Real Assets

Navigating the Muddy Waters of Real Assets Benchmarking

June 18, 2019

In the world of private real assets, benchmarking represents a particularly challenging and complex task, as compared to traditional assets. Within certain areas of private real assets benchmarking is better defined, with industry-accepted indices and methodologies. Elsewhere, the industry is attempting to play catch-up as new investment options become available and plan sponsors evolve their portfolio structures and objectives. Parsing through all the nuances inherent in private real assets benchmarking would require exceeding the word count that we’ve allotted ourselves for this article – or, let’s be honest, that most people would be interested in reading. Still, these are crucial concepts to investing successfully in private real assets, so we have endeavored to relay a number of core principles that we believe are most relevant for institutional investors today.

When benchmarking private real asset portfolios, there are three primary elements that can influence returns: asset allocation, investment selection and market timing. Additionally, returns can be evaluated at three levels: the overall real assets portfolio level, by each real asset sub-sector (e.g., real estate, infrastructure, natural resources) and, finally, at the individual fund level (e.g., Manager A, Manager B). At each level, we place varying degrees of emphasis on the evaluation of the elements of return; therefore, the index by which we measure may differ by level.

But let’s not get too far ahead of ourselves. After all, before we unpack each of these levels, it’s important first to define the objectives of most real asset investors. Typically, investors commit capital to real assets to achieve some combination of the following: (i) portfolio diversification due to low levels of correlation with traditional asset classes, (ii) inflation hedging, (iii) potential compelling total returns, and (iv) yield. Unlike some alternative asset classes, most investors do not invest in real assets simply to achieve outperformance over the public markets.

Further, developing a diversified real assets portfolio requires careful attention to portfolio construction. You cannot simply invest in a single fund and be diversified across sub-sector and region, much less across risk type, vintage year and/or deal size. Building this framework requires identifying the appropriate market betas that, in aggregate, align with the overall portfolio objectives, followed by selecting the best-fit index. The final step involves identifying the individual fund investments that are capable of adding alpha within their specific betas.

There are four main types of benchmarks, each suited to a particular portfolio configuration:

  1. Private Market Indices (e.g., NCREIF Property Index)
    • Best for evaluating diversified portfolios
  2. Private Market Peer Group Indices (e.g., Cobalt)
    • Best for evaluating individual fund performance
  3. Economic Indicators (e.g., Consumer Price Index)
    • Best for evaluating diversified portfolios
  4. Public Market Indices (e.g., DJ Brookfield Global Infrastructure Index)
    • Best for evaluating diversified portfolios only if public market outperformance is an objective

At the overall real assets portfolio level, the primary goal of benchmarking is to evaluate your asset allocation decisions and underlying fund selections to determine whether they are achieving the top-line goals of the portfolio. At this level, market timing is only of minor consideration for most large institutional investors. And, just as no single fund is capable of gaining full diversification across real assets, neither is there one single index that fully captures the asset class.

Ultimately, the best index to utilize at the portfolio level is the one that aligns most closely with the overarching goal of the portfolio. If the goal is simply to outpace inflation, perhaps the Consumer Price Index is the right choice. If the goal instead is to try to generate total return and diversify away from traditional assets, then a private market index is likely most appropriate, or a hybrid index combining several private market indices. If the goal is to generate yield, the better comparison may be a fixed income index. Unless the goal is to outperform the public markets, a public market index is rarely the best or most relevant option for benchmarking private real assets.

Another factor to keep in mind when selecting a benchmark index ties back to the asset allocation decisions that originally prompted a commitment to real assets. Most institutional investors utilize a form of Modern Portfolio Theory that seeks to develop optimal portfolios using a model-based approach. These models typically rely on a set of assumptions for each asset class, and often those assumptions are based upon a reference index for that specific asset class. For purposes of continuity, it’s important to keep the reference index in mind as you select an overall real assets index, as the defining characteristics of the index that were on exhibit during the portfolio construction process are generally those desired to be present in the ensuing portfolio.

At the real asset sub-sector level, the goals are much the same as those of the overall real asset portfolio level where the focus is on asset allocation and investment selection. In this case, although index selection is often much more targeted, it is more intuitive, since sub-sector-specific index options exist. Most investors will select a private market index for evaluating performance at this level, though broad private peer group indices can be a useful option particularly in areas where private market indices are not available.

Finally, it comes down to evaluating performance at the individual fund level. At this level, we’re looking at performance relative to beta, but primarily we want to understand whether these individual investments have generated alpha. Given that most investments are far more nuanced at the individual fund level, it seems most practical to evaluate performance relative to peers using an appropriate private market peer group index. Peer groups are typically defined by a combination of factors including vintage year, geography and sub-sector; sometimes additional factors are taken into consideration. In this scenario, our goal is to understand whether a specific fund has generated top-quartile performance.

