Real Asset Strategies For 2023, With Kara O’Halloran

With equities and bonds both in a sustained bear market, many family offices and HNW investors have looked to real assets to be portfolio ballast.

But the devil’s in the details; what’s the best way to allocate a portfolio slice to real assets? Kara O’Halloran, director of investment research at FS Investments, joins the show discuss real asset strategies for 2023 and beyond.

Watch On YouTube

Episode Highlights

  • How HNW investors need to think about their portfolios in the context of higher inflation.
  • Why investors should consider RICE as a good starting point when determining the types of real assets in which to invest.
  • Kara’s definition of “next gen” real assets, and how they compare to traditional real assets.
  • Why a well-constructed real asset portfolio should contain both next gen real assets as well as traditional real assets (and why these are complementary).
  • How HNW investors can take a tactical approach to real asset investments, using product wrappers with varying levels of liquidity.

Today’s Guest: Kara O’Halloran, FS Investments

About The Alternative Investment Podcast

The Alternative Investment Podcast is a leading voice in the alternatives industry, covering private equity, venture capital, and real estate. Host Andy Hagans interviews asset managers, family offices, and industry thought leaders, as they discuss the most effective strategies to grow generational wealth.

Listen Now

Show Transcript

Andy: Welcome to the “Alternative Investment Podcast”. I’m your host, Andy Hagans. And wow, what a turbulent time for investors right now. Inflation remains stubbornly high. We have a pretty hawkish Fed, I would say, you know, hiking interest rates. And the big question is, what does all this mean for investors heading into 2023 turbulent markets. They can be scary, but they can also be a big opportunity for enterprising investors. So, we wanna talk about real asset strategies as we wind down Q4 and head into 2023. And joining me to discuss this topic is Kara O’Halloran from FS Investments. And Kara, when you actually suggested the topic for this episode and it turned out to be, like, so timely, I think we lucked out by timing it. Today is November 3rd as we’re recording this.

Kara: I know. I mean, it is such a…as you said, it is such a timely topic. It’s obviously…we’ll get into the inflation backdrop, but it’s so hard to talk about inflation without thinking, “Oh, how the heck am I supposed to invest in this environment?” And, you know, in comes real assets. So, I’m really excited to be here. Thank you for having me.

Andy: Yeah, income and real assets. Gee, I’m thinking even in… I wanna get back to that because I’m thinking, “Well, what kind of income survives inflation?” But let’s start with that. Let’s start with inflation. So, I had your colleague, Laura, on the show. So that was episode 65. I’ll link to that in the show notes if anybody missed that. We talked about the macro landscape. We talked about inflation. And her prediction was that it was already peaking based on forward-looking indicators. However, and actually, I should say it wasn’t her prediction. I think this was your team’s prediction, but she basically said it’s gonna come down a little bit from eight to maybe around six, and then we’ll head into the new year. But it’s gonna be stubbornly, you know…it’s not gonna go back down to, like, four or anything like that next year.

Kara: No, no. Which is where we kind of…coming into this year, a lot of people thought we might end 2022 back maybe under 5%, or maybe we hoped we would end under 5% which is still much higher than the 2% inflation target that the Fed has, right. And so, it really changes the investing landscape even if we had gotten back sub 5%, but we’re sitting here November 3rd. I think consensus for CPI, which comes out next week is still 8.1%. It’s over 8%. So, I think there’s little question that we are going to end 2022 probably on that, you know, the wrong side of 5%. So, this is not a… inflation was not transitory, right? We all know that. But it is certainly something that we’re going to be contending with in the economy, but also in our portfolios for some time to come.

Andy: So, when you’re predicting that it’s gonna be on the wrong side of five, is there any time limit to that? I mean, should I be anticipating that’s 2023 or could that be 2024, 2025?

Kara: I may have you have Laura back on for that one. She is our economist. But you know, I think what’s important is that we’re just not seeing inflation really get back to the Fed’s target anytime soon. And even slightly elevated inflation just really changes the investing landscape. So, I think that’s really what it comes down to and the most important thing. And if you think about…we’ve done a lot of work on just looking at what inflation does to a traditional portfolio. I think the fixed-income side is pretty obvious, right? You know, you’re getting…yeah, we’ve seen interest rates rise. I think the tenure’s a little over 4% today. It’s wreaking havoc on your bond prices, right? So, your fixed-income portfolios are down significantly this year. Income, yeah, you’re getting 4% or a little more than 4%. Still not outpacing inflation.

