The diversification and inflation protection offered by real assets make them a valuable component of broader portfolios. Paradigm shifts within real asset industries also create new opportunities for investors. In a Q&A, Massif Capital portfolio managers explain the benefits of real assets, the role real asset industries will play in the transition to a low-carbon economy, and the ways a long-short strategy can capitalize on the shakeout from this transition.
Q2 2020 hedge fund letters, conferences and more
The Q&A addresses important concepts around:
- Why the current market environment calls for inclusion of real assets in portfolios
- The vital role currently carbon intensive real asset industries play in society’s low carbon transition
- Why exclusionary ESG strategies may actually slow the low carbon transition, not enable it
- Other key aspects of Massif Capital’s unique approach to the real assets universe
Q. Why do investors need an allocation to real assets in their portfolios?
Real assets provide investors with a desirable blend of capital appreciation, inflation protection, and diversification. Real asset cash flows are the backbone of the global economy and can offer benefits in periods of economic contraction and expansion. End-use demand drivers for essential industrial goods and commodities are often inelastic, providing opportunities for productive investment in periods of economic contraction. During periods of economic expansion and inflation, real assets produce a “real” return that preserves the purchasing power of investors’ capital.
Today, we see several growth drivers for real assets. The push toward carbon neutrality is creating sustained demand for renewable assets. The transition will also require significant investment in the physical infrastructure of heavy industry and the development of new approaches to old industrial processes, many of which have not changed meaningfully in more than a century. A wide range of critical metals such as lithium, nickel, and copper will experience significant demand growth as larger parts of the economy electrify. Combined with the limited exploration budgets and a lack of investment in new mines over the last decade, the potential for a multiyear supply crunch of various metals is meaningful. Much of the developed world’s infrastructure is approaching the end of its useful life and will require replacement over the coming decade, while much of the developed world is still in need of infrastructure build-out.
Q. Explain your real assets investing universe?
Our investable universe includes companies in the energy, materials and industrial sectors. A difference between our strategy and some real assets strategies is that we don’t invest in real estate, directly in commodities or instruments such as TIPS.
These industries represent a pocket of the market in which we have significant expertise, and which are undergoing a significant evolution as governments attempt to address climate change. Investing with an eye toward those changes is a way we believe we can add considerable value.
Q. Why is the real assets space best approached with a long/short strategy, and what are some of the key criteria that determine which companies you short?
Investing in public companies through a long/short strategy allows us to limit market exposure and maximize exposure to company specific variables. We view this as a real value add given the inherent cyclicality in commodity-oriented businesses. Furthermore, given the extensive real asset exposure that many institutions and investors have via private equity, the ability to counterbalance the long exposure with the short exposure is unique for most portfolios.
A long/short strategy also allows us to fully express our views on a paradigm shift transforming real asset industries. Governments’ urgency to address climate risk means dramatic changes for real asset businesses, which are the world’s largest polluters, but also essential to the global economy. We view an economically feasible path toward carbon neutrality as the North Star for our evaluation of real asset business models. Sustainability cannot be considered just an environmental issue; businesses must be sustainable before they can compound. Understanding the path forward for a business in the context of a transition to a low carbon economy is essential to maximizing returns while limiting drawdowns.
Some incumbent companies are acting quickly, becoming first movers to innovate and lower their carbon footprint. Others are making only incremental changes, and others are stubbornly refusing to evolve. At the other end of the spectrum, some new “green” business models will prove successful, while other companies will look to take advantage of the appetite for green investing with a business model that might be environmentally sustainable but is not economically sustainable. Many of the economically unsustainable businesses do not work without constant access to capital markets, a significant issue that will result in the permanent loss of capital for investors in many of the newly popular but less nuanced ESG strategies. A long/short strategy is a good avenue to fully invest with an eye toward winners and losers during this critical transition.
Q. You mentioned that real asset companies are large polluters, but also essential to the global economy. Explain their role in the transition to a low carbon world.
Real asset businesses have the most critical role to play in the energy transition. The industries we follow are currently responsible for 70% to 80% of U.S. carbon emissions. Yet they are also a critical cog in the supply chains of nearly all other industries, whether one is looking at renewable energy technologies or cloud computing.
For example, businesses can’t produce wind turbines without an abundance of steel. To electrify the transportation industry, we’ll need a significant number of energy storage devices for the power grid and for vehicles. Those batteries require a lot of lithium, copper, nickel and cobalt. Those supplies all come from the mining industry. The notion that we’re going to scale up the nickel supply by 10 times its current level to meet demand for storage systems without decarbonizing mining operations is an incomplete thought process toward decarbonization.
Q. An ESG strategy would typically screen out and avoid stocks in a carbon intensive industry such as mining. What does that mean for these businesses, and ultimately, a carbon neutral transition?
Unfortunately, this is where the intentions of ESG investors and the outcome of ESG strategies are misaligned. Every investor is different, but one would assume most ESG investors want to enable the carbon neutral transition. The average ESG strategy doesn’t invest in a way that will affect that type of meaningful change.
Most ESG strategies invest in companies with a low carbon footprint, for example a technology company, but avoid companies in the energy, industrial and materials sectors. This divestment strategy is counterproductive to enabling a feasible carbon neutral transition. If real asset companies don’t have access to capital it will create price spikes or deprive them of the ability to invest in technologies and processes that are essential to reducing emissions.
We believe a better way for investors to bring about change is to invest thoughtfully in real asset industries, providing capital to those businesses that are forward thinking about reducing emissions and shorting the ones that are not.
Q. Why are real assets a good market for active management?
The sectors tied to real assets have been underinvested for many years. With fewer investors following the industries it has translated into more mispriced opportunities. The nature of addressing climate risk also makes the environment fertile for active management. Government policy around carbon neutrality is still undetermined in most countries. This has left management teams to chart their own course to emission reduction. We see widely divergent strategies among companies – even in the same industry – which will lead to substantially different outcomes over the next decade.
Q. What are some of the unique risk controls you employ for the strategy?
By their very nature, long/short strategies limit market exposure. The short positions within the fund offset long positions and this has historically lowered drawdown during a market downturn. We also invest in S&P 500 options to hedge against tail risk. We don’t make the hedging strategy overly complex – we simply buy put options 30% out of the money 90 days from expiration. Over time, this hedge has been quite effective. It produced a portfolio return greater than 10% during the recent market downturn but has never been more than a 2% drag on total performance.
Q. How might a strategy investing in public real asset companies be an alternative or complement to a private equity strategy investing in the space?
Private equity has become an increasingly institutionalized strategy, out of reach for individual investors, RIAs and even smaller institutions. We can provide that same exposure to real asset industries, but without the 10-year lock up.
From a pure valuation perspective, the current environment may be more favorable for public market exposure. A lot of capital has flowed into the private equity real asset space, leading to inflation in what firms pay for real assets. But in public markets, mining and energy stocks trade at historically low valuations relative to the broader market.
