Episode 93: Investing in real assets —Market Insights Monthly Special Edition

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Kevin Headland:

Copyright Manulife. Commentary is for general information purposes only and shouldn't be relied on for specific financial, legal, or other advice.

Yesterday's solar eclipse required protection from the potential harm it could inflict. Thankfully, we had lots of advanced warning to prepare. Unfortunately, investors are not often afforded that amount of advanced warning when it comes to volatility in the portfolios. 2022 Isn't that long ago, but many investors have already forgotten about it given how equity markets have fared since the beginning of 2023. A quick refresh, we were facing the highest inflation in around 40 years, a Federal Reserve that was starting to raise rates with a commitment to tame it, and the worst performance for the traditional 64 portfolio in history as both equity and fixed-income returns were negative. Alternative investments were some of the only bright spots, yet many investors didn't have access to them. Today, many equity indices are back to record high levels and fixed EME yields are the highest since the great financial crisis 15 years ago. Given that positive backdrop, there's a belief perhaps there's no longer need for uncorrelated asset classes in a portfolio.

On this episode of Investors Unplugged, I'm joined by Alex Catterick, head of Alternative Investment Solutions at Manual Investment Management and Eric Menzer, lead portfolio manager for the Manulife Real Asset Investment Fund. We'll be discussing the increasing demand for alternative investment solutions and specifically real assets, and how our solution is bringing access to a diversified suite of real assets to a larger audience. We think it's time to get real about real assets. Listen on, this is Investments Unplugged.

Gentlemen, welcome.

Alex Catterick:

Hey.

Eric Menzer:

Hello.

Kevin Headland:

So Alex, I think we're going to start off with you and talk a bit more about the broad asset class. And we know that large pension plans have been investing in real asset for quite some time, as big growth in private placements and private investments. How are institutions taking advantage of that and where do you see the growth pattern in those products?

Alex Catterick:

Yeah, thanks, Kevin. Institutions have historically had higher allocations to private market investments and the reason for that is they tend to be patient and long-term capital, they have the benefit of not necessarily having same liquidity constraints or requirements that an individual investor might have. So for a long time, if you look at Manulife and the way that we've been deploying capital for the past decades, if you will, we've had a high allocation to private markets, private equity, private credit, and in particular real assets. And the real assets that we have been able to acquire and own tend to be in the real estate space and the infrastructure space and timber and farm. Additionally, we're able to do that on a direct basis. And by being able to own these assets on a direct basis, you're able to map out what you think your long-term liabilities and liquidity requirements might be.

Additionally, there's been a change, I think, over the past 10, 15, 20 years where a greater portion of the economy has been taking place in private market securities. So on the private equity side, companies are staying private longer, they're waiting longer before they go public. In the private credit realm, we've seen banks move away from lending on a direct basis to a lot of these private companies and private capital has stepped in. And additionally, in the real asset space, if you really want to get the actual exposure to these individual real asset investments, whether it's a data center in the real estate or infrastructure space, cell phone towers, wind farms, timber lots, farms, a lot of these exposures are only available through private market allocations. And again, institutions have historically been able to access this, but what we've seen is the gravitation towards democratized solutions. So giving individual investors ways to be able to access these types of investments that traditionally were only available to institutions.

Kevin Headland:

What are some of the common objectives you're hearing from perhaps the retail space in terms of adding alternative assets and maybe real assets to the portfolio? Specifically more drilling down into the real assets. What are the individual type of sleeves we're looking at within those real assets?

Alex Catterick:

I tend to think that in the private market space, and investing in general, there's a couple of things you're trying to do. You're trying to maximize your returns and allocation to private markets typically does allow you to boost your returns. Additionally, you're looking to generate income, provide diversification, or maybe some downside protection. And it's really these latter areas that we think that the real assets realm really kind of shines when you think of providing diversification benefits that you have by allocating to these types of solutions. So if you look through that, we can talk about real estate, but I think a lot of people when they first think about real estate, they might think of their home, or maybe a multifamily property, or maybe corporate, or office real estate, but real estate actually is a broader asset class than that.

