Description of latent challenges in real asset investing as investors rush to seek for diversification and yield from traditional stocks and bonds.

1. Some Unspoken Challenges
in Real Asset Investing
GS Khoo, PhD
Former Head of ERM
AIMCo & Temasek Holdings
gskhoo@gmail.com

2. Prologue
• More and more institutional investors are turning to real assets in their
search for sources of long-term income, and as a diversifier to the
mainstream stocks and bonds because of their low correlations.
• In addition, real assets are also perceived as offering protection from
market volatility and future inflation embedded in the economy through
global quantitative easing programmes.
• However, in their rush to include this asset class (real assets - which can be
broadly classified to include real estate, private equity, infrastructure,
agricultural land, etc.) in their portfolios, these investors including the
pension funds must always be cognizant of the specific challenges involved
in investing in these real assets.

3. Example of Real Assets - Agricultural Land

4. Quick Overview
Challenges in Real Asset Investing
• What they really are: Real assets are actual, tangible assets that include art works (alternative), gold, land, real estate (commercial buildings,
etc.), etc. The focus of this article is on the traditional real assets like real estate, private equity, infrastructure, etc.
• How are they like: From a lifecycle view, these assets can range from a greenfield project to one that is mature or a brownfield.
• When and where to invest in them:
• As above, the stages of the development of the project or asset will influence the risk-return profile of these assets, as at various stages of the lifecycle, the various
forms of risk exposures will also vary, e.g., at the greenfield stage, construction and material availability incl. commodity risks will typically prevail over the rest,
notwithstanding the government regulations, tariffs and tax structures, etc.
• If the real asset investment is cross-border, it brings with it even more idiosyncratic challenges, incl. FX/currency risk (translation, etc.), repatriation risk,
geopolitical, environmental, regulatory (ownership, legal, taxation, etc.), third party (partner, outsourcing, supplier, etc.) risk, political, macro- and micro-economic,
etc.
• What investment horizon to consider: typically, the investment in real assets is for the medium or longer-term
• hence, unlike for stock and bonds, liquidity risk is more apparent and
• an ALM view esp. a consideration of the multi-year liabilities and replacement capex (expenditure for repairs, maintenance or replacement of certain assets, etc.,
beyond the initial capex) is often critical and missed or ignored by the investors when they rush to invest in these real assets
• Why invest in them: The perception is that they often have low or negative correlations with the listed or liquid assets (stock and bonds).
• However, from a tail risk point-of-view, because of the increasing global interconnectedness of financial markets through fund flows, the advent of ETFs, and
Internet-based trading and information flow, they can still be influenced by the herd behavior of investors in terms of their valuations because of the herd
mentality described previously as investors search for higher yields or in alternative incl. real assets as a result of the QE programs and low interest rate regimes.
• How to assess their risks and expected returns: In truth, there’s no holy grail as their risk premia are not as easily estimated via the traditional
COE or WACC approach as most of these approaches are based on the liquid markets in equities and fixed income in the developed world.
• Here, the risk premia (esp. for cross-border investments) are often a function of:
• their stages in the lifecycle (leading to the J-curve and vintage analysis), the specific political and regulatory risk (e.g., Trump trade, Brexit, etc.),
the inherent investor preference in terms of risk-taking (the dynamic “risk on, risk off” (RORO) regime) in the various geographies or sectors,
inflation and currency risk, the illiquid nature of their domestic currencies and financial markets, the dependence on commodity prices and
hence the USD fluctuations, etc., beyond the traditional credit (sovereign/country, etc.) risk, equity market risk (often inaccurate because of the
lack of liquidity in the domestic market, etc.) and project risk premium.

5. Managing Risk in e.g. Infrastructure Investing
Issues in Valuations & Assessing Risk in Illiquid Investments
• Primarily marked-to-model based on IRR and discount factor (DCF)
assumptions
• Importance of independent model review and validation
• Risk models more factor-based (quantitative & qualitative)
• Importance of independent model review and validation
• Portfolio perspective – smoothening the J-curve
• FX translation risk for cross-border investments
• Etc.

6. Risk-Return Challenges
Liquid Asset vs. Illiquid (e.g. Infrastructure) Investments
Liquid Assets (e.g., stocks) Illiquid Assets (e.g., Infrastructure)
Daily marked to market Yearly (at best quarterly) valuation
Low liquidity premium (bid-ask spread) High liquidity premium (illiquidity)
Ease of liquidation (e.g., for rebalancing) Buy-to-Hold (difficult to liquidate)
Shorter- to longer-term investing Long-term investing
Ease of access (to invest) Supply “of good quality assets” constraints
Exhibit high volatility Subjected to “J-curve” P&L profile
Affected mainly by macro-economic factors Affected by environmental, political &
specific factors
Risk proxied by volatility-type measures Risk dependent on long investment horizons
Higher correlation with other liquid assets Lower correlation with ‘traditional’ assets
EXAMPLE

7. Active Returns-Risk Analysis
• Typically, active managers’ performances are compared to say an index
or benchmark, e.g., S&P500. With daily MTM values for both the active
portfolio and benchmark, it’s easier to compare and assess the active
returns/risk and/or tracking error.
• With illiquid investments where valuations are performed less
regularly, e.g., annual/yearly appraisals, comparing their performances
to liquid benchmarks is potentially challenging (to me, it’s like
comparing apples to rice, so meaningless) with scarce data and
idiosyncratic profiles of the illiquid asset, including investment horizons
• Differentiated profiles: some illiquid assets are more inflation-sensitive,
some are more bond-like with periodic income streams and some are
subjected to specific risks, e.g., drought, flooding (transport), or
resource nationalization (e.g., dominant infrastructure), etc.

