Ask investors to describe the perfect investment, and they are likely to respond, “steady income, predictable cash-flows, equity-like returns without equity-like risk, low correlation to other asset classes and, maybe especially in this uncertain climate, an inflation hedge. And, oh yes, if it could increase returns while lowering risk in my portfolio, I’d like that, too.”
Unbeknown to many of them, listed infrastructure is just such an investment.
Because infrastructure assets provide essential services in both good and bad economic times, they are not as cyclical as other investments and, therefore, provide reliable income and strong diversification benefits, as well as downside protection if the markets begin to turn. The “essential service” nature of the assets also provides growth that is tied to overall economic activity, population growth and inflation.
“The fact that there is generally a global shortage of high-quality infrastructure provides an added boost to the asset class, as governments increase the pace of privatizations and private-sector capital plays an important role,” says Craig Noble, CEO and CIO, Brookfield Asset Management’s Public Securities Group.
Listed infrastructure has historically offered equity-like returns with lower volatility than the equity markets, along with downside protection. For example, in the seven years since the great financial crisis, listed infrastructure (using the FTSE Global Core Infrastructure 50/50 Net Tax Index) has returned 8.7 percent per annum (versus the MSCI World Index at 8.1 percent), with a standard deviation of 10.7 percent (versus 13.6 percent for global equities) and has had downside capture of 50.8 percent.
“These characteristics are important at a time when investors are wary of fixed income, given secularly low yields, and want continued equity exposure coupled with downside protection,” says Benjamin Morton, portfolio manager on infrastructure strategies at Cohen & Steers. “More broadly, we continue to see the macro environment as supportive of infrastructure investments. Growth could continue to accelerate, as the business cycle has strengthened, while developed markets are still benefitting from an accommodative monetary environment. Policy may also become increasingly supportive of infrastructure businesses, with, for example, President Trump making infrastructure spending, tax cuts and energy market reform key themes of his agenda.”
Depending on the index used, a reasonable long-term return for listed infrastructure is between 8 percent and 9 percent, based on the 20-year historical average. That’s consistent with what institutional investors expect from their core direct infrastructure allocations. Approximately half of that return comes from the current dividend yield, and approximately half from organic growth. Near term, however, infrastructure assets are realizing above-average returns.
“We saw 12 percent returns last year,” says Jeremy Anagnos, CFA, chief investment officer of global infrastructure and senior global portfolio manager at CBRE Clarion Securities. “We're also seeing 10 percent to 12 percent return expectations in 2017.”
This bump in returns is being driven by reduced regulatory risk, as well as a changing political climate around the world that is supporting increased infrastructure investment and development.
“Listed infrastructure has historically offered superior returns to the broad global equities market, with less volatility,” says Morton.
The sector can also be a key portfolio diversifier: The FTSE Global Core Infrastructure 50/50 Net Tax Index’s overlap with the MSCI World Index is just 5.9 percent of the broad market’s holdings, for instance. With its modest correlation with global equities, adding infrastructure to a portfolio could offer the potential to enhance returns and reduce risk.
“When you start looking at the efficient frontier of a portfolio composed of mixed equities and bonds,” says Anagnos, “you can move up in terms of return and to the left in terms of risk — so less risky — by taking out your global equity exposure and adding global infrastructure.”
While performance is always the number one reason for investors to consider an asset class, diversification comes in a strong second — and infrastructure offers a supercharged diversification profile. Not only is infrastructure lowly correlated to other investment asset classes, but each of its own subsectors is lowly correlated to the others. In addition, it provides global diversification across geographies, economies and demographic growth trends. The various subsectors that make up the class can be roughly split in half between defensive- and cyclical-oriented sectors. Passive managers of diversified funds can count on at least some of the subsectors to be up when others are down, while active managers can overweight and underweight among the subsectors while still remaining in the infrastructure class.
“From an active management standpoint, you have the opportunity to flex and tweak your exposure by country, by sector, by economic factors, such as interest rate and inflation expectations,” says Ted Brooks, global infrastructure portfolio manager at CenterSquare Investment Management. “By rebalancing these different factors, you can give yourself more cyclical or more defensive exposure, depending on what’s appropriate.”
Another advantage to infrastructure, which is often overlooked, is its growth potential. Because investors tend to look at it for its cash-flow and diversification characteristics, growth is sometimes dismissed. But infrastructure is one of the best ways to access the growth opportunities presented by the development of a global middle class, global trade and the build out of technology. It is a way to get exposure to long-term secular trends that will run over the next 20 to 30 years, and probably longer.
“Infrastructure is one of my favorite underappreciated and underinvested asset groups,” says Brooks. “There’s an upside to that. Growth and opportunity in the class isn’t just from the huge need to add to and improve current infrastructure. It also comes from the probability that utilization will increase globally.”
Americans use roads, airports, utilities and communications systems at a much higher rate than even most of the other mature economies. As both mature and maturing countries around the world increase their use of infrastructure, whether it is transport, utilities, communications or other subsectors, we will see the infrastructure’s revenue line also increase — as these investments are businesses as much as real assets. This increase in revenue is the basis for increased dividends.
