What benefits can global infrastructure can provide an investment portfolio?
Infrastructure investing is increasingly popular within retirement savings plans and it’s easy to understand why. An allocation to infrastructure can potentially deliver lower volatility and a higher dividend yield than global equities, and a diversifying addition to a multi-asset class portfolio.
In this article Ganesh Suntharam, CIO and Senior Portfolio Manager with GSFM’s newest investment partner Redpoint Investment Management, discusses the benefits global infrastructure can provide an investment portfolio.
From the roads of Rome in the west to the Silk Roads of the east, society has always recognised the importance of good infrastructure in sustaining a strong and well-functioning economy. The types of infrastructure required by modern day society has expanded from its origins of a broad road network, but the importance of these assets to society has not lessened.
Australia has played an important global role over the last 20 years in helping transform infrastructure assets from sleepy utilities of the past to attractive long-term investment opportunities for the future. To this end, Australia has been at the forefront of financial innovation in this sector and the government alone is expected to commit over $100 billion over the coming decade to keep pace with population and economic growth.
Since the advent of specialist funds targeting infrastructure for investors, Australian policy makers, business leaders and superannuation investors have developed a greater understanding and acceptance of the direct role private investment can play in developing infrastructure, whether on a standalone basis or in partnership with government.
Traditionally, investing in infrastructure was seen as the domain of large corporate investors like superannuation funds as opposed to individual investors. For the large superannuation funds, buying a toll road as an example was a great way to preserve the purchasing power of their cash holdings in a changing interest rate environment. Although this still remains the case for unlisted infrastructure, the emergence of listed infrastructure assets has made the asset class more accessible for retail investors.
The benefits delivered by infrastructure are natural outcomes of investing in a globally diversified portfolio of companies who manage core infrastructure assets and deliver essential services. Across the global economy, these companies include water and electrical utilities, toll road and rail transport operators, and those that own gas pipeline, telephony and satellite networks.
Retirement investments are generally designed to generate steady income. Global Listed Infrastructure provides an asset class with the ability to integrate this requirement with a number of additional benefits. These include additional diversification potential, reduced inflationary impacts and potential long-term income growth. The characteristics of this asset class – less value volatility than equities in general and greater stability and consistency in dividend growth – lead us to believe that listed infrastructure has an important role to play in building a retirement portfolio.
Infrastructure – the building blocks of society
Infrastructure is considered to be a facility or service that is essential for an economy or society to function efficiently. Global listed infrastructure provides a large and growing investment opportunity as demand for new and replacement infrastructure increases and governments rely more heavily on the private sector to finance, build and operate them.
Infrastructure return characteristics are different to mainstream growth asset classes like shares and property in that the risks that they are exposed to, the factors that influence their revenues and the regulated nature of the assets tend to deliver more stable income returns over the business cycle.
The income generation of ‘user-pay’ infrastructure assets like toll roads, public transportation services and telecommunications projects is derived from the inherent demand for, reliance on, and use of the assets. In addition, the usage charges for services of many infrastructure assets are linked to the inflation rate.
This means the real value of these revenue streams are less affected if the economy slows and inflation rises.
The duration of infrastructure projects is often supported by long-term contracts or government regulation. This, in conjunction with stable demand, relative insensitivity to economic conditions and greater resilience to inflation, delivers a pattern of returns that is somewhat independent of other listed asset classes that aren’t driven by the same underlying characteristics. Consequently, while listed infrastructure securities do fluctuate in value from day to day, they can be a diversifying allocation in a multi-asset class portfolio.
Creating a portfolio with defensive characteristics using infrastructure is as much about picking suitable companies as it is about seeking a diversified mix of different infrastructure activities.
Capturing the essence of the asset class
For global and single country equity and listed property investments there are widely accepted benchmarks – often a single, dominant index; and where there are multiple choices the differences are minor. In contrast, the accepted definition of infrastructure assets in the listed space has varied through time and cross-sectionally; with index vendors and individual managers taking distinctly different approaches.
