Todd Canter explains why global real estate and infrastructure provide significant diversification benefits and have therefore earned their place in a globally diversified mixed-asset portfolio.
Investor demand for listed infrastructure has been on the rise due to growing interest in real assets which offer predictable cash flows and compelling investment characteristics. Infrastructure assets are typically described by the characteristics they share.
They are often large monopolistic assets such as roads, seaports, airports, electricity networks, and water assets. Since many of these companies have monopolistic businesses, they tend to have relatively consistent and long-term cash flows due to regulation, long-term contracts and inelastic demand.
Governments around the world have used infrastructure spending to propel economic growth, leading to increased private investment in this sector.
Like property, infrastructure has a strong performance history leading to a growing recognition of the asset class. We believe interest will continue to grow in infrastructure as the US and other countries modernise their ageing infrastructure systems and as the sector continues to deliver strong investment performance.
Defining the infrastructure sector
The core infrastructure sector is best described as companies that own, operate, manage, or maintain physical structures or networks used to process or move goods, services, information, people, energy and/or life essentials. Revenue from operations is similar to stable, annuitised cashflow over a relatively long period of time while often being inflation linked.
The sector is comprised of three major categories: transportation, energy and telecommunications. Within each of these categories are many subcategories.