Infrastructure allocations below 3 per cent “meaningless”

Listed infrastructure drew attention last year for all the wrong reasons. Kristen Paech talks to Bruce Eidelson, San Diego-based director, real estate securities at Russell Investments, about the viability of the asset class post-crisis, and why privatisation in the US could boost US pension allocations.

While infrastructure as an asset class has been embraced by pension funds in Europe and Australia alike, in the US it is still a nascent concept.

The difference is largely down to a lack of privatisation in the US, where infrastructure historically has been provided by local and state government.

In North America, funds such as the C$87.4 billion ($80.1 billion) Ontario Teachers Pension Plan (OTPP) and Canada Pension Plan have looked abroad for investment opportunities in infrastructure, with the OTPP recently acquiring an additional 35.5 per cent stake in UK-based Bristol International Airport in a deal with Macquarie Airports. The fund had acquired a 14.5 per cent stake in 2002, the September purchase lifting its holding in BIA to 50 per cent.

However the global financial meltdown could spur more privatisation on US shores and with pension funds seeking diversification through uncorrelated assets post-crisis, global listed infrastructure may prove to be one of the beneficiaries.

Bruce Eidelson, San Diego-based director, real estate securities at Russell Investments, says he’d expect to see more privatisation in America given the deficiencies in US infrastructure and constrained government budgets.

“Those fiscal constraints should lead to increased privatisation along the same lines as what we’ve seen [in Australia] but it hasn’t happened to the same extent,” he says.

With localities at the metropolitan level unable to borrow to the degree that Federal Government is able to, Eidelson says they are looking for opportunities to capitalise on infrastructure assets that may be in place, but also to secure sources of capital in financing to expand current resources.

“It’s an ideal opportunity for increased privatisation,” he says.

This, in turn, could drive US funds to consider allocating to infrastructure, but given its emerging asset class nature, Eidelson expects initial allocations to sit below the average weighting to property, which for US funds typically ranges from 5 to 10 per cent.

Any allocation less than 2 to 3 per cent “would not be meaningful”, Eidelson says, adding that it sits best in the defensive segment of equity portfolios.

In the wake of the crisis and share price collapse of a number of infrastructure vehicles, some investors have questioned the viability of the infrastructure model.

Others, like the C$26.7 billion ($25 billion) Hospitals of Ontario Pension Plan, don’t see it as a separate asset class, preferring instead to view it as an equity or debt deal.

However Eidelson says the characteristics of the underlying assets, which are real and tangible as distinct from many sectors in the broader equity markets, suggest infrastructure belongs in an asset class of its own.

“In essence it’s akin to property, albeit with longer duration cash flows,” he says. “That tends to argue for consideration of infrastructure as a distinct asset class or certainly as a distinct sector within the broader equity market.”

For funds wary of making an allocation, he points to the fundamentals of the asset class, and says many of the issues that emerged following the crisis revolved around the high gearing levels of those companies.

“What we’re focusing on here is the character of the underlying infrastructure assets which continue to present certain benefits in terms of stability of income,” he says.

“That hasn’t changed, in fact if anything investors are looking for more stable income sources post-crisis in many cases than before hand so infrastructure should be well positioned.”

Due to its reliance on bricks-and-mortar assets rather than the vagaries of financial markets, infrastructure tends to sit in the ‘defensive’ portion of pension portfolios.

Most infrastructure assets, such as utilities, transportation and energy, have legal or economic market monopolies, or quasi-monopolies, meaning their returns are not subject to competitive market forces.

According to Eidelson, the yields also tend to be higher than you might find in the broader equity markets.

Infrastructure assets certainly offer some bond-like characteristics, including stable income and cash flow streams, but the listed sector bears higher correlation to equities than unlisted infrastructure.

The S&P Global Infrastructure Index, which provides liquid and tradable exposure to 75 companies globally that represent the listed infrastructure universe, took a battering in 2008, returning -38.98 per cent in the 12 months to the end of December. Like most asset classes, the index has since recovered ground, posting a 13.29 per cent return year-to-date.

“These are long-duration assets in terms of cash flow stability that would provide some bond-like characteristics but these are assets traded in equity market so there would be more equity-like characteristics than you’d find in a fixed interest portfolio,” Eidelson says.

“The more that investors embrace the idea that it’s distinct it tends to reinforce performance characteristics that are distinct from other sectors of the broader equity market. That’s consistent with what we found in the REIT market, historically, where as more investors adopted dedicated REIT investment programs we did see generally a decline in correlation to broader equities.

“That isn’t always constant in terms of the correlation level but in the last 20 years or so there’s certainly been a noticeable reduction in correlation as more investors have adopted dedicated REIT allocations.”

The benefits of listed infrastructure over the unlisted sector include liquidity and transparency, and the ability to achieve broad diversification by both sector and geography.

“Listed infrastructure companies typically offer lower gearing than you’d find in unlisted vehicles, and finally because of the relative ease of asset management you’re looking at lower management fees than you’d find on an unlisted vehicle, where you’d be looking at compensation structures more akin to what you’d see in the private equity sector,” Eidelson says.

On the flip side, correlation to equities is higher, which could ultimately reverse the diversification that the allocation set out to achieve.