Lonsec finds investors benefit from active investment approach

Infrastructure performed strongly in early 2014: Lonsec

Investment in listed infrastructure funds has continued to grow over the past year, buoyed by strong long term performance, increasing investor awareness and a preference for defensive equities in the face of conflicting macro themes, according to a report by investment research house Lonsec Research (Lonsec).

Lonsec’s Infrastructure Securities Sector Review rated 15 funds and found a majority of fund managers exceeded the 8.5% per annum long-term return forecasts of Lonsec-rated fund managers. Over a five year period to March 2014, the sector has averaged a return of 18.2% per annum, although the report warns it is unlikely for this type of performance to be repeated.

The report observed that while global infrastructure stocks generally lagged broader equities in 2013, the sector has

as investors shifted to less risky securities in the face of mixed US economic data and expectations that interest rates would remain lower for longer.

Expectations of rising US interest rates over the past year have filtered through to interest rate sensitive assets such as infrastructure stocks, leading to comparatively higher volatility than previous years.

Lonsec’s Senior Investment Analyst Andrew Coutts said while interest rate risk affects the infrastructure sector because many assets are backed by relatively high levels of debt finance, managers can actively adjust their allocation to specific assets to manage exposures.

“Infrastructure assets tend to be unique, with each offering a different risk-return profile in sectors varying from airports and roads to utilities and communications, so by investing in companies across subsectors, investors can diversify this risk,” Mr Coutts said.

This is a case in support of active management, with Lonsec suggesting investments in assets with strong market positions, sustainable growth opportunities, inflation protected income and relatively low or hedged debt levels to minimise risk.”

Other key highlights Mr Coutts noted from the report:

• Europe was the top global listed infrastructure performer by region, as the area was bolstered by receding fiscal austerity and sovereign bond yields falling to multi-year lows
• Majority of emerging market equities underperformed developed world equities amidst concerns of China’s economy slowly and further quantitative easing by the US Federal Reserve
• Growth is expected to be underpinned by resilient demand for services and long term structural drivers including urbanisation, globalisation of trade, mobilisation of data and securitisation of energy supplies

Lonsec notes infrastructure is a strong asset class to help investors achieve portfolio diversification, offering reasonable levels of long term expected growth with higher yields than equity. It also has the benefit of being underpinned by physical assets which can offer protection against inflation.

“Infrastructure is appealing as it is expected to deliver an attractive yield and provide a relatively strong return at lower risk than equities and global property. However, considering the correlation with broader equities of the sector, Lonsec considers infrastructure a growth asset and recommends inclusion within the balanced and growth options within a strategic asset allocation framework,” Mr Coutts concluded.

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Lower volatility on global infrastructure securities.

Investment research house Lonsec Research (Lonsec) said global infrastructure securities has delivered equity like returns with lower volatility over recent years, and global investor demand for yield saw the sector outperform the majority of major asset classes over the year to March 2013.

The Lonsec Infrastructure Securities Sector Review, which covered nine infrastructure securities funds, found the sector has recovered from the losses experienced during the global financial crisis, with the majority of funds providing solid single digit returns over the five years to March 2013.

Andrew Coutts, Senior Investment Analyst, Lonsec said the global macroeconomic environment was a key factor contributing to the recent performance of infrastructure securities funds.

“Over the past year, the sector has been the beneficiary of investor preference for yield and defensive equities in the face of wider economic uncertainty.”

“Fund managers also have an optimistic outlook for the sector – demand for the services are expected to remain steady and global structural drivers such as urbanisation, globalisation of trade, mobilisation of data and security of energy supplies are expected to underwrite future growth,” Mr Coutts said.

“However, fund managers remain divided over the investment prospects in emerging markets, as favourable economic and demographic trends are weighed up against the risk / return trade off. While emerging markets infrastructure is attractive because of its role in supporting these growing economies, the idiosyncratic nature of emerging markets means there is also elevated risk.”

These risks include regulatory and political risk, along with corporate governance, market transparency, liquidity and trading costs.

Despite being a small proportion of global market benchmarks, Australian stocks feature prominently in infrastructure portfolios, highlighting the relative maturity of the local listed infrastructure market, the high asset quality held by listed vehicles and the established regulatory processes.

While the sector has enjoyed a rapid rise in popularity since the initial launch of funds in 2006, flows in 2012 were relatively flat, reflecting the wider trend of muted investor demand for equities.

The Lonsec review also found relatively wide performance dispersion between fund managers over the past year due to the ‘benchmark unaware’ approach to portfolio construction and differences in investment styles, although performance over the longer term has generally converged.