So, you know, your real income is still, you know, still negative. But really importantly, inflation really eats at the equity side of a portfolio as well. We have brilliant quantitative strategists here at FS who have done a lot of work on this. And the data shows that in an environment of high inflation, that’s rising. So, whether or not we’ve peaked, you know, we might have peaked maybe last month, which means just one month ago we were in that high and rising inflation environment. The forward 12-month return for equities is negative. So, we’re still looking at a forward 12-month return that, you know, historically after an environment like we were just in, has been really challenging for equities. Obviously, that’s coming on the tails of this year, that’s already been extremely challenging for equities. And then so you’re having trouble on your 40 side of your, you know, your 60-40, trouble on the 40 side, trouble on the 60 side.

And then the relationship between those two assets breaks down when you have higher inflation. So, our research has shown, has told us that in environments where inflation is greater than 2%, that negative stock-bond correlation that we relied on for so many years to build balanced, diversified portfolios, that negative correlation turns positive. So, stocks and bonds, when inflation is greater than 2%, stocks and bonds are moving together more than they’re moving apart. So, that is really…and that is the bedrock of what we’ve built our diversified portfolios on for so long because we had such low inflation for the last couple of decades. So, really the entire, you know…you have to really rethink portfolios at a whole, you know, at a whole…in this elevated inflation environment.

Andy: Yeah, and just one thing I always bring up, and I am a lot of fun at parties is, you know, when people mention 4% bond yields, I’m like, “You’re actually taxed…unless this is an IRA or 401k or a muni bond, you know, you’re taxed on that nominal rate.”

Kara: Yeah, good point.

Andy: So, it’s not a negative four real yield, it’s actually lower than that.

Kara: It’s a great point, yeah.

Andy: Which is just…it’s silly. So, obviously, enter real assets, right? So, that’s our topic for today, a real asset strategy for 2023. And I think, as you pointed out very eloquently, this is the time when investors need real assets in their portfolio because we have high inflation that’s also rising. Equities don’t perform well on that forward 12-month basis. You know, bonds obviously do not perform well, so it’s really what’s left. What’s left is alt. So, let’s dive into real assets. And I know that you like to use the RICE mnemonic, so can you tell us about that?

Kara: Yeah, I’m a big sushi eater, so that helps me remember it. So yeah, RICE, it’s R-I-C-E. So, real-estate infrastructure, commodities, and energy. So, that just helps me keep it straight. So, you know, if we’re thinking about traditional real assets, real-estate, it’s, you know, farmland, it’s office buildings, retail, all of that. Infrastructure is, you know, bridges and tolls and airports, cell towers. Commodities are…we know commodities, right? It’s the basic raw materials. It’s wheat, it’s energy or oil and natural gas. It’s, you know, all those raw material inputs. And then energy is really kind of the…we view it as the ecosystems surrounding those raw energy commodities. So, pipelines, you know, midstream companies, utilities, all of that, that really store and process those raw materials.

Andy: Okay. Well, among those, seems like we’ve had oil and gas be in the news a lot lately. Obviously, commodity prices and real-estate. But let’s start with commodities. I mean, the interesting thing to me is some of these commodities, some of these inputs remain, you know, stubbornly high, you know. Think oil, gas prices, but some of them seem like they are well off their peaks, some of these input costs. Is there any rhyme or reason? Do I, you know…some of this…it seems like the supply chain is, like, one-third of the way fixed or something.

Kara: Who even knows about that? But yeah, I mean, I think certainly we’ve seen some commodities come off their highs, especially those highs that we saw right after the Russian invasion of Ukraine, which is really when we saw that supply shock. But I think there are really structural and secular tailwinds in… or headwinds in place to keep those from falling significantly. So, I think…and we’ll get into all of this because we have so much to talk about. I’m so excited. I get excited about this topic. But I really think this…you know, the Russian invasion of Ukraine and some of the events of the last two years, the pandemic, all of this really kind of necessitated a reexamination of these global supply chains, right. So, we realized how fragile our energy ecosystem is and, you know, we’re heading into the winter months and I know natural gas in Europe is going to be a challenge, all of that.

So, really, I think that there’s structural things in place that are going to keep commodity prices elevated for some time, maybe not at the highs that we saw directly after, you know…in February, March, April, directly after that invasion that, you know, really acute supply shock. But probably not. You know, what we’re gonna…probably not gonna go back to the prices that we saw in the depths of the COVID pandemic, right? Yeah. I think food shortages, all of this…I mean, there’s all of these trends in place that almost kinda came to a head in the last couple of…or this year, really.

Andy: You referenced that we realized how, you know, sensitive our energy supply chain was, but I’m thinking, “Did we really realize that?” Like, I guess we kind of realized it, but I’m not really seeing any major policy changes or even changes in how capital’s being deployed, you know, really. So, it’s structural, as you say.