We often are asked whether a set return premium (e.g., +300 bps) should be added to private market indexes for benchmarking private real assets, particularly when the strategy being pursued by a client has a higher return and risk profile than the index. This approach is common across traditional private equity, as the premium over a public market index most often is intended to represent the return premium required for the lack of liquidity in the space and can reflect the long-term outperformance of the asset class relative to public markets. However, and as we mentioned, it’s more the exception than the rule that investors are committing to private real assets simply to outperform the public markets. While this potential outcome is appreciated, it’s often farther down the list of reasons for investing in private real assets. Instead, the logic often offered for using a premium over private real asset indices is to account for leverage or strategy differences between the index and the expected portfolio. While this attempt sounds attractive in principle, we believe it is difficult to objectively determine what static level of return premium is best for capturing a dynamic portfolio - is it +300 bps, +500 bps or more? Because of the lack of objective support, we often find investors circling around years later to analyze relative performance; if underperformance occurs, those investors may very well have difficulty determining whether that is due to true underperformance or poor index composition. Thus, we typically avoid the use of set return premiums because of their seemingly arbitrary application and questionable subsequent analysis takeaways. This is one area where the available options of benchmarking private real assets simply fall short.

Investors looking to benchmark a private real assets portfolio need to first identify their portfolio goals and objectives, and then determine what elements of performance are most relevant for measurement at the overall portfolio, sub-sector and individual fund levels. Finally, investors should focus on selecting specific benchmarks that are best geared to analyze those performance elements.

This presentation has been prepared solely for informational purposes and contains confidential and proprietary information, the disclosure of which could be harmful to Hamilton Lane. Accordingly, the recipients of this presentation are requested to maintain the confidentiality of the information contained herein. This presentation may not be copied or distributed, in whole or in part, without the prior written consent of Hamilton Lane. 

The information contained in this presentation may include forward-looking statements regarding returns, performance, opinions, the fund presented or its portfolio companies, or other events contained herein. Forward-looking statements include a number of risks, uncertainties and other factors beyond our control, or the control of the fund or the portfolio companies, which may result in material differences in actual results, performance or other expectations. The opinions, estimates and analyses reflect our current judgment, which may change in the future. 

All opinions, estimates and forecasts of future performance or other events contained herein are based on information available to Hamilton Lane as of the date of this presentation and are subject to change. Past performance of the investments described herein is not indicative of future results. In addition, nothing contained herein shall be deemed to be a prediction of future performance. The information included in this presentation has not been reviewed or audited by independent public accountants. Certain information included herein has been obtained from sources that Hamilton Lane believes to be reliable, but the accuracy of such information cannot be guaranteed. 

This presentation is not an offer to sell, or a solicitation of any offer to buy, any security or to enter into any agreement with Hamilton Lane or any of its affiliates. Any such offering will be made only at your request. We do not intend that any public offering will be made by us at any time with respect to any potential transaction discussed in this presentation. Any offering or potential transaction will be made pursuant to separate documentation negotiated between us, which will supersede entirely the information contained herein. 

Certain of the performance results included herein do not reflect the deduction of any applicable advisory or management fees, since it is not possible to allocate such fees accurately in a vintage year presentation or in a composite measured at different points in time. A client’s rate of return will be reduced by any applicable advisory or management fees, carried interest and any expenses incurred. Hamilton Lane’s fees are described in Part 2 of our Form ADV, a copy of which is available upon request. 

The following hypothetical example illustrates the effect of fees on earned returns for both separate accounts and fund-of-funds investment vehicles. The example is solely for illustration purposes and is not intended as a guarantee or prediction of the actual returns that would be earned by similar investment vehicles having comparable features. The example is as follows: The hypothetical separate account or fund-of-funds consisted of $100 million in commitments with a fee structure of 1.0% on committed capital during the first four years of the term of the investment and then declining by 10% per year thereafter for the 12-year life of the account. The commitments were made during the first three years in relatively equal increments and the assumption of returns was based on cash flow assumptions derived from a historical database of actual private equity cash flows. Hamilton Lane modeled the impact of fees on four different return streams over a 12- year time period. In these examples, the effect of the fees reduced returns by approximately 2%. This does not include performance fees, since the performance of the account would determine the effect such fees would have on returns. Expenses also vary based on the particular investment vehicle and, therefore, were not included in this hypothetical example. Both performance fees and expenses would further decrease the return. 

Hamilton Lane (UK) Limited is a wholly-owned subsidiary of Hamilton Lane Advisors, L.L.C. Hamilton Lane (UK) Limited is authorized and regulated by the Financial Conducts Authority. In the UK this communication is directed solely at persons who would be classified as a professional client or eligible counterparty under the FCA Handbook of Rules and Guidance. Its contents are not directed at, may not be suitable for and should not be relied upon by retail clients. 

Hamilton Lane Advisors, L.L.C. is exempt from the requirement to hold an Australian financial services licence under the Corporations Act 2001 in respect of the financial services by operation of ASIC Class Order 03/1100: U.S. SEC regulated financial service providers. Hamilton Lane Advisors, L.L.C. is regulated by the SEC under U.S. laws, which differ from Australian laws. 

Any tables, graphs or charts relating to past performance included in this presentation are intended only to illustrate the performance of the indices, composites, specific accounts or funds referred to for the historical periods shown. Such tables, graphs and charts are not intended to predict future performance and should not be used as the basis for an investment decision. 

The information herein is not intended to provide, and should not be relied upon for, accounting, legal or tax advice, or investment recommendations. You should consult your accounting, legal, tax or other advisors about the matters discussed herein. 

The calculations contained in this document are made by Hamilton Lane based on information provided by the general partner (e.g. cash flows and valuations), and have not been prepared, reviewed or approved by the general partners. 

As of June 18, 2020

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