Bonds have been the worst-performing asset among habitual investment classes, after commodities and hedge funds, over five-, 10- and 20-year horizons, according to PWC data. For public pension funds, which have an average allocation to fixed income of almost 40% of the total portfolio, this has created significant pressure on their returns, forcing investors to seek alternatives.
Sovereign funds, which are dependent on oil revenues for a large part of their total assets, have struggled to preserve their value in the face of the dramatic decline in oil prices since 2014. Sovereign funds’ average 25% allocation to bonds, while lower than pension funds’, is still large enough to present further headaches for these investors.
This combination of forces, exacerbated by a decade of quantitative easing, low interest rates, slow productivity growth and aging populations in advanced economies, has led to heated debate over which asset classes and strategies public investors should pursue.
Recent reforms allowing great flexibility in asset allocation for European public sector investors have helped intensify the shift into alternative assets, particularly real estate and infrastructure.
From July, the Swedish pension buffer funds, which hold combined assets of more than $200bn, will be allowed to invest up to 40% in ‘illiquid’ assets, up from the current 5% cap on unlisted assets. The minimum allocation to top-rated fixed income products has also been reduced to 20%, from 30% of the total portfolio.
In April the Norwegian finance ministry signalled its intention to allow Norges Bank Investment Management, which has more than $1tn in assets under management, to invest in unlisted renewable infrastructure, following years of lobbying by the fund.
These developments are part of a broader trend. The value of real estate and infrastructure within sovereign fund and public pension fund portfolios has risen by 120% and 165%, respectively, since 2009. According to an OMFIF survey of public investors with around $4.6tn in AUM, more than 70% have increased or significantly increased (by up to 6%) their allocation to these assets in the last three years.
The role of real assets within the total portfolio has shifted. These are no longer viewed solely or primarily as part of a core or core-plus strategy. Value-add and opportunistic strategies are gaining in importance, affecting the types of assets investors are pursuing and the way they access them.
Some investors are targeting a higher share of private real assets, driven by factors including diversification, higher yields and lower volatility than listed public assets. This allows investors to access a wider range of projects and to specialise in non-prime real estate and other niche investments.
Sovereign and pension funds are pursuing larger and more complex investments and collaborating with limited partners to reach deals of sufficient scale. Interest in private equity is waning as the large build-up of ‘dry power’ – estimated at around $300bn in the real estate sector alone – adds to the costs.
Direct debt and equity are instead becoming more widespread as investors seek exposure to specific, carefully selected projects. They are trying to overcome the high costs of more traditional prime assets in core locations, which have been driven by strong competition from other investors.
Many institutions are bringing more of their asset management in-house. This is forcing external managers to update their value proposition by offering new fund structures, greater transparency and flexibility, and lower costs, to remain competitive. The potential rewards are substantial.
Over the next three years, sovereign and public pension funds plan to increase their investments by $334bn in infrastructure and $130bn in real estate, according to the OMFIF survey. However, matching the supply of readily available sums of cash with investment needs – estimated at more than $90tn over the next 20 years for infrastructure alone – remains the biggest stumbling block.
In view of the long-term nature of real asset investment, political, legal and regulatory certainty is vital. Improved information, benchmarking and hedging products are also needed. The hope among investors facing low returns elsewhere is that the scale of their demand for real assets spurs on these reforms, expanding the range of investable assets.
Ben Robinson is Senior Economist at OMFIF. The OMFIF report on real assets, in association with BNY Mellon will be available in June.