Kara: Yeah, yeah. I mean, I think we’re very big believers of this kind of idea of deglobalization and this is something that’s going to take years to play out, not months or quarters. But it, you know…the rebuilding of supply chains, the onshoring or friend shoring, whatever it is. So, yes, you know, I don’t know that we’ve seen in the last couple of months a ton of change, but it is, really is longer-term thesis.

Andy: And so deglobalization, that will just be sort of constant inflationary pressure, no?

Kara: That’s exactly right. Yes. So, globalization has a direct link to low inflation. You know, we saw durable goods deflation for so many years that really offset some of that inflation that we did see in services in the decades leading up to the pandemic. So, yeah. So certainly, deglobalization could contribute to inflationary pressures going forward. We are also really big believers of the idea of the end of the great moderation. So, the great moderation being this period of really low macroeconomic volatility. So, that really kind of slow, steady growth, low inflation, low volatility in your macroeconomic backdrop. And so, you know, that period has really ended. And our view and what that will cause is heightened volatility in the macro backdrop, which is then going to translate into volatility in markets. So, more quicker, faster cycles, more volatility, and inflation. And that’s going to…we’re seeing that in markets right now, all of that volatility with such a macro-driven backdrop right now. And that’s just our view that we’re in for more of that going forward. It’s gonna be a challenge.

Andy: That’s a really interesting way to put it, the end of the great moderation. And I think I agree. And, you know, one thing that’s occurred to me a lot lately…well, I mentioned this to Laura, your colleague, was, you know, the Fed, they mentioned their long-term inflation target, 2%. And they also, you know…at the meeting this past week, Chairman Powell…I think they…or they released a statement that sort of reiterated that long-term inflation target. And I personally, I said, you know, I think the target maybe is, like, in the threes or short-term target, even in the fours, if, like, by January, February they can get a CPI print that’s 4.75, they’re gonna…

Kara: I think they’d be thrilled.

Andy: Exactly.

Kara: We’d all be thrilled.

Andy: Exactly. And I think if they get it to 3.75, they might think we can hang out here for a good long while. Like, my…I’m doubting that they really have the stomach to cause enough of a recession to get the inflation rate back to 2% because some of it is not this short-term, you know, short-term shock. Some of it, it’s underlying structural, secular as you pointed out. Do you think we should just sort of prepare as investors for that higher floor of what the CPI will be, like, maybe for the rest of my life? Yeah, I don’t know.

Kara: Yeah, I mean, it’s hard to forecast that far out, let alone, you know, just one year out. But I do think these are challenges. Like, we haven’t faced inflation like this, as we know, since the 70s, but with this idea of the end of the great moderation as we just talked about, we think inflation’s going to be more volatile. So, yes, like, there are probably periods that we’re going to see more elevated inflation and volatility in inflation and so, yes, we need to prepare our portfolios not just for that, but also just more broad volatility in markets. I just…I think the great moderation, something I always say is it made a lot of us look like really good allocators because the 60-40 portfolio just, you know…you couldn’t beat it.

This ever-declining interest rates boosting your bonds and a really supportive Fed boosting equities, you couldn’t beat the beta trade. So, it made a lot of us look really, really good. And I think things are gonna be really challenged going forward. But I think the good news is that there are a lot of solutions out there to address these challenges. We haven’t needed a lot of the solutions for the past decade. Alternatives obviously is what I’m getting at here. And so, there are…these alternatives do exist and I think they’re going to be very, very important in every portfolio going forward.

Andy: Absolutely. So, we talked about energy commodities. I wanna turn to real-estate for a minute. I’m seeing these opposing forces, right, where we have obviously interest rates going up. So, debt’s more expensive, it’s more expensive to finance any kind of real-estate transaction. So, we’re seeing activity in commercial real-estate, residential real-estate really slow down quite a bit, but, you know, we’re not seeing huge price adjustments. I mean, we’re seeing maybe modest price adjustments, maybe more significant in certain MSAs, but there’s not some big national, you know, 10%, 15% dip in home prices. Do you think it…like, if an investor’s thinking about allocating more to real-estate, should they be waiting for a dip or is it just the dip’s never gonna come type of thing?

Kara: So, I think let’s separate and talk about the housing market and then the commercial real-estate markets. There’s different dynamics at play there. I think I’ll touch on the housing market quickly. Housing is a really emotional asset, right. It’s really…like, you don’t want to sell your house, you don’t wanna cut the price of your house. You don’t wanna…if you saw your neighbor sell their house for $500,000, you’re not gonna say, “Oh, I…” You know, last year. You’re not gonna say, “Oh, I can only get $450,000.” You’re gonna say, “No, my house is better than theirs. I can get 550,000.” So, I think it’s…you’re not gonna see probably these really broad-based price cuts yet. I also think we’re so structurally underhoused just given that kind of hangover from the global financial crisis.