“The benchmark unaware approach and lack of a widely accepted market proxy makes relative performance difficult to measure, but the trend of long term outperformance of major sector indices indicates investors have been rewarded for active management within the infrastructure sector,” Mr Coutts said.

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“Our increased conviction in management teams has resulted in two upgrades in this year’s review – the RARE Infrastructure Value Fund and Lazard Global Infrastructure Fund were both upgraded to Highly Recommended,” said Andrew Coutts, Senior Investment Analyst.

“This is the first time we have had two Highly Recommended funds in this sector since Lonsec commenced coverage of infrastructure securities funds in 2007.” 

While the sector is still relatively immature, Lonsec has continued to gain conviction over time as managers have shown they can meet objectives over the market cycle while consistently investing to their style.

Sector observations
Listed infrastructure outperforms
With volatility being a dominant theme in global equity markets during 2011, the predictable cash flows, attractive yield profiles and more modest volatility offered by infrastructure securities were qualities that exerted significant pull for investors. 

Over the year to 31 March 2012, both global and domestic infrastructure benchmarks fared considerably better than their broader equities counterparts, a trend which is also observable over the longer term. Despite short-term economic concerns, Lonsec continues to see long-term opportunities for listed infrastructure and believes its inclusion in a portfolio should improve its overall risk return profile.

Australian infrastructure companies feature prominently
Australian companies were popular in most portfolios, despite making up a minor portion of most global infrastructure indices.  

“Australian listed electricity distribution company Spark Infrastructure was the most popular global infrastructure company, appearing in the top 10 holdings of four of the six global infrastructure funds we rated,” commented Coutts.

Other common Australian infrastructure companies appearing in global portfolios included Transurban, DUET Group, Sydney Airport and Asciano.

Emerging Markets Infrastructure
Investment in emerging markets infrastructure can be an effective way to access the growth story of emerging markets, while reducing the risks relative to broader EM equities due to the inherent defensive characteristics of infrastructure assets. However, accessing this growth potential also carries a number of additional risks.

While the peer group of infrastructure funds is relatively small, the managers within the peer group vary significantly in their approach to investment in emerging markets. Despite making up only a portion of portfolios for those with the largest allocation, this can serve as an important point of distinction when selecting an appropriate infrastructure manager.

6 July 2012

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Andrew Coutts, Investment Analyst responsible for this sector commented, “This is a small and specialised sector with a number of quality managers who each have a number of strengths and competitive advantages.”

“Lonsec has focused on reviewing a select list of higher quality offerings in this review, rather than researching all the products in this space.” 

Investment teams build and there’s increased competition for talent
Since Lonsec began its coverage of the infrastructure securities sector in 2006, investment teams have typically enjoyed a high level of stability relative to managers focused on broader equity strategies. 

“In part this can be attributed to the size and relative immaturity of the infrastructure securities sector, although hiring freezes resulting from the GFC also likely kept movement to a minimum,” observed Coutts.

“In contrast, over the past 12 months we have seen higher team turnover, with several managers in Lonsec’s universe experiencing departures in investment team staff due to competition from other infrastructure securities managers.”

In the past 12 months, the sector has also been a beneficiary of an exodus of talent from specialist listed and unlisted infrastructure manager CP2 (formerly Capital Partners). “RARE and CFS have added to their ranks with quality personnel from CP2,” said Coutts.

“Lonsec has met with each of these hires during the research process (as well as on previous occasions) and observes a consistent message in terms of the level of discipline and depth of research undertaken in the CP2 investment process, which seems to be highly aligned with the bottom up process adopted by other managers within the sector.”

Emerging markets exposure
While most product mandates typically allow managers to invest in emerging market stocks subject to threshold limits, the extent to which this capacity is used is an important point of distinction between the funds rated.

“Most managers agree that there are long-term trends in emerging markets that are favourable for infrastructure; these economies have undergone significant development in recent years, with a combination of economic and demographic trends such as population growth and increased urbanisation expected to lead to increased demand for infrastructure,” said Coutts.

“Managers fall into two camps – those that invest directly in emerging markets and those that don’t believe expected returns compensate for the increased sovereign, political and regulatory risk in such economies.”

Lonsec believes that managers with broader infrastructure mandates and security selection criteria may be more suitable candidates for investors more open to capitalising on the sector’s expected long-term growth across both the developed and emerging markets.

“Those funds with an OECD focus are likely to provide less volatile returns and provide greater defensive qualities in falling markets,” said Coutts.

“In considering non-OECD infrastructure exposure, investors should be aware that they may be gaining meaningful exposure to emerging markets through their broader global equities allocation.”

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