The importance of the right benchmark

A new paper by EDHECInfra argues that selecting the right benchmark could completely change investors’ preferred asset allocation to infrastructure equity and debt.

Asset allocation choices famously determine a significant proportion of investment outcomes, but as recent research shows, benchmark selection is an integral part of this process. For example, the authors of Benchmark selection and performance in the Journal of Pension Economics and Finance last year find that in the cross-section of pension funds, asset allocation explains on average only 19 per cent of the variation in pension fund returns while benchmark selection dominates and explains 33 per cent of cross-sectional returns.

In a new paper published entitled “Strategic Asset Allocation with Unlisted Infrastructure – Better Data for Sensible Results”, we show the importance of benchmark selection for investors who want to include the infrastructure asset class in their strategic allocation. Using the latest benchmark data shows that unlisted infrastructure equity and debt could play a significant role in institutional portfolios with as much as 10 per cent of the global portfolio.

For years the OECD has reported low allocations to infrastructure of 2 per cent on average for large pension plans, suggesting that private capital is not about to plug the ‘infrastructure investment gap’ often lamented by the G20 and other international bodies. This new research suggests that with the right benchmarks data, allocations could be five times higher.

Given the importance of SAA in the implementation of efficient long-term diversification, establishing ex ante the role of illiquid asset classes such as unlisted infrastructure in the total portfolio at this stage is important because these investment decisions are not easily reversed: transaction costs are high and, in bad times, unlisted infrastructure is almost completely illiquid.

In fact, investors have been using the wrong data to assess the role of unlisted infrastructure investments in their global allocation: listed proxies and appraisal-based indices as policy benchmarks leaves them none the wiser about the strategic role of unlisted infrastructure.

Listed proxies are perfectly correlated with stocks and are therefore not a separate asset class, and appraisal indices are not correlated with anything and cannot be used to perform a serious asset allocation exercise because they rely on stale net asset values that do not reflect market prices. In the paper, we show that un-smoothing appraisal-based returns only makes the problem worse.

Instead, using data that reflects the evolution of asset prices yields convincing results. Using the infra300® index, which captures the fair market value of 300 infrastructure companies in more than 20 countries, we show that unlisted infrastructure equity could account for as much as 10 per cent of the portfolio of yield-seeking investors. Likewise, using a broad market index of infrastructure debt, the paper finds significant allocations to infra debt for liability-driven investors.

Most investors are under-invested in this asset class because they lacked robust data showing the potential of infrastructure equity and debt in the total portfolio. But thanks to recent advances in data collection and asset pricing technology, they can now answer long-standing questions about why and how they should invest in infrastructure.”

In the paper, we conduct multiple robustness tests of the quality of the data of the role of infrastructure in the portfolio. The infra300 index data is not smoothed, exhibits meaningful correlations with other classes and is representative of the investible universe. Now we can show that infrastructure improves the risk-adjusted returns of a multi-asset portfolio without using arbitrary or binding constraints.

The paper also explores how investors can improve the quality of their asset allocation by using granular data that matches their exposures to different infrastructure sub-segments, each of which corresponds to very different types of investments and risk exposures.

For investors just starting to consider infrastructure as an asset class, these insights can make a significant difference. For existing infrastructure investors, it is the opportunity to revisit and adjust their allocation to this important asset class.

The paper can be accessed here.

Frédéric Blanc-Brude is the director of EDHECinfra.

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