Like, we just don’t have enough houses. Obviously, that is pressuring rents contributing to inflation. So, maybe that’s a good way to pivot into the commercial real-estate side of things. With multi-family obviously being a… really a pandemic darling, is how we like to put it. But, you know, I think if you’re thinking about an investment in commercial real-estate right now, things are slowing, yes, but they’re slowing off of a really, really exceptional base. I mean, we saw massive property price appreciation over the past few years, you know, record sales volume. So, it’s slowing, yes. It’s not outright decelerating at this point. I do think that there are ways…I think real-estate is also one of the…kind of the real assets that people instantly look to, right. Like, it’s, like, kind of a brain synapse there.

It’s one of the more common real assets. And, you know, it’s for good reason, right. It has almost a 1.0 beta to inflation. So, it’s almost historically been a one-for-one inflation hedge as, you know, really tenants or landlords, excuse me, are able to pass along those price increases through increased rent. And it’s really a nominal asset, you know, it’s tied to nominal GDP, which we’re still seeing strong nominal GDP. But I do think you have to consider the fact that we are seeing rising interest rates as we’ve talked about, which is, you know, the cost of financing is going up. So, if you’re thinking about a real-estate investment right now, you know, maybe that means there’s probably less, you know, less income left over for the equity holders, right. So, maybe it’s moving up the capital structure. We really like CRE debt right now. If most of your return is going to come from income anyway, getting that subordination below you is a nice place to be.

Andy: Understood. Okay. So, I mean, among the RICE mnemonic, do you have a particular favorite? I mean, you know, oil and gas or commercial real-estate?

Kara: I love being asked what my favorite asset classes are and, like, getting excited about…I’m a lot of fun at parties too, as you can tell. No, I actually don’t. And I think that it’s because if you’re designing a very, you know…a well-constructed real asset portfolio, I think you need all of them. And I think that they all serve different purposes and I think we’ll get into what a well-constructed portfolio looks like, but I do think having the ability to invest across those asset classes is important and you can toggle it up, toggle it down based on the macro. But I think being able to invest in all of those is what’s going to give you the best well-constructed real asset portfolio.

Andy: Got it.

Kara: I mean, if you wanna talk my personal interest, I always think real-estate is fun, but that’s just a… you know, that’s my side thing, my just personal thing. But I think in an investing case, it’s all of them.

Andy: Yeah. Well, I mean, that can…you know, having something be fun or be a passion, I do think that that can be important in the sense that, you know…like, when the going gets tough, when an asset class has a price dip or faces some headwinds, you know, being a believer, having the strong hands, I mean, I do think that is a little bit important as we’ve seen with, you know, physical gold, you know, Bitcoin, crypto, real-estate, you know, when…if you’re not a long term believer, then maybe you shouldn’t…

Kara: That’s true.

Andy: …deploy capital.

Kara: Yeah, it’s a good point.

Andy: So, I read some of your research prior to, you know, this podcast recording, some of the research about these RICE assets. And one thing that the research mentioned was NextGen real assets. Could you talk a little bit about what you mean by NextGen real assets?

Kara: Yes, absolutely. So, we’ve talked about real assets as really being that inflation hedge in your portfolio. And it’s because they have that intrinsic value, they’re physical, you can touch, you can hold them. But if you think about why real assets exist at their core, it’s to build and power, and I will add protect after, you know, the geopolitical tensions this year. So, it’s build, power and protect our nations and our economies. And so, we didn’t mention this, but I host the FS podcast, so I’m gonna ask you a question now. It’s the only one, I promise. But, you know, does the world today look the same as it did in the 1970s?

Andy: No, goodness, no.

Kara: Yeah, it doesn’t even really look the same as it did two years ago before…three years ago before the pandemic, right? So, really, these NextGen real assets are the companies that we think are gonna play a critical role in building, expanding, and maintaining that global digital and social infrastructure required to build, power and protect our nations and our economies in the future. So, if it’s helpful, I could walk through examples…

Andy: Yeah, no, I…

Kara: …to kinda bring this to life a little bit.

Andy: Well, two things. Well, one is I wanna plug your…it’s called “FS FireSide”, is that right?

Kara: It is. It’s called “FireSide”. Yes.

Andy: Yeah. And it’s really good content, so…

Kara: Thank you.

Andy: You know, if you’re listening…any listeners who are on iTunes right now, go into the search bar and search for that right now because I actually told Kara I don’t really care for most investing podcasts. I don’t listen to a lot of them. But it is a good one that I’ve listened to quite a bit. That was my first question. But my second question is with these, you know, NextGen real assets, would they not be, like, in my equities part of my portfolio, you know, like, with venture capital type, you know, or startups or [crosstalk 00:22:50]

Kara: Yeah, it’s not as startupy as I just made it sound.