I mentioned a moment ago infrastructure and data centers. That's a new class of real estate that really has blown up over the past few years as we've seen the increase in cloud computing, the shift to the need for AI. So investing directly in real estate, in say a data center, is a great way to get that exposure. Additionally, if you look at other infrastructure projects, people typically think of bridges and tunnels and airports and transmission lines and all of those are inclusive of infrastructure, but additionally you do see other things like cell phone towers, like wind farms and turbines. These are new areas of infrastructure that both institutional and individual investors are looking to get access to.

And then finally, Manulife is the largest owner of Timberland globally, the second largest owner of farmland, and there's a lot of trends that really support the need to have timber and farm in portfolios. If you think of timber, there's a housing shortage, we see it in the United States where I'm based. You also see pockets of it in Canada and other parts of the world and timber is a large input in building homes. And then additionally on the farm side, I think we're all kind of mindful of healthy diets and access to high quality farm goods. And again, being able to directly own those individual underlying investments is important to, again, provide that diversification and downside protection when we're thinking about investor portfolios.

Kevin Headland:

The public market and retail investors tend to be much more short-term focused. They look to add niche products as a tactical allocation, a short-term investment. How do you respond to that and what is the typical holding period for real assets in a portfolio?

Alex Catterick:

So I would argue one of the benefits that institutions have had is they do have that long-term perspective. Again, if I look at Manulife where we're an insurance company and we're doing asset liability matching, we know we have long-dated liabilities, and therefore we're going to invest in asset classes that have a long tenor and a long lifespan. So when I look at a real assets allocation and when we're talking to individual investors and helping them understand why they might want to add that to their portfolio, you really need to have a very long-term perspective. By taking that steady approach where you're getting annual appreciation and income from these underlying investments without a need for liquidity from that part of your portfolio, it really allows you to be slow and steady, lower the volatility to be able to achieve those types of returns, but you really do need to have that long-term time horizon.

If you think of a piece of real estate, people are in their homes for 5, 10, 15, 20 years. It's the same thing when you're getting exposure to any real estate. If you think of timber and farmland, we own these timber and farm assets for their natural lives. Right? This could be 15, 20, 25, 30 years. So having a long-term mindset, really quite important when allocated to the asset class. And again, we would look to the way that institutions have managed these portfolios and suggest that individual investors, to the extent that they're able to, should look to try and mimic that type of time horizon.

Kevin Headland:

Thanks Alex. Eric, one of the asset classes that really sticks out on this chart to me, and many investors of course, is real estate, especially in Canada. Alex mentioned a lot of Canadians think that real estate is all about their home and where they live, and perhaps they have an investment property. There's been a lot of talk about corporate real estate and some of the challenges being faced by corporate real estates. And even in Canada, we have price bubbles perhaps in Canadian residential real estate. How do you respond to the pushback on investing in real estate right now?

Eric Menzer:

That is getting a lot of, I think in some cases, unfair negative headlines. Real estate encompasses a broad spectrum of different areas to invest in. You talk about the single family housing market, but it also includes office as well as industrial logistics assets, data centers. There's a lot of other facets, residential student housing, life sciences, a lot of areas that are actually growth areas and presenting opportunities for us right now. A lot of the sensitivities out there in the market right now are geared towards what they're seeing in terms of office.

We've all been having the post-covid return to office conversations quite often. What is that going to mean for the future? And there are certainly some challenged investments out there with regards to office as it relates to debt financing and the fact that there are a handful of investors that are coming up against debt maturities at higher rates. And you're definitely going to continue to see, without question, continued pain in the office sector in certain areas. But I think it's important to focus on the specific products in the specific geographies in the specific sectors, because there are still now and are becoming, as a result of valuation declines, more opportunities in the space.

Kevin Headland:

Given the changes in valuation, given perhaps the negative headwinds facing that asset class, broadly speaking, are you able to take advantage of that and find opportunities for your investments?

Eric Menzer:

Yeah, we're starting to see that. Geography plays a huge role here as does sector. Our portfolio within the Manulife Real Asset Investment Fund has allocations to Canada, US, as well as Europe. Each market has reacted on their own timetables with regards to the impacts of rising rates and what we're seeing on valuations. Europe has definitely felt a lot more pain quicker, and as a result what we're seeing now is opportunities in Europe first, whereas Canada hasn't felt as much pain as, say, the US. So it really does depend. It's important to have a manager that understands the local geography and the sectors that they're operating in.

