What do real returns mean to portfolio managers?

Surging prices have been less of a concern after combating the post-Covid inflation. In Singapore, the central bank has called the disinflation trajectory “well-entrenched” with economic recovery seen extending into 2025. 

In terms of core inflation, the country is expected to end 2024 with inflation clocking in at around 2%. Even as inflation sits at a seemingly unharmful level of the long-term average, our purchasing power is slowly chipped away. 

As little as a 1% annual inflation rate could reduce purchasing power by 26% over 30 years. In this article, we are interviewing portfolio managers from Janus Henderson Investors, KBI, M&G, Nordea, and PIMCO to find out how not to quietly lose wealth. 

What are real returns?

In short, real return is what is earned on an investment after accounting for inflation, commonly stated as inflation-adjusted returns. Real rates of return are lower than nominal returns, as the latter does not subtract inflation.

Here’s how Tim Gibson, Co-Head of Global Property Equities at Janus Henderson Investors, puts it in one sentence: “Real returns simply mean providing more money in your pocket when adjusted for inflation.”

Until recently, inflation has been so low that many have not had to give it much thought, states Gibson. This has changed, though, and he says: “As inflation has picked up in the last few years, people now know what it feels like, and that the same amount of money buys fewer goods and services than it used to – just look at the prices at your local Hawker centres or supermarkets, compared to a few years ago.”

That’s exactly how it feels as inflation hits closer than cold numbers and this real-life example supplies evidence. The quintessential Singapore breakfast, a kaya toast set from a local chain store cost S$4.8 in 2021, and the same set is now asking for S$6.3. 

The difference of 1.5 dollars seems inconsequential, but effectively means prices have surged 30% in three years.

To Gibson, a higher inflation environment is essentially a higher cost of capital environment, with higher interest rates – and while now moderating, he anticipates levels to remain structurally higher than the lower levels seen over the past 15 years.

What real returns mean to a portfolio manager

Inflation is unlikely to head back to the muted levels when we barely felt it, so are interest rates. Wearing the money manager hat, Gibson discusses that as custodians of clients' capital, “We realise the importance of compounding wealth over time from a real, inflation-adjusted perspective so that hopefully you don’t have to.”

For Alex Araujo, a fund manager at M&G, real returns come more tangible. 

The M&G (Lux) Global Listed Infrastructure Fund Araujo manages is benchmarked against inflation. “Our fund is unique in having the defined objective of delivering income growth to unit holders above G7 inflation each year. We understand the power of compounding income growth and the need to protect real wealth.”

After an extended period of non-existent price rises, he thinks the inflation surge has been a timely reminder to investors that the return hurdle is materially different in an inflationary environment.

Araujo said: “These asset classes and sectors have inherent inflation protection because of pricing power. Many infrastructure assets are backed by inflation-linked escalators meaning that returns can be preserved during times of rising prices.”

How real assets provide real returns

There are multiple categories of real assets that can produce real returns and provide inflation hedge.

1. Assets value rises with inflation

Commodities may provide a very powerful and effective hedge against inflation because they tend to appreciate in value or generate income that rises with inflation. 

According to PIMCO, during higher inflation environments, markets tend to register higher uncertainty measured by an increase in volatility, which makes owning real assets even more important. In 2022, when global inflation spiked, stocks and nominal bonds posted double-digit declines, while commodities delivered a 15.6% annual return as proxied by the Bloomberg Commodity TR Index (SGD hedged).

2. A higher rate of cash flow or income that more than nets higher borrowing costs

Real estate values tend to rise with inflation, as well. Its cash flows and dividends from REITs cannot be overlooked. The rate can be at a pace that may more than offset higher borrowing costs from rising interest rates and the negative effects of higher inflation, according to Duff & Phelps Investment Management Co, which manages the Nordea 1 - Global Real Estate Fund. 