Andy: Okay. All right. So, walk us through.

Kara: And we’ll get into that. I know it sounds a little like Cathie Wood, but it’s not, I promise. So, I think walking through some examples could be helpful.

Andy: Let’s do it.

Kara: So, I’ll use the same RICE acronym and I can do, like, a traditional and a NextGen equivalent because I think that’s kinda what helps solidify it for me. So, we talked about real-estate. So, if farmland was your traditional real…you know, your traditional in the 1970s or beyond, then, you know, now it’s data centers, it’s cold storage, it’s life sciences labs. I’m thinking about, you know, we just developed multiple effective COVID vaccines in record time. And so, life science labs, the demand is just going to continue to be there. It’s food safety, it’s all of that. Thinking about commodities. So, historically it’s wheat, livestock oil, natural gas. Think about the transition to renewable resources.

So, lithium, nickel, cobalt, the things that are used in batteries. It’s aluminum that’s used in solar panels. And then infrastructure. I think this is the one that has…I just went out of order. I apologize, but I get all excited. But so, infrastructure, so it’s your…we talked about it. It’s, like, airports, cell towers, all of that. Going forward, it’s 5G, it’s cloud computing, semiconductors, data security, it’s reliable broadband for so many, you know, rural parts of the country. And then what’s my last one? Energy. See, this is why I can’t go out of order.

So, this is, again, it’s the solar, wind power, you know, all renewable resources, electric vehicles, all of that. So, there’s kind of a traditional and then a NextGen counterpart, I guess, for all of our categories. And really these are a result of…we’ve talked about…I keep saying structural and secular tailwinds, but they’re really the result of these, you know, decades-long trends that I believe were really accelerated by the onset of the COVID pandemic and to a degree, the Russian invasion of Ukraine. So, we were trending towards, you know, more reliable broadband access for all or 5G, and then all of a sudden, we’re all at our homes and we need to be online 24/7. Right? So, and then things like…we talked about the energy ecosystem already. So, really all of these long-term trends kind of came to a head in the last couple of years, and in our view, really necessitated a, not a reexamination, but more of an expansion of the definition of real assets.

Andy: That’s really interesting. So, I’m thinking of, like, Amazon. Like, you mentioned the COVID lockdowns and all that, but, like, AWS cloud computing, like, that’s a huge infrastructure thing, all their logistics. But then I’m thinking, well, I own VTI, right. I own my Vanguard Total Equities fund, but what are the inputs, you know, the raw materials, the commodities that an Amazon needs to run to expand in 2023? Or same thing with Tesla, electric cars. You mentioned lithium. So, it’s maybe just a, like you said, a broadening, you know, beyond wheat.

Kara: Exactly.

Andy: Wheat and cattle.

Kara: Exactly. Yeah. Yeah, yeah. I think that’s exactly right. I actually think electric vehicles are kinda the perfect microcosm for thinking about NextGen real assets because it’s…you know, you could…if you’re thinking about it from an investment case, right? You could buy an electric vehicle, the stock of an electric vehicle maker, but you could also buy the commodities used in the solar panels, you could buy…or the batteries. You could buy…you know, there’s the entire charging infrastructure that needs to get built out. So, there’s really all of these knock-on effects from this one kind of industry. And all of it is going to require massive, massive investment and capital.

Andy: Yeah, absolutely. So, man, there’s so much to unpack there. So, one thing I wanted to ask about in reference to energy. This is something that I’ve been thinking about a lot. So, I’ve seen surveys among RIAs and wealth managers even. It’s roughly 50-50, I think, where about half of wealth managers find that ESG has become a sort of a political term, not just a pure investing term. And I know a lot of institutional investors and even publicly traded corporations, they’re now allocating capital to energy projects that are, you know, ESG friendly, meaning that there’s a, you know, relatively lower amount of capital flowing into the, just the old school, like oil and gas deals in the United States, for instance, which could be an opportunity for private capital, for family offices, for, you know, very high net worth accredited investors to potentially have outsized returns because it’s an area of the commodities market in the real assets market where a lot of institutionals are just shying away from. So, I view that as a potential opportunity right now. What are your thoughts?

Kara: Yeah, I mean, I think it’s a good question. I think that, you know, I guess the way that I view the space and view this is that, you know, you are talking about the opportunity in a traditional real asset that is almost created by the shift towards the Next Generation real asset. So, we still need the traditional, right. The combination of the two is what I think is really the important part of building a good portfolio. So, yeah, you know, maybe that is a good opportunity for some of the, you know…that private capital and probably there’s some sort of liquidity premium available there if you are going private. But we really view the combination between…because we still need to drive our cars. We still need to drive on bridges. You know, I still go to an office building. So, there are still the need for really those traditional assets, but it’s combining them with the NextGen that allows us…we think unlocks the full opportunity set. And also, what we haven’t touched on yet is allows us to build more of a full cycle real asset solution, more durable.