Kevin Headland:

Now, Alex, you mentioned timber and farmland and you can't just go out and buy a forest or buy some primary fields. It takes time and expertise to invest in real assets, especially timber and farmland. I've been at Manulife for over 20 years now and had heard about all the investments that we have, especially on the private market side. Can you talk a bit about our expertise? You mentioned we're the largest timber manager in the world, I think the third in agriculture. Perhaps you can expand on that and talk about the expertise that Manulife has in this asset class space.

Alex Catterick:

So the timber and farm assets that we own, we manage them directly ourselves. So we have folks that are on the ground, that are walking these timber lots, that are working directly on these farms. So it's a fully vertically integrated operation, and that's a really important aspect for the way that we think about not just investing, but also being good stewards of the assets. It also gives us the ability to scale and improve efficiencies from an operational perspective, in terms of having folks on the ground. And then also, you just think of managing third party relationships and the supply chain and the operating characteristics of running these businesses and being able to acquire things at scale, have to go to market to sell these goods at scale. So being an integrated manager as well as being an investor, I think, has been a really important example.

You mentioned you can't just go out and buy a timber lot. As the largest manager of timber, one of the benefits is we get to see just about every transaction that takes place in a given year, and be able to consider whether or not that's something that we want to be able to add to our portfolio or not. So there's a huge benefit that comes from being one of the incumbents in the space, and again, we believe that that expertise that we have, that access that we have, it goes beyond just the investing and right down into really understanding how to operate and price and sustainably run these assets.

Kevin Headland:

That's a very good point you mention, especially as perhaps there's opportunity as companies start to invest themselves, with property or timber being one of the biggest or the biggest players in this space, you're getting the phone call and that provides you opportunities to take advantage of some of the new investments that come on the market, shall we say.

Now, Eric, we talked a lot about the asset class. Let's dive into the fund a little bit here. The Manulife Real Asset Investment Fund. I think one of the unique aspects of this fund is it's not just investing in one real asset or one skew of real assets or private markets, but it's diversified play on the opportunity set. Can you talk about a few of the benefits for investors when they're investing in a diversified suite of real assets like the Manulife Real Asset Investment Fund?

Eric Menzer:

Yeah, I think Alex made a good point in some of his comments earlier on with regards to the fact that these assets are historically institutional and there's a democratization of real assets happening in the marketplace right now. And I think that's exactly what we're trying to solve for here with MRAIF, the Manulife Real Asset Investment Fund, is to be able to take that institutional risk return profile that the large institutions have been so accustomed to for many years and making that accessible to the mass affluent, high net worth market. And that includes not only creating the investment skill set, but also structuring the portfolio of the product in such a way that it is more friendly for the retail client.

And a lot of that is driven by the need to have some amount of liquidity in there, but structuring it the way we have, not only bringing to bear all the different private real assets that we've talked about here so far across real estate, timber, farmland, and infrastructure, but also putting a liquidity component in that, so that should investors need to have access to their fund, under normal market conditions, they can get access to it. There's a lot of practical benefits and structuring that's required in products like these. And something that's not talked about quite often is around the legal and the tax and the compliance and all the non-investment stuff as well, and we needed to really structure this portfolio in a way that advisors were going to find it easy to do business with Manulife for. That includes being able to have a single ticket solution where advisors can put their clients in on a quarterly basis through a single fund serve ticket.

That's really important, because as an institutional investor, I can tell you from experience, it takes a greater deal of patience and a much longer time horizon as we typically will commit to investments over a ten-year period and capital will get called over an investment period of three to four years. We've structured this product in such a way that advisors can get their clients access to it, and the clients will come in and have immediate access. Meaning on day one when they come in and we call that capital on whichever particular quarterly raise we're doing, the investor is getting the entire experience across all the different private real assets immediately. So that takes away what is often referred to as the J-curve, or that investment period where you're not seeing results for quite some time and you're really playing for the longer end. Here, we've striked a balance between the benefits that institutions get over that ten-year period investing in private assets, but also making it attractive and more feasible for retail investors to be able to gain access to it.

Kevin Headland:

So you're saying it's not just easy to create a real asset investment fund. Is that take a lot of work to try and structure it?

