Seeking Alpha
Value, long only, growth, alternative energy
Profile| Send Message|
( followers)  

JP Morgan recently published a report titled "The Realization" detailing the case for a 'tectonic shift' of money into real assets. Although destined for professional and institutional investors the findings are still relevant to retail investors and should give investors some tools for portfolio strategy.

The report's main thesis is that the continuation of the current investment environment characterized by low bond yields, high equity market volatility and the risk of future inflation will force a dramatic change in asset allocation. In this environment JP Morgan believes global real assets (real estate, infrastructure, and natural resources) can provide higher yields than bonds with less inflation risk and superior risk adjusted returns compared to equities. The idea is that bonds yield poorly and carry significant risk if interest rates rise, and although equities have performed well recently there has been increased volatility in the last decade and this is likely to continue as the world's economic growth remains stunted and high debt to GDP ratios remain a source of risk.

JP Morgan believes that in the next decade real assets will move from an alternative to a mainstream asset class moving from 5%-10% in portfolio allocations today to as much as 25% in the next decade; and those investors that do reallocate will have better risk weighted returns than those that don't. I favor having a larger portion of my portfolio allocated to equities than JP Morgan recommends, however the case for real assets remains compelling and investors should consider allocating a portion of their investment portfolio (5-10%) if they haven't already.

Why Real Assets

Incorporating real assets into a portfolio can have a variety of advantages depending on the type of real asset, including: improved diversification, lower volatility, higher returns and inflation protection. Many investments categorized as real assets generate yields that are competitive with fixed income alternatives and also exhibit long-term stability. In the case of infrastructure investments yields tend to be stable as they are derived from underlying long-term contractual agreements on high quality assets. An example would be the income from a toll road in the case of an infrastructure investment.

Another advantage exists if the investment represents an equity stake in the real asset there is often the ability for asset appreciation which helps mitigate the inflation risk present in debt only investment products.

Furthermore, as evidenced by the chart above, real assets not only have a low correlation with equities and bonds, but they also have a low correlation with each other. This makes them ideal for diversification and reducing portfolio volatility.

Something to remain cognizant of when evaluating real assets is that they aren't a homogeneous group, real estate differs dramatically from solar which differs dramatically from timberland making generalizations problematic. Each individual investment must be analyzed carefully to fully understand the investment and the risks involved.

How to invest in Real Assets

Unfortunately many real assets, especially in the realm of infrastructure, are not available to the retail investor, however there are still ways to diversify. My area of expertise does not allow me to recommend specific REITs, MLPs and infrastructure funds, however I can expand on solar's potential as a real asset.

 

Mosaic Notes Fixed

Alerian MLP Infras Index

Vanguard REIT Index

Bilfinger & Berger Global Infras Fund

Mid-American Solar Bonds

Investment Type

Debt

Equity

Equity

Equity

Debt

Tenor

10-12 years

N/A

N/A

N/A

22 years

Yield

4.50%-5.75%

5.4%

3.60%

4.62%

5.75%

Liquid?

No

Yes

Yes

Yes

No

Diversified 10+

No

Yes

Yes

Yes

No

Real Asset?

Yes

Yes

Yes

Yes

Yes

Interest Rate Risk

High

Medium

Medium

Low

High

Solar

Solar project equity and debt can be compared with other investments in infrastructure and infrastructure debt. Similar to infrastructure projects, solar projects are real assets that are set up using special purpose vehicles with legal arrangements dictating output, payments allowing for predictable, long term returns.

Buffett has made the foray into solar and MidAmerican Energy Holdings has purchased a 550-MW plant will have the capacity to generate enough renewable energy to power about 160,000 average California homes. The Topaz project will be built, operated and maintained by First Solar (NASDAQ:FSLR). To finance construction MidAmerican (NYSE:BRK.B) issued $850 million in bonds yielding 5.75% percent. These bonds are one of the first large issuances of debt interest in solar infrastructure and is probably on the forefront of a trend in solar financing.

Investment in Buffet's projects are not currently possible for the retail investor however solar notes offered by Mosaic offer a similar product on a smaller scale. Not exactly a direct investment in real assets, solar notes represent claims on future cash flows from solar projects in exchange for a debt investment in the solar project. Solar notes that are pay fixed rates unfortunately carry significant risk if interest rates rise. However on the positive side the cash flows are based on the performance of a real asset and the risk profile is different from that of bonds and returns are competitive.

Conclusion

The current economic environment of low interest rates and volatile equities allows real assets to perform well on a risk adjusted basis. Investments in real asset equity have the ability to appreciate as rates rise, and current yields on real assets can be competitive with bonds. Real assets are also exposed to a different set of risks which make them ideal for portfolio diversification. A 10% portfolio allocation to a diversified basket of real assets can be good for reducing portfolio volatility and boosting risk adjusted returns.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: I currently work with Mosaic.

Additional disclosure: I own Mosaic notes and WRE, Washington Real Estate Investment Trust. Regarding Mosaic Note yield, past performance is not a guarantee of future performance. Any opinions expressed herein by persons not affiliated with Mosaic reflect the judgment of the author and not necessarily that of Mosaic. Nothing herein shall constitute or be construed as an offering of securities, or as investment advice or recommendations by Mosaic. Mosaic's investments are limited to investors who meet applicable suitability standards based on income, net assets and state of residence.

Source: JPMorgan's 'The Realization' And Why Real Assets Belong In Your Portfolio