Andy: Interesting. Interesting. Yeah, that makes a lot of sense. I mean, the combination of the two…because even if you think of the electric car, you know, the Tesla, how much hydrocarbon energy, how much oil is used to even produce a Tesla or an electric car, right…I mean, almost every part of our life is touched by hydrocarbons, you know, they’re used at some point in the supply chain. So, you really look at this like it’s almost…it’s its own portfolio. The real asset slice, and it’s not an either-or, it’s both.

Kara: No. It’s a both-and.

Andy: Okay. So, then let’s talk about that. So, and actually, I have a pre-question to the question. So, the eventual question I wanna talk about constructing that real asset portfolio, but the precursor question is what slice of an investor portfolio really should that be? Because I feel like, you know, maybe 10 years ago that would’ve been a 10% slice, maybe a 5% slice. A larger slice for institutionals. But for a lot of very high net worth investors, a lot of families, they weren’t really allocating that significant of a part there. So, it’s, like, if it’s only 10% real-estate, maybe a little bit in precious metals, oil and gas, it doesn’t matter. Are we really talking about a larger allocation within that portfolio, to begin with?

Kara: Yeah, I mean, I think it’s so hard to put a number on portfolios that I haven’t seen. But I do think that…yeah, I mean, I think this deserves a… given the challenges that I outlined at the front, you know, just in constructing well-diversified portfolios, I think alternatives in general deserve a much larger slice of the allocation right now. And then within that, given that we’re still in this really elevated inflation environment, yeah, I think real assets need to be a decent chunk of that. I don’t think that 60-40 math adds up anywhere, right. Maybe it’s 50-30-20, it depends. But yeah, I certainly think that this is a space we really need to be allocating to.

Andy: Got it. So, everyone should be in an exactly 50-30-20 portfolio? I hear you…?

Kara: That’s it. Yeah. I just solved the…I told you I’m a good allocator, remember? The great moderation made me feel like I’m really good at this. No. No, it’s impossible to just put numbers on, obviously, a broad swathe, but I think we just…we truly believe that these need to be…I think more importantly than a number, I guess, I’ll say is that these need to be strategic holdings. These are not…you’re not timing this, these are not tactical. Yes, real assets are important because we are battling that elevated inflation, but we do view this as a strategic allocation and we’ll talk about when we get into the well-constructed portfolio about why that can be true and why you should hold these throughout a cycle.

Andy: Well, that’s interesting that you mention it’s not, you know…you don’t recommend it as a tactical piece of a portfolio because a lot of institutionals are overweight alternatives right now, because if they were 50-30-20 or 50-25-25, you know, going into 12 months ago, and then now they’ve marked down pretty significant losses on the equities and on the bond side and the…whereas the real asset side of the portfolio is probably holding up better. So, it’s interesting that a lot of institutionals are probably in a position right now where they’re overweight, but nevertheless, retail investors as a whole are wildly underweight, this asset class.

Kara: Yeah. Well, I think they’re especially underweight real assets because we have not…so we have viewed them as a strategic part of a portfolio for a number of years, even before this inflationary cycle. I think obviously they are kind of in vogue right now because of…they’re getting attention now because of this inflationary cycle. But investors have not really paid attention to them since the 70s because they thought they didn’t need to. Right? Because we have not faced inflation like this.

And I also think a little bit the notion that for the first year that we…or first…call it during 2021 when we talked about inflation, we called it transitory, right? Like, I don’t think a lot of people were really adjusting their portfolios in the way that they needed to. And again, I’m talking like it’s a tactical trade. I’m just thinking about what we actually hear from advisors and investors and what they’re doing. I don’t think a lot of people were really reexamining their portfolios probably in the way that we believe you needed to during that time, because we had this idea that, “Oh, inflation’s, transitory. The Fed’s not gonna have to hike and cause all this massive volatility.” But as we’ve talked about, you know, we think this is the environment we’re gonna be in for the foreseeable future.

Andy: And it’s not too late, right? I mean, it’s…

Kara: No, definitely not. No. Never too late.

Andy: So, we’re not talking about any individual’s portfolio, but let’s say we’re talking about a generic 50-30-20 portfolio. I think that, honestly, I think, that is a great starting point for, like, a family office. So, talk about the 20. What does a well-constructed real asset allocation look like?

