Thursday, September 10, 2015

Picking Correct Hard Asset Benchmarks

Hard assets deserve more attention than they get. Commodities, real estate, and perhaps even infrastructure are often lumped together into a very broad asset class. Picking them apart into sensible components requires identifying benchmarks for apples-to-apples comparisons.

Commodities are a very broad subject. Base metals, precious metals, energy sources, foodstuffs, and other materials have radically different uses. The Bloomberg Commodity Index Family is both broad enough and specialized enough to track the sector. The Commodity Research Bureau Indexes represent a less flexible allocation but is nevertheless included in other commercial index products. Picking a broad proxy like the CRB matters for fund managers who run portfolios large enough to include all of the benchmarks components. A fund managing that only hedges with energy futures or metal futures needs more specialized benchmarks tracking just that one thing.

Timberland and farmland are not the same thing in real estate. The end products, final markets, and supply chain inputs (fertilizer, climatology, etc.) are all different. Comparing timber REITs and farmland REITs means using their separate benchmarks. The real estate sector makes it easy. The NCREIF Timberland Index and NCREIF Farmland Index are as different from each other as corn stalks and black walnut trees.

Infrastructure may or may not deserve consideration as a separate asset class. It shares many risk characteristics with equity yet is often funded like a fixed income fund. The problem with benchmarks like the S+P Global Infrastructure Index is their tendency to track actively traded equities that build or maintain infrastructure. It is difficult for infrastructure-related investment products to make pure-play claims if they cannot hold ownership in the infrastructure projects themselves. Muni bond issuance remains the primary funding method for publicly-owned infrastructure. It makes no sense for an investment manager to benchmark a muni bond portfolio against an equity infrastructure index.

Institutional investment managers are often the dumbest people in finance, aside from financial advisers in retail wealth management. They led the charge into alternative assets decades ago with the Swensen Yale model. Some of them probably rode the recent commodities bear market all the way down. Herd mentalities drive smaller endowments and pension funds to mimic the poor portfolio models of the largest universities. Many things can go wrong with an asset allocation leaning heavily on illiquid hard assets. Doing right by any fund's beneficiaries involves picking the correct benchmarks and understanding which hard assets they track.