury 7-10 Year Bond Index measures the performance of public obligations of the U.S. Treasury that have a remaining maturity of greater than 7 years and less than or equal to 10 years.
Data quoted represents past performance, which is no guarantee of future results. There is no guarantee that any historical trend illustrated/referenced above will be repeated in the future, and there is no way to predict precisely when such a trend might begin. There is no guarantee that any market forecast set forth in this commentary will be realized. The views and opinions in the preceding commentary are as of the date of publication and are subject to change. Diversification is not guaranteed to ensure a profit or protect against loss. There is no guarantee that actively managed investments will outperform the broader market.
This material represents an assessment of the market environment at a specific point in time and should not be relied upon as investment advice, does not constitute a recommendation to buy or sell a security or other investment, and is not intended to predict or depict performance of any investment. This material is not being provided in a fiduciary capacity and is not intended to recommend any investment policy or investment strategy or take into account the specific objectives or circumstances of any investor. We consider the information in this presentation to be accurate, but we do not represent that it is complete or should be relied upon as the sole source of appropriateness for investment. Please consult with your investment, tax or legal professional regarding your individual circumstances prior to investing. The views and opinions expressed are not necessarily those of any broker/dealer or its affiliates. Nothing discussed or suggested should be construed as permission to supersede or circumvent any broker/dealer policies, procedures, rules or guidelines.
Real assets risks: A real assets strategy is subject to the risk that its asset allocations may not achieve the desired risk/return characteristic, may underperform other similar investment strategies, or may cause an investor to lose money. The risks of investing in REITs are similar to those associated with direct investments in real estate securities. Property values may fall due to increasing vacancies, declining rents resulting from economic, legal, tax, political or technological developments, lack of liquidity, limited diversification and sensitivity to certain economic factors such as interest rate changes and market recessions. The market value of securities of natural resource companies may be affected by numerous factors, including events occurring in nature, inflationary pressures and international politics. Global infrastructure securities may be subject to regulation by various governmental authorities, such as rates charged to customers, operational or other mishaps, tariffs and changes in tax laws, regulatory policies and accounting standards. Foreign securities involve special risks, including currency fluctuation and lower liquidity. An investment in commodity-linked derivative instruments may be subject to greater volatility than investments in traditional securities, particularly if the instruments involve leverage. The value of commodity-linked derivative instruments may be affected by changes in overall market movements, commodity index volatility, changes in interest rates, or factors affecting a particular industry or commodity, such as drought, floods, weather, livestock disease, embargoes, tariffs and international economic, political and regulatory developments. The use of derivatives presents risks different from, and possibly greater than, the risks associated with investing directly in traditional securities. Among the risks presented are market risk, credit risk, counterparty risk, leverage risk and liquidity risk. The use of derivatives can lead to losses because of adverse movements in the price or value of the underlying asset, index or rate, which may be magnified by certain features of the derivatives. No representation or warranty is made as to the efficacy of any particular strategy or fund or the actual returns that may be achieved. Futures trading is volatile and highly leveraged and may be illiquid. Investments in commodity futures contracts and options on commodity futures contracts have a high degree of price variability and are subject to rapid and substantial price changes. Such investments could incur significant losses. There can be no assurance that the options strategy will be successful. The use of options on commodity futures contracts is to enhance risk-adjusted total returns. However, the use of options may not provide any, or may provide only partial, protection from market declines. The return performance of the commodity futures contracts may not parallel the performance of the commodities or indexes that serve as the basis for the options they buy or sell; this basis risk may reduce overall returns.
Cohen & Steers Capital Management, Inc. (Cohen & Steers) is a U.S. registered investment advisory firm that provides investment management services to corporate retirement, public and union retirement plans, endowments, foundations and mutual funds. Cohen & Steers U.S. registered open-end funds are distributed by Cohen & Steers Securities, LLC and are only available to U.S. residents.