“Historically, publicly listed infrastructure companies have grown their underlying dividends by approximately 5 percent, according to our research,” explains Noble. “And this relatively stable growth rate is often underappreciated.”
Many investors think they already have exposure to global infrastructure through their global equities funds, but infrastructure is a very small component of a broad equities fund — usually just 2.5 percent to 3.0 percent — leaving investors underweighted and underexposed to infrastructure.
Other investors believe that REITs provide much the same benefits — and carry much the same risks — as unlisted infrastructure funds. After all, they are both real assets and can be purchased on stock exchanges. There are, indeed, many similarities between infrastructure and REITs. The underpinning of hard assets, the long-term nature of the cash flows and even the approach to investing can be similar.
But real estate is a cyclical asset class, and the demand profile for REITs is determined by economic activity that drives demand for space and tenant take up. Infrastructure, on the other hand, is a far less economically sensitive asset class.
“Infrastructure assets have a need-based demand profile,” says Anagnos. “So you have far less amplitude through a cycle because infrastructure is made up of things that we use as we go through our day, whether that’s energy or transportation or communications. This leads to a lower volatility pattern than you have with real estate.”
Real estate and infrastructure can be viewed as complementary to each other, rather than overlapping each other. If you look at how institutional investors implement an infrastructure strategy, you will often find that it is combined with real estate as part of a real assets allocation.
Other investors feel that if infrastructure is bond-like, why not have the real thing and just stay with bonds.
“The main difference is growth,” explains Noble. “Many investors may equate infrastructure to be a bond substitute given the dividend yield, which is currently about 4.5 percent on average. We believe that income is very visible and stable over the long term, which is attractive. However, it is the generally predictable growth profile that really differentiates infrastructure securities from fixed income.”
The sources of the growth relate to the fundamentals of the infrastructure assets themselves. Top line revenue tends to grow in-line with economic activity plus inflation. In addition, expansion of the asset base adds to the organic growth. Add a modest amount of financial leverage, and the result is cash-flow growth that has been, on average, in the range of 5 percent for the past few years. This is really the main difference when comparing infrastructure securities to fixed income.
Trying to stay with a fixed-income allocation can be frustrating in today’s climate, with interest rates still low by historic standards and an unclear picture as to whether this is the new normal. Infrastructure provides an attractive alternative.
“This may be the end of the 35-year-long secular bull market for bonds,” says Brooks. “If that is the case, the ability to rotate into a sector that has a lot of bond-like characteristics, relatively stable equity returns, visible cash flows and long-term, inflation-linked contracts — which can be as long as 80 or 90 years — is a wonderful place to live on the risk curve. A global infrastructure allocation allows investors with a higher-return threshold to obtain that without getting the same level of risk they get when rotating into full-blown equities.”
HOW MUCH IS ENOUGH?
Whenever investors consider adding a new asset class, they can’t help but wonder how much is enough to make a difference. And, just as important, if they are adding infrastructure, what are they subtracting?
“I think private investors should look at what larger institutions are doing,” says Anagnos. “Even though they can’t access infrastructure the same way in terms of putting together billions of dollars to buy one airport, they can buy a portfolio of listed securities that gives the private investor the same infrastructure benefits that institutions seek. Those large investors are making allocations in the 10 percent to 15 percent range as part of their overall asset allocation. Therefore, I think 10 percent would be a reasonable allocation for private investors to consider for this asset class, as well.”
Where investors find that 10 percent in their portfolios depends on what they are using infrastructure for. If it is primarily for its income-producing benefits, it makes sense to reduce the fixed-income portion of the portfolio to add infrastructure.
Most investors, however, consider listed infrastructure to be part of their equity allocation, particularly if they are looking for more global exposure.
“They are stocks, so you are going to see more volatility than with a fixed-income allocation,” says Anagnos. “But if you look at the data, replacing your global equities exposure with global infrastructure is a way to bring significant improvement in return and while reducing risk.”
Investors can access this market via individual company stocks or through listed funds. For the private investor, the best way to access infrastructure is most likely through a diversified listed fund or two. Trying to choose the right company in the right sector in the right part of the world — and doing that enough times to diversify an infrastructure allocation — is difficult even for institutional investors.
“In any given year, the return profile from the individual sectors is highly dispersed,” says Anagnos. “You can have a 20 percent to 40 percent difference between the top-performing and bottom-performing sector. It would be a challenge to time investments into specific subsectors, thus the true benefit of the asset class is the diversified benefit of putting these sectors together, giving you that broad diverse infrastructure exposure in one fund.”
Infrastructure fund managers are looking at the next few years as the perfect time for private investors to jump into this asset class. Macroeconomic factors, as well as deregulation trends, would seem to portend continued growth in an alternative asset class that offers the returns and safety of a traditional class.
“In our opinion, infrastructure provides investors with growth potential, as well as meeting the need for alternative sources of income,” says Morton. “The defensive qualities of many infrastructure subsectors have historically resulted in resilient performance in down markets.
“In addition to the supportive market environment and compelling secular case, in our opinion, infrastructure stocks are currently attractively valued and trade at only modest premiums to long-term average valuation metrics.”
Sheila Hopkins is a freelance writer based in Myrtle Beach, S.C.