The question of whether you need real assets in your portfolio may sound silly to the novice investor – is that instead of imaginary assets? Certainly, an accountant with imaginary assets is cooking the books!
In truth, ‘real assets’ simply refers to assets that are tangible items with intrinsic value as opposed to purely financial vehicles. Gold, commodities, oil/natural gas, and real estate are “solid” examples — pun intended. (Technically, things like your baseball card collection are real assets as well, but they are probably not investment grade.)
There are two primary reasons to include real assets in your portfolio:
- Portfolio Balancing – We often speak of a balance between stocks and bonds when balancing a portfolio, but real assets are a useful third component. They typically have low correlations with stocks and bonds, so they can be used to balance out the risk, volatility and return factors in your portfolio.
Gold, commodities and real estate all have different volatility, liquidity and return characteristics; therefore, as a class, they represent tools that can adjust unbalanced portfolios in a number of aspects. If applied correctly, you can lower the overall risk of your portfolio while increasing long-term, risk-adjusted returns.
- Inflation Hedging – Since inflation represents changing in the buying power of a currency and real assets represent the intrinsic value of actual goods (and not the currency used to purchase them), real assets are often used to hedge against inflation and reduced buying power.
In today’s unusual low-inflation environment, this is not much of an issue. However, the economy cannot stay stagnant forever, and significant inflation will eventually reappear despite the efforts of governments and central banks to manage it.
What type of real assets should you consider? Their characteristics vary, so it depends on the component that is missing in your portfolio.
- Direct Real Estate Investments – Raw land, single-family homes, multi-family developments, and commercial property are the most common types of direct real estate holdings. For each property purchased, an entire cycle of investment due diligence and transaction contracting is required. This can be very time consuming and expensive.
- Real Estate Investment Trusts (REITs) – REITs are pooled funds of multiple real estate holdings, and are an excellent alternative to direct real estate investing. Like a mutual fund, they provide professional management and the benefits of asset diversification. REIT’s also provide some of the best historical returns available and, although they are not particularly liquid compared to other real assets, they certainly are more liquid than direct property ownership.
Whether you invest directly in real estate, or purchase shares in REITs, you have to decide whether to make your money via rent (holding properties) or debt (holding mortgages and leases), as well as what market you wish to be in – industrial, office, retail, multifamily/apartment housing, or individual homes.
- Gold – Gold prices have a very good inverse correlation with interest rates on 10-year Treasury securities, although today’s artificially low interest rates have produced anomalies. Typically, gold appreciates in weak economies and uncertain times because of its perceived value as a safe haven.
- Commodities – Commodities are dealt with on a contract basis, but remain reasonably liquid depending on the type of commodity (grain, cattle, oil, etc.) and its volume of trading. Most commodities have a cyclical component and somewhat predictable trends, so make sure you trade in commodities you know. If you do not understand that market, educate yourself before you invest.
Other types of real assets include timber and natural resources, global infrastructure such as investments in buildings and bridges, and alternate precious metals.
A popular way to invest in real assets is through Exchange Traded Funds (ETFs). They are securities that track a particular asset class and trade on exchanges in a similar fashion to stocks, altering the liquidity and risk levels. For example, two of the largest ten ETFs are the SPDR Gold Trust ETF (NYSEARCA: GLD) that tracks gold bullion spot prices and REIT ETF (NYSEARCA: VNQ) that is composed of holdings in REITs.
Investments in oil and gas may be made through Master Limited Partnerships (MLPs), which are publicly traded limited partnerships. Similar to corporation owners, limited partners cannot lose more than they put in (unlike general partnerships). MLPs can invest in real estate or other ventures, but most deal with oil and/or gas.
Whether you choose to invest in real assets through ETFs, MLPs, physical holdings in gold or real estate, commodities contracts – or your baseball card collection, we suppose – it is wise to consider adding real assets to your portfolio as a means of managing your risk, hedging inflation, and optimizing returns over time.