Kara: Yeah. It’s exactly as I’ve kind of outlined. It’s really…it’s the combination of a blend of these traditional real assets and these NextGen real assets, and really importantly…so it’s twofold. It’s that, and then importantly, it’s the ability to be very active, very flexible, and very tactical within that portfolio. You know, the allocation as a whole is more strategic, but markets are moving faster than ever. We’re all experiencing that every single day. So, the ability to be really active in that sleeve is extremely important. So, I think thinking about a full cycle, you know, real assets when they’re working can offer phenomenal return potential. I think anyone who…they’re very cyclically tied to the economy, right. So, in times like ’08 in the global financial crisis, anyone investing in real assets was probably in just traditional real assets, I should clarify.

They know how hard that can be because they’re so cyclically oriented. You can really get burned. So, that is why we think you really need to pair the traditional with the NextGen that has more of that secular growth component. And we didn’t even talk about the…there’s so much we could get into, but we…the tailwinds behind these NextGen real assets, right. There’s the social tailwinds that we talked about with ESG investing. There’s the government tailwinds, you know, the pledges to decarbonize, the political tailwinds, the trade wars with China. All of these are tailwinds to the necessity for these NextGen real assets. And quite frankly, you don’t have to…we talked about…you mentioned ESG being kind of a political topic right now. You don’t even really have to believe in ESG as a concept. You can or you cannot, it doesn’t really matter. But at the end of the day, government…you know, there are mandates for decarbonization, right. And so, if you’re…

Andy: Yeah, I’m not gonna bet against the government plowing billions of dollars into it, for sure.

Kara: Yeah. And so, it’s, like, if you’re able to be, you know, on the receiving end or one of the companies that has to supply those services that they’re going to be mandated to supply, I think that’s a pretty good place to be. So, whether or not you fundamentally believe that ESG is political, or believe that we are going to decarbonize by the dates that, you know, we’re mandated to, there’s still massive opportunity and massive capital that’s going to flow to those providers. And that’s, you know…being there, you can still benefit. So, a lot of tailwinds in place. And so really, you know, if you think about…I’m just thinking about a cycle, right. So, early cycle…and this is not a hard and fast rule, but early cycle, maybe you’re kind of overweight commodities, equity, underweight fixed income, like, treasure tips or something. And then, you know, as you advance in a cycle, you’re kinda toggling or you’re toggling commodities down a bit. I don’t think you’re gonna completely sell out of them, but maybe you’re toggling some of those NextGen, right. And so later in the cycle, you’re going into more of those secular growth stories. And then fixed income, you know, the tips maybe get overweight. So, there’s really a way that…in our view, it’s combining, as I said, the traditional, the NextGen to build this full-cycle solution.

Andy: I really like that. One part of that that I struggle with, I guess, is staying tactical, though, in the sense that a lot of alternative investments are either very illiquid or at least somewhat illiquid. You know, now there’s a spectrum, right. So, you have some alternative investments. Like, let’s say a qualified opportunity fund. The whole period is 10 years, right. It’s basically you write your check and you’re holding it for 10 years. So, there’s, I think there’s some pieces of the portfolio that it’s hard to adjust. You know, maybe you could kind of time when you’re investing, you know, into it. Do you have any comments on that? Like, how does one stay tactical when there are pieces that are illiquid?

Kara: Yeah, I mean, I think it’s very, very, very important to match your structure with your strategy and your underlying assets, right. So, I’m thinking take just a daily liquid mutual fund, real asset fund. They exist. You can access the equity of some of these real asset providers. And we have data on this. It’s the sectors, there are sectors that can grow their revenue. They have the high beta to inflation, these certain sectors. So, it’s those real asset sectors. It’s industrials, utilities, energy, real-estate. So, you can access…you can get exposure to real asset-linked companies in a daily liquid form. The challenge though is that those sectors, at the index level, at the S&P 500 level, they only make up 20% of the index. So, that is what I mean by being really active and tactical, is that, you know, there are earnings to be had, and there are places that you can go to get exposure to these companies that are poised to benefit from inflation. It’s just that you can’t do it at the index level. So, you really…that is what I mean by being really active and tactical.

Andy: Got it. I mean, it’s an opportunity for alpha, right? I think so many investors just gave up on alpha and quite frankly, for good reason, right? I mean, there were a lot of active managers that were not adding value in the fixed-income space and in the equity space. But to your point, you know, active management does pay off in the alternative space.

Kara: Absolutely. Yes, 100%.

Andy: So, do you see there being a trend in alternatives towards increased liquidity as time goes on? Like, in other words, some of the more popular wrappers or product types that are more liquid, do you see them kind of gaining steam as more folks invest and want that liquidity?

