By Michael Natale, Head of Intermediary Distribution at FlexShares.

Michael Natale, Head of Intermediary Distribution at FlexShares.

We believe that real assets – defined as real estate, infrastructure, and natural resources – should be an essential element of any diversified portfolio.

In an unclear global market environment, investors are looking for what real assets can offer: the potential for income, diversification and capital preservation. At the same time, investors continue to benefit from innovation within a variety of investment vehicles that focus on real assets, as well as access to an unprecedented supply of opportunities for investment.

Portfolio diversification

Real asset returns have historically had low correlations to traditional equity and fixed income investments, which our findings suggest can provide an effective way to enhance the diversification of a traditional stock and bond portfolio.

Individual real asset categories have also shown low correlations with each other — consequently, investors may be able to diversify further by investing in more than one real asset class. As highlighted in the chart below, the correlations of real estate with infrastructure and natural resources are 0.85 and 0.69, respectively. The return streams of two assets having a correlation of 1.00 would be perfectly correlated.

Source: FlexShares.

Capital appreciation potential

Northern Trust research has shown that both income return and capital appreciation represent a meaningful amount of the historical total returns generated by real assets. Historically, many of these hard assets tend to increase in value over time, as replacement costs may rise and operational efficiencies can be achieved.

For many investors, this scenario may be visualized within their own daily experience as they see leasing of vacant space, a steady climb of toll road fees, rising usage of energy or climbing wood prices. We believe that income from real asset-related investments may help protect value on the downside, while operational efficiencies may enhance value on the upside.

Source: FlexShares.

Potentially higher risk-adjusted returns

The addition of real assets may also enhance the risk-adjusted returns of a mixed-asset portfolio.

The chart below shows the various historical Sharpe Ratios of the three real asset categories in comparison to equities and bonds. The Sharpe Ratio is a measure of return per unit of risk, which indicates whether an investment’s return sufficiently rewarded investors for the level of risk assumed (the higher the Sharpe Ratio, the greater the level of risk-adjusted performance).

For example, the 10-year Sharpe Ratio for infrastructure as defined in the chart below is 0.716, which means that an investor should have a greater risk-adjusted return in comparison to an investment in a Treasury bond which has a Sharpe Ratio of zero.

Real assets performance also generally lacks drastic movements in either direction. This potential performance stability may provide investors with portfolio benefits in a variety of market environments.

Source: FlexShares.

Implementing the real assets portion of a portfolio

A number of considerations should be taken into account when building a portfolio of real assets. One approach for the initial structure is to define the investor’s objectives in terms of yield versus growth-oriented strategy and sensitivity to the impact of inflation.

For the yield investor, a real assets strategy may be used to emphasize more income-oriented but inflation sensitive investments that generate potential steady cash flows.

Source: FlexShares.

For the growth investor, a real assets strategy may be a broader exposure to natural resources to help meet the growth objective.

Source: FlexShares.

Building a real asset portfolio is a process that requires multiple considerations in terms of planning, implementation, and monitoring. Real assets can play a fundamental role in a portfolio, given the potential diversification that real assets have historically provided, the opportunity for capital gains, and potentially higher risk-adjusted returns.

(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)