8. In Relation to Portfolio, What Can We Do?
• How
• Managing risk throughout the investment life cycle
• Combining long term objectives and short term constraints
through a risk-based performance approach to investing
• Diversification beyond traditional asset classes to alternative or
real asset classes (1), like real estate or infrastructure*
• Inherently, additional dimension of diversification by time buckets
or investment horizons (2) or regions /sectors (3) and strategies
(4) or by pool sizes (5)
• Portfolio Management Strategies complemented by optimal
rebalancing (for the liquid assets) and deal-by-deal investments
• Returns distribution analysis, superior stock/sector selection*, lifecycle
investing (deal-by-deal) across vintage, etc.
*Examples (thematic growth): water, genomics, waste management, consumer, fintech, e-commerce,
etc.

9. Diversify across Time or Investment Horizons
(incorporates ALM consideration)
• Why not?
• Buy & Hold: impact on efficient frontier profile & wealth preservation
• Real or Private assets like real estate, infrastructure, venture (incl. emerging sector
like fintech), etc. in medium or long-term portfolio sub-pools (can also have liquid
assets)
• Liquid assets in short-term* / medium- / long-term pools for alpha & beta
opportunities
• Multi-year ALM alignment with liabilities
• Multi-period diversification/rebalancing
• Size migration, tied to asset selection (see Appendix)
• *Liquidity Challenge: Funding Risk (state of Fund Shortfall);
Availability of Dry Powder during stressed periods

10. Vintage-based Timing of Investments
in Brownfield & Mature Real e.g., Infrastructure Assets
Smoothening the J-Curve (excl. divestment)
Challenges:
• Valuation, e.g., post-recession, bubble territory, etc.
• Geopolitical /Credit(regional or sector turbulence), e.g., Brazil, Myanmar, China, etc.
• Exogeneous Impact, e.g., Swiss FX peg and depeg, Brexit, Trump effect, etc.
• Demographic effect, e.g., Japan, etc.
• Others, e.g., domestic inflation, FX risk, etc.
Returns
Time

11. Multi-dimensional Diversification by Geography/Regions/Sectors in
addition to Investment Horizons and Strategies

12. Multi-Dimensional Diversification
Geography
Investment Horizon /
Time
Vintage
(Green-, Brown-field, Mature)
Infrastructure Sector or
Asset Class

13. Risk Modelling, Scenario & Stress Test AnalysesRisk Modelling, Scenario & Stress Test AnalysesRisk Modelling, Scenario & Stress Test AnalysesRisk Modelling, Scenario & Stress Test Analyses
• Investment Horizon??
• Short-, Medium- and Long-term Investments
• Short-term investments akin to trading
• Investments??
• Asset class type, sector
• Investment Strategy??
• Top-down/bottom-up approach??
• Tactical & Overlay plays - see Appendix on Countercyclicals
• Risk Appetite/Objective??
• Minimization of Risk/Maximization of Returns

14. Epilogue
AUM Size Impact is Another Issue
With regards to the size of the AUM, in-house studies have shown that for large funds:
• Size effect – require at least 10% to 15% allocation to a “good” performing asset class to shift the fund’s
portfolio risk-return profile meaningfully to the right, i.e., moving the returns meter
• Market capacity constraints & impact - global equity markets are constrained by supply (as a function
of free-float and market cap), e.g., humongous fund portfolio value often dwarfs market caps of
emerging markets or secondary boards, e.g., AIM, TSX-V, etc., with resulting implications for funds
deployment and may not allow the opportunities to be optimally realized – related to challenges in
transition management and liquidity, esp. when investing in real assets
• “Active” alpha - separate 10-year study of individual companies and sectors suggests concentrated bets
with a small allocation in a diversified sector or asset class via a “VC–like” approach could potentially
be rewarded handsomely, e.g., clean water, genomics, etc.
• Appropriate to look into segmenting the “huge” total fund into smaller pools, with different asset
mix, time (investment horizon), and strategy profiles, in different regions, further enhancing
diversification
• Addressing market slippage/impact and transition management issues (aligned with real asset
investing)
• Top-down portfolio risk-return analysis to complement individual bottom-up investments to yield
a meaningful shift in right-tail gain

15. Thank You
Guan Seng Khoo, PhD
email: gskhoo@gmail.com