Our analysis of the ‘collective wisdom’ of active managers and index vendors identified a six-way breakdown of the asset class that explains most of the risk (and return) differences between the various indexes and managers (figure one). The six subgroups draw from a wide opportunity set – including stocks from non-traditional subsectors – and then focus on stocks with a significant majority of their revenues deriving from core infrastructure activities.
Redpoint’s research shows that specific subgroups of infrastructure activities (figure one) carry distinct risk characteristics While each sub-group has a lower beta (i.e. is considered more defensive) than listed global equities in general, they also exhibit different risk characteristics relative to each other. The different volatility outcomes delivered by most infrastructure strategies can be explained by the different exposures which they have to these six subgroups.
Figure two highlights these differences with listed Utility companies having lower volatility (and a lower beta) to global equities relative to subgroups of Transport and Networks. This analysis highlights that while Transport and Network subgroups have similar betas to global equities, the Network sub-groups are inherently riskier than Transportation. The volatilities shown in figure two are the residual volatilities of the subgroups after removing the common effect which is driven by their respective relationship with global equities in general.
Another dimension of risk is the correlation between subgroup returns, as reflected in figure three. In theory, the lower the correlation in figure three, the less similar the returns and the better the diversification benefits of combining the two subgroups should be. The negative correlation between energy networks and non-rail transport subgroups are particularly attractive.
As per the volatilities in figure two, correlations shown are between the residual returns of each sub group after removing the common effect which is driven by their relationship with global equities in general. This highlights that there are true diversification opportunities across the subgroups which are not simply driven by their respective relationship with global equities in general.
A well-diversified portfolio of infrastructure securities can take advantage of each subgroup’s global equity beta, volatility and correlation characteristics to attempt to deliver a strategy with lower volatility than more concentrated approaches – and this can be rewarded with less negative returns in periods of market stress.
Risk and return differences among active and passive managers can be explained by effective exposures to:
- a global equity beta – characterising the sensitivity of a given strategy to global equity market returns; and
- a set of six “infrastructure subgroup” betas.
The dominant driver of the global equity beta and total volatility outcomes of different manager and index strategies is predominantly explained by differing exposures to these six infrastructure subgroups.
During the Global Financial Crisis, many diversified Australian and global equity portfolios fell 50% or more in value. Compounding this fall in value, many companies, including global giants such as Toyota and the local banks, cut dividends in 2009 and 2010 in response to the market turmoil of 2008.
In contrast, typical, well-diversified listed infrastructure portfolios fell by a more muted 35%. However, for the buy and hold investor, the dollar-dividends from these portfolios were only marginally affected. Many infrastructure companies – such as Union Pacific Corp (a US rail company), Flughafen Zuerich AG (the operator of Zurich Airport) and APA Group (an Australian gas pipeline owner) – delivered steadily rising dividends through the period.
Geographic and company diversification matter too
Ensuring that infrastructure portfolios are properly diversified at a subgroup level is just part of the story. Investors also need to ensure that they diversify their portfolios geographically. While there may be well run infrastructure companies in Australia, it arguably makes sense to consider companies in other countries that may simply be better investments. Furthermore, with a global perspective, investors can access companies operating in sectors not represented on the ASX, such as satellite owners and water utilities.
Another key consideration is that index strategies and typical active strategies generally deliver relatively concentrated portfolios. While popular global infrastructure benchmarks appear diversified with 75, 100 and more than 150 constituents, depending on the index, market-cap weighting often results in fewer than 20 stocks accounting for more than half of the relevant index’s weight in most cases.
Typical active strategies are generally concentrated by design, with most active managers holding far fewer stocks than any of the indices. As a result, both index and typical active strategies generally place a significant bet on the performance of just a few companies. Redpoint believes that diversifying across individual infrastructure companies to reduce this concentration risk delivers better outcomes in the long term.
Well-managed companies delivering core infrastructure services across the world are arguably well positioned to grow as an investment for retirement savings. Having a global perspective – diversified across a range of different subgroups and companies – arguably assists investors capture the essence of this asset class.
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