Eric Menzer:

No, there's a lot of work, but it's also extremely capital-intensive. Most of the investments that we have under the hood here across our funds are $10 million minimums just for a single fund or a single asset class.

Kevin Headland:

One thing I think is important is also that although it's a diversified suite of real assets, underneath those asset classes, it's not just Manulife investments they're holding. It's not just Manulife property they're holding. Can you talk a bit about the third party institutional investors investments you're investing in?

Eric Menzer:

We've structured this Kevin in a way that is best of breed multi-asset class. I'm part of our multi-asset solutions team, so it's in our DNA to source investments across the markets, both in public and private assets. The way we've structured this here is gives us the ability to not only leverage the value and the skill set and the experience and the long tenured history that Manulife has running private assets, and we certainly want to obviously lean towards all the areas of expertise that we have, not only for scalability and pricing, but what we believe will ultimately lead to a better outcome for our clients. But there tends to be, in some instances, there could be gaps in a particular asset class. Or, for us to be able to deliver the product so that we can continuously have capital being called, we want to make sure we have a large opportunity set to be able to get money to work in an efficient manner.

And that's really, really important. We don't want clients sitting on the sidelines while having us trying to get into these private assets where all of a sudden there's an exorbitant amount of public assets or liquidity in the portfolio and it gets diluted. We need to really have a way to make sure that we're not only getting the asset class diversification, the manager diversification and the sector diversification, but also keep capital moving efficiently. We tend to try to have capital moving in and out throughout these private assets within a six-month period, which is typically industry standard. So we want to make sure that we're delivering on the ultimate outcome in terms of the performance and risk objectives, but also meeting expectations with regards to getting money invested.

Kevin Headland:

Thanks Eric. You talked earlier about the liquidity and the need for liquidity for retail investors. The target allocation of the portfolio is 30% public assets. Can you talk about why that sleeve is so important and perhaps how it's managed? Are you looking at active investments versus passive ETFs? How do you go about managing that public asset?

Eric Menzer:

Public assets portion of the portfolio is roughly 30%. We did a lot of modeling work around that to try to come up with the optimal split between public and private. 30% was the optimal in terms of being able to help us provide the necessary liquidity that we potentially need to provide to our clients, but also it gives us enough of a vessel to call money in immediately and then deploy that capital. The liquidity bucket, the public market sleeve really serves two key important aspects. Basically, it gives us the ability to every quarter when we go out for a capital raise, call money from clients so that when that money comes in, it goes right into the public sleeve. Advisors and clients don't have to worry about the time it takes to get money invested into the private assets. That's something that we do behind the scenes and make it so that our investors can just get the experience of the entire 70-30, and then we're responsible for deploying that capital off to the various private investments.

So being able to mitigate the J-curve, get that money in right away, that's a key component of the public market sleeve, but also to be able to provide liquidity. The fund is structured with quarterly liquidity up to 5% of the NAV, and we need to be able to make sure that we have multiple levers to pull. The public market sleeve is one of those key levers. We do invest, within our institutional fund, many open-ended private market strategies which also have various liquidity characteristics but embedded in them as well. Some have a semiannual liquidity, some have quarterly liquidity, some have annual, but we can balance that out with what we have inside the public sleeve.

The public sleeve is split between equity and fixed income. It's roughly a fifty-fifty split between real asset equities, so we have agriculture equities in there, REITs, infrastructure equities, as well as timber equities. And that really gives investors a first step, or for us to be able to mirror the exposures inside the public space with the way we're going to be ultimately deploying that capital into the private space helps us get that immediate real asset exposure. Now on the fixed income side, we tend to be more active. We have a mix of Canadian core fixed income, along with global fixed and tips, so we have some inflation protection securities embedded in there as well.

Kevin Headland:

Great. That's important as well, of course, as real assets tend to be a great hedge against inflation, so tips would definitely help in that scenario.

Now, we often think about this portfolio perhaps as North American based, a lot of the belief system that timber ag is North American based real estate. But this is actually a global portfolio, as we mentioned earlier, Eric. Why is this so important to have a more global picture for this type of product?