For example, owners and operators of real estate have the ability to pass on inflation to the end users of their assets mostly through annual rent escalations built into leases that are tied to inflation. With sectors with shorter lease durations – such as lodging, student housing and self-storage, property owners have the ability to reprice leases more frequently to incorporate the cost of inflation. 

Active management is required to navigate the heterogeneity of real assets

Gibson, who is managing the Janus Henderson Horizon Global Property Equities Fund, notes that selection remains key. 

“Take an obsolete office building in the wrong location, its rents can go to zero; whereas key urban logistics assets may have greater rental growth due to the scarcity of such assets and growing e-commerce demands. Also, some leases can re-price quickly – a hotel on a daily basis, whereas some assets may have longer-term leases – and some have inflation-adjusted clauses to provide a cleaner match.”

The nature of real estate lends itself to offering real returns, but stock selection, asset-specific and supply/demand characteristics will always dominate. He thinks quality investments that can consistently earn a sufficient return on capital, not just benefiting from cheap capital, are preferred. 

Besides inflation protection, what other benefits do real assets offer?

Real assets are particularly important in a higher and more volatile inflation environment, as they can offer not only inflation protection but also much-needed diversification in traditional stock-bond portfolios. 

From PIMCO, Greg Sharenow, portfolio manager, commodities and real assets and Andrew DeWitt, portfolio manager, commodities, have looked into prior periods of inflation. They observe that the stock-bond correlation tends to increase, meaning that the same portfolio may have higher embedded risk when inflation is higher vs when inflation is lower.

“Adding real assets to stock-bond portfolios may help diversification and reduce risk precisely when it’s needed most, in inflationary environments. Despite the recent slowdown in CPI rates, the risk of inflation shocks going forward makes it essential for investors to include real assets in their portfolios to maintain real value.”

On top of inflation protection and diversification, some real assets portfolios have exposure to long-term secular trends including the energy transition, digital infrastructure, and increasing infrastructure spending.

Sustained deflation causes “muscle memory” of real assets underweight

What a decade of low to zero inflation left us with is a habit of many to overlook the benefits of real assets. Now, what investors will have to face is something different, likely a more “sticky and volatile inflationary regime,” according to Araujo from M&G, who pointed to the three Ds: Debt, Deglobalisation, and Decarbonisation, as powerful and enduring reasons for that. 

“Asset allocators are underweight infrastructure, real estate and commodities given the ‘muscle memory’ of deflation. This means these inflation-resilient sectors are fundamentally mispriced for a more challenging period ahead,” adds Araujo.

He thinks infrastructure broadly offers exposure to economically defensive sectors. They generally offer reliable cash flows and dividends that grow in real terms while the fundamentals and valuations are highly compelling for this asset class.

Another infrastructure fund manager, Colm O’Connor from KBI, shares a positive outlook. “Returns from listed Infrastructure in 2024 have rebounded after two years of slower growth and the peaking of interest rates may potentially signal a more supportive period for the asset class.”

O’Connor, who is the lead portfolio manager for the KBI Global Sustainable Infrastructure Fund, continues: “In an environment where inflation (and interest rates) are higher than the long-term average, assets that can generate inflation protection are particularly attractive.” Infrastructure has historically generated strong returns (relative to broader equity markets) during periods of higher inflation, driven by inflation-linked pricing mechanisms. 

Own them all – Start with Endowus Real Assets Portfolio

Investors need to be judicious in not just focusing on real income return, for example, from the rents they receive from their physical properties. There is also an aspect of real total return, by considering both income and capital values. Diversification is always important and is certainly key in the more volatile environment we are now in. 

Based on your investment objectives and risk tolerance, to own broad categories of real assets equity funds, you can consider Endowus Real Assets Portfolio. The key aspect of the Real Assets Portfolio is its ability to serve as a satellite allocation, one that is complementary to a core allocation like the Endowus Flagship Portfolios. Each of the underlying funds does not have major overlaps with the global equity proxy and among themselves as well. The inclusion of various real assets categories has led to a lower maximum drawdown. 

Start today with Endowus.