The U.S. stock market has been eventful lately to say the least, although still cresting near record highs. At all times, but especially when market volatility and lingering inflation remain a concern, strategic portfolio diversification can help lower portfolio risk and through that potentially bolster long-term risk-adjusted return.
Common sense says that it makes sense to diversify (don’t put all your eggs in one basket). But it’s not just common sense. In a recent paper, the LNW investment team explained how exactly the addition of real assets to client portfolios — real estate, infrastructure, commodities and natural resources – enhances diversification.
The rationale is evident in the chart below, which covers asset price movements over the past decade. It shows the level of price correlation between stocks and bonds vs. a variety of real assets, from timber and farmland to commodities (oil, gold, etc.). A correlation of 1.0 means price movements in the two assets are locked in step. Zero means no correlation.
As you can see, there was a relatively low correlation between most types of real assets vs. stocks and bonds. It is the low correlation levels that make a mix of real assets a good addition to portfolios. And the correlation levels vary significantly. Real assets with the highest correlation to stocks include Real Estate Investment Trusts (REITs), global infrastructure and natural resources. Also interesting is the low correlation among certain types of real assets.
There were also some negative correlations — pricing heading in opposite directions. Not surprisingly, U.S. bonds have the highest amount of negative correlations with real assets, especially assets that are sensitive to inflation (commodities, energy, agriculture, natural resources).
Getting Real
LNW invests in real assets through various access vehicles in both the public and private markets. Investment can be direct, through the ownership of shares in companies that own real assets, or through financial instruments tied to the trading of real assets (for example, commodity futures).
During periods of higher inflation and market volatility, the value of real assets lies in their inherent physical attributes, be it an apartment building or a bar of gold. The multiple benefits of an allocation to real assets include:
• Potential inflation hedge: Many types of real assets increase in market value and/or their earnings rise (either contractually or through regulatory allowances) as inflation increases.
• Portfolio diversification: Real assets can enhance portfolio diversification across sectors, industries, countries and especially (as the chart above shows) against financial assets such as equities and bonds.