Eric Menzer:

What we're seeing right now within real estate as we just talked about a few moments ago, is a key example to why global can be a huge benefit. Each market is going to react differently at different times and it's going to create more opportunities for us ultimately. We're seeing right now as we've had a pretty large drawdown in real estate, in some cases 15 to 20% peak to trough and in terms of valuations. Each market is reacting differently, and now we're seeing opportunities in Europe right out of the gate. I'm confident more opportunities in the real estate space will show up in US and Canada as well and we will be able to rotate across that.

So being able to not only have the flexibility to overweight our underweight various asset classes, for the last year as real estate was drawing down, we've really been deploying more capital into infrastructure where we've seen a tremendous amount of opportunities. So we have that flexibility to tilt the portfolio to more favorable asset classes where we think we're going to get a better risk adjusted return, but also geographically being able to tilt the portfolio and take advantage of those opportunities. So that diversification really helps us as asset allocators really have more flexibility in the portfolio.

Kevin Headland:

European real estate, we talked about the opportunity there. Can you talk a little more about how you see European real estate right now?

Eric Menzer:

Yeah, so Europe is obviously, there's a lot of different areas to talk about. But what we're seeing out there right now is a lot of new funds being created and a lot of capital moving in that direction. And the sheer fact of the matter is that market does tend to be more geared towards office compared to the U.S and Canada. So the multifamily, multi-res market is not as robust as, say, the US and Canada.

So it's a little bit of a different animal where we're seeing the opportunities tend to be more in the student housing and in the logistics assets where we have seen some tremendous breakdowns, and in some cases market values are below replacement costs. So this is posing a tremendous opportunity for a lot of the large players in the space to take their capital and go out there and really, for lack of a better term, kind of act as a white knight in terms of helping those individuals, those organizations that are looking for liquidity or maybe coming up against debt refinancing and it may not be as economical for them to refinance depending on where they're at in the cycle.

Kevin Headland:

Thanks Eric. And Alex, we've talked of course a lot about the diversification benefits of real assets in a portfolio, but it's not just about diversification, it's return enhancements and income. Can you talk about the excitement really around those two aspects for investors?

Alex Catterick:

It's participation in trends and being able to capture the returns in a lot of these longer term trends. Right? Eric made the mention just now around logistics assets. Right? And I made mention earlier of data centers. Right? So you think of that whole realm of infra and real estate, where it's basically an intersection there. But we have seen that there's a huge increase in the need for cloud computing, and we've seen a huge increase in shipping demand for goods. And you look at that class of industrial real estate and digital real estate and digital infrastructure, and the returns that you're getting from that corner of the economy are significant and you can play it through in some cases public market securities, but if you really want to get direct exposure, you really need to traffic in this space. You really need to get direct exposure to a data center or to an industrial warehouse. Right?

And that is where we think there's the opportunity for outsized returns, and ability to boost the returns in a portfolio. Additionally, if you look across just about everything that we're doing across real assets, there is an income component to it and finding ways to boost income is going to be important, particularly if we move into a cycle where interest rates start to come down. I'm not sure what the timing is on fed rate cuts. I'm not sure what the timing or the path of interest rates are, but to the extent that I can add a real assets portfolio that helps me boost the income of my overall asset allocation, I'm going to be really excited about that.

Kevin Headland:

Eric alluded to earlier the capital required to get access to real assets. Can you give us a sense of the capital required to recreate a portfolio similar as this?

Alex Catterick:

It's tremendously difficult to do what Eric and the team have done if you wanted to do it at an individual line item basis. Right? If I take a look through, in terms of the way that we've built out our own asset allocation on the institutional side, on the insurance side, we are able to go out and invest directly in an infrastructure project as a line item. We are able to do that and buy a commercial real estate property. We are able to own an individual timber lot or an individual farm. So it's very difficult to replicate that.

With the changes in the market, and again this notion of democratization of access to private market solutions, there are a lot of different ways that are coming to market to be able to add some exposure. But then, I come back to, if I put my asset allocation hat on, and I think, okay, if I look at institutional investors that have a 30-plus-percent allocation to private markets, how much of that do you want to be real assets? How much do you want that to be private equity? How much do you want that to be private credit? And then, you start to run into just a line item constraint. So, by being able to have a single ticket go into a multi-asset fund like this, that really ticks a lot of boxes across real estate, infrastructure, timber, and farmland, and able to do it as a single allocation, I think, is a really unique way to be able to replicate what institutions are doing through multiple investments.

Kevin Headland:

Eric, it was a tough year for real estate last year. Can you talk about some aspects of the portfolio that actually contributed to positive aspect of returns in 2023?

Eric Menzer:

Given how diversified we are, we obviously had a lot of offsets against real estate here in the portfolio. And infrastructure is one of those big offsets that we had. Typically in the mid-market, where we've been able to deploy capital to and see some good outsized returns. There's a lot of tailwinds on infrastructure right now, in particular around renewables. The Inflation Reduction Act is obviously a key tailwind there where it's providing tax incentives to move capital into the asset class. The demand is there and there's plenty of supply in terms of investment opportunities that we're still seeing out there. We're not seeing underwriting standards from our managers to grade. You're still getting from a risk adjusted basis some good returns. And frankly, the increase in rates does not have the impact that it has had on infrastructure as, say, it has had on real estate, where the rising rates were obviously a major impact on real estate valuations.

We didn't see that. We haven't seen that in infrastructure. And frankly we haven't seen that broadly across most of farmland as well, where the supply demand and balances are so strong that valuations on farmland have held steady, and while inflation has had an impact and input costs have gone up, profit margins are still healthy across the sector. And as a result, we continue to see some nice returns and some good opportunities in that space as well. Timber, I think, has had some short-term headwinds with regards to housing, but the fact of the matter is there's a huge housing shortage. We're confident that if we start to see rates come down a bit, that we're going to see a little bit more new construction come into bear, and as a result, that's going to bode well for timber.

Kevin Headland:

Thanks, Eric. And last word to you, we know inflation is coming down. We have some disinflation. Equity's been rallying strongly of record highs across the board almost. Fed is really going to be cutting rates, so it should be positive for fixed-income investments. Why should investors be looking to add to real assets today?

Eric Menzer:

Well, I think what we've been seeing in the markets right now is very much a momentum-driven equity market. There's definitely a fear of missing out happening out there right now, and it's 10 key stocks really driving the bulk of the returns out there. Yes, rates have been high and some of the challenges we've had with seeing new assets come into the asset class have been for the fact that clients have been able to get nice returns and nice yields out of their fixed income. I would say to investors that, one, the equity markets don't go straight up forever. And I would also say that yes, while you may have some capital gains as a result of rates coming down in the short term.

The fact of the matter is there's huge benefit in lowering volatility as a whole relative to rates and relative to the equity markets. And when we look at volatility inside of these types of private assets, we look at much lower volatility relative to equity markets and very much bond-like volatility. So, when you look at the correlations, when you look at the overall volatility, the portfolio diversification benefits that exist with these assets is tremendous, and I would encourage advisors and clients to think about an allocation to real assets and the impact ultimately that that's going to have on your portfolio over the much longer term time period.

Kevin Headland:

Great. Thanks so much Eric, and thank you as well, Alex. I appreciate the time you spent today, gentlemen. Talk soon.

Uncertainties surrounding geopolitical tensions, global supply shocks, and the long-term impacts of fiscal and monetary support in response to COVID-19 pandemic is all the more reason to look for diversified sources of return and income in a portfolio. Weaker than expected economic growth, and higher than expected inflation can create stagflation type scenarios where real assets have historically performed well compared to traditional public assets such as stocks and bonds. Long-term returns are quite attractive for real asset performance. It's time to look past the traditional 60-40 portfolio and look at using real assets to diversify a source of return while mitigating volatility over the long term. Tune in on May 16th at 2:00 P.M. Eastern Time for our next Market Insights Monthly Call with Roshan Thiru and Chris Chapman.

One more shameless plug for this podcast, if you enjoy this podcast, please rate us. If you don't enjoy this podcast, please don't rate us. I'm joking. You always want high ratings on our podcast, and really comments and ratings just help bring this podcast to light for like-minded investors. And if you do enjoy it, please share it with others. Right? Let people know you have this podcast out there that you really like, and we're always looking for new subscribers, new listeners. So by all means, please share it and like it. And thank you so much for listening. Once again, it's Kevin Headland, and this has been an Investments Unplugged. Take care.

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