Environment
Rising Rates
The primary challenge for real asset investment companies has been the pervasive upward pressure on interest rates. This macroeconomic trend has significantly affected the investment landscape.
Notably, the increase in interest rates has surpassed the changes in discount rates. Discount rates are crucial for real asset valuations as they capture the contractual revenue growth in many underlying assets. The disconnect between interest rates and discount rates can introduce volatility and affect the perceived value of these assets.
Switching to Bonds
Real assets have lost favour among investors as many have opted to reallocate their portfolios towards bonds. This shift in investment preferences is driven by various factors, including the desire to rebuild bond positions.
Real assets have historically been utilized by some investors as income generators, especially during periods when generating income from bonds was challenging. However, comparing the income generated by long-life real assets benefitting from progressive income streams with nominal bond yields can be misleading.
The example of 3i Infrastructure highlights this mismatch. The dividend of the stock has experienced substantial growth, rising from 5pps in 2008 to 11.9pps in 2023 and reflecting the progressive income streams of real assets. At the same time, the Net Asset Value has also risen significantly from 100pps to 351.4pps. While the stock has provided an “alternative” income stream, it is in no way a bond proxy.
Look-Through Charges
As a result of retained EU rules, UK-regulated wealth managers are now obligated to include the look-through costs of investment trusts in their ongoing charges figure (OCF) disclosures. While the aim of this regulation is well-intentioned in that it enhances transparency and provides investors with a more accurate understanding of the total costs associated with their investments, many in the industry believe that it has been misapplied to the investment trust sector.
Nevertheless, the inclusion of look-through costs in disclosures has led some wealth managers to reconsider their investments in the sector. The additional scrutiny on costs may have resulted in some wealth managers either abandoning the sector altogether or refraining from making additional purchases.
Despite the outstanding performance of certain companies (3i Infrastructure, for example), the increased focus on costs may have overshadowed their positive performance, leading to a hesitancy or reluctance among investors to engage with real asset investment companies.
Catalyst for change
Rates Cycle and Market Sentiment
Recent economic data releases support the view that the rate cycle appears to be peaking. In recent months, real assets have responded positively to every news release that supports this narrative, with the most recent announcements leading to a 10% increase for the Sanlam Real Assets Fund in November thus far (past performance is not a guide to future performance).
At the same time, the inflation environment seems to be improving, contributing to a more positive market sentiment. Despite this positive shift, it's essential to highlight that even after a significant rally, real assets are still trading at substantial discounts, indicating significant further potential upside.
Bond Yields and Comparative Analysis
With bond yields already starting to decrease from their highs, the gap between real assets and static bonds is a crucial factor that should not be overlooked indefinitely.
For example, from current levels, holding HICL Infrastructure versus a government bond yielding 5% over a 10-year period would provide a 32% capital downside cushion, assuming zero dividend growth. If instead we assume that the dividend grows by 2% per annum then this cushion would increase to 44.7%, emphasizing the potential resilience and stability of real assets over the medium term compared to bonds.
Regulatory Developments
A motion was recently tabled in the House of Lords by Baroness Altmann to address the previously mentioned regulation surrounding look-through charges. The sentiment from the debate suggests a strong likelihood of change, with the key question shifting from "if" to "when”.
Right on cue, the Autumn Statement confirmed the government’s plans for the replacement of the EU's PRIIPs regulations with a UK-centric regime which should provide a framework that allows the cost disclosure issues that currently weigh on the sector to be addressed.
The potential revocation of these retained EU rules should have positive implications for real asset investment companies, reducing regulatory headwinds and producing more favourable market sentiment.
Operational Performance and Strategic Initiatives
Despite a period of poor share price performance, real asset companies have demonstrated robust operational performance, particularly in contracted revenue growth.
Companies are actively engaging in strategic initiatives such as selling assets at or above NAV, conducting share buybacks, repaying debt, and increasing dividends. These measures contribute to validating valuations and signify a proactive approach to enhancing shareholder value.
Outlook
With the potential shift in the rates cycle, decreasing bond yields, anticipated regulatory adjustments, and strong operational performance, there is a sense of optimism that the challenging period for real asset investment companies may be coming to an end, offering a more favourable outlook for investors ahead.
Fund risks
The Fund has holdings which are denominated in currencies other than sterling and may be affected by movements in exchange rates. The Fund may invest in derivatives to reduce risk or cost and/or generate extra income or growth. There is a risk that losses could be made on derivative positions or that the counterparties could fail to complete on transactions. Part of the fund may invest in bonds. Investment in bonds and other debt instruments will be impacted by factors such as changes in interest rates and risk of default by the issuer.
Important information
This communication is marketing material for professional investors only. The opinions are those of the named author(s) at the time of publication and are subject to change, without notice, at any time due to changes in market or economic conditions. Whilst care has been taken in compiling the content of this document, neither Sanlam nor any other person makes any guarantee, representation or warranty, express or implied as to its accuracy, completeness or fairness of the information and opinions contained in this document, which has been prepared in good faith, and to the fullest extent permissible under UK law.
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