Kara: Yeah, I mean, I think it’s important to have a range of liquidity options, right. And again, matching your underlying assets to that structure. I do think that there’s the evolution of the space. You’re able to offer that daily liquidity. There are products that fit nicely inside that mutual fund wrapper, excuse me. But they’re all…I think there’s also a place in the portfolio for more of your illiquid. I just think that there’s, you know…your alternatives portfolio, maybe a lot of people only invested in one or two alternatives historically, but they’re going to need to invest in more, and you’re gonna diversify within your alternatives bucket. So, maybe that’s some daily liquid, some more illiquid. So, I just think that there’s certainly opportunity for really liquid…you know, investments that span the liquidity spectrum.

Andy: So, let’s zoom out for a minute. Given what you said about just that larger allocation to real assets, to the point where there’s enough of an allocation that, you know, investors can diversify within that allocation, what do you see being the tailwinds for alternatives in the, let’s say, the next decade or two? I mean, obviously, in the past few decades, it was institutions, you know. We had the Ivy portfolio and all these pension funds and institutions who…very interested in alternatives, deploying increased amounts of capital into alternatives. And now it’s, you know, in theory, at least, the retail investor is finally gonna enter that market in a big way. Do you think that’s gonna play out as planned? I mean, I forget the actual stat. It’s something, like, 4% or 5% is what the retail investor has allocated. Do you think that level is really going to grow to match what institutional investors have in real assets?

Kara: I do. Yeah, yeah. I mean, I do. I think really what FS was designed to do is to democratize alternatives, to really bring alternative investments to the retail investor. And I think that in a lot of ways the market has come to us. We’ve talked about that, the need for alternatives now. And, you know, while that great beta trade was playing out and you were fine in your traditional investments, there’s been so much evolution in the space that’s really, you know…we have these structures that retail investors are able to access that fit really nicely in a diversified portfolio. I think it’s going to continue. It’s gonna require education, right. These are complex, nuanced topics. So, I think, you know, your podcast is a fantastic example of, you know, education in the space, and we try to provide a lot of that as well. So, I think that, yeah, I mean, I think retail investors need alternatives and alternatives exist. So, I think it’s really…it’s gonna take education. It’ll take some time for adoption, but really yes, you know, the time for alternatives is now.

Andy: You’ve mentioned the wrappers there. Could I put you on the spot? Are there any wrappers that you think are really poised to outperform that offer just intrinsically more value to that, you know, RIA retail segment of the market?

Kara: Yeah, sure. I mean, I think that, you know, the…if you are willing to give up some liquidity, there are semi-liquid products that exist right now. So, take an interval fund, for example. Relatively new-ish in the grand scheme of investing. So, you’re getting quarterly liquidity, which, you know, is still a relative degree of liquidity, right. You’re not locking up your assets for years or, you know, decades. So, I think that allows you…I think what that does is it really takes a lot of the emotion out of it. I think it’s really easy to, when markets are tanking like they are these days, it’s really easy to look at your statement and say, “I don’t want that anymore.” Right? So, I think it’s really managing that emotional component. And I think that if you’re willing to give up a little bit of liquidity and, you know, give the manager that capital to manage through the cycle and not be forced to sell, I think that’s a really interesting structure. But again, I think that there’s really a need for a range of liquidity within portfolios.

Andy: I like it. Yeah. You know, so there’s really something for every investor if you really…

Kara: Absolutely.

Andy: And I mean, I would say, you know, a lot of people don’t need the liquidity. They think they do but…

Kara: They think they do. Exactly right. Yeah.

Andy: And as you point out, it can hurt you. I mean, the behavioral risk that liquidity sort of…what’s the word? Sort of incentivizes almost bad behavior, I think.

Kara: Yeah, absolutely.

Andy: Manic Mr. Market repricing your portfolio every single day. Well, Kara, you’ve given me a ton to chew on here. I can’t thank you enough for just all these insights about real assets and portfolio construction. I wanna plug your podcast one more time. I’ll be sure to link to it on our show notes page. But if you’re listening on Spotify or on iTunes right now, just search “FireSide”. Is that right?

Kara: “FireSide”. Yep. “FS FireSide”, it’ll come up. Yeah.

Andy: It’ll pop up. But where else, Kara, where else can our viewers and listeners go to learn more about FS Investments and your research?

Kara: Yeah, and then in the insights tab, all of our research is there. I have a page. So, all of my stuff is there, and you can sign up for all of that on our website and obviously subscribe to our podcast wherever you get your podcasts.

Andy: Awesome. So, for our listeners and viewers, I’ll be sure to link to all those resources in our show notes that you can always access at Kara, thanks so much for coming on the show today.

Kara: Thanks, Andy. It was a pleasure.

Andy Hagans
Andy Hagans

Andy Hagans is co-founder and CEO at AltsDb, and host of The Alternative Investment Podcast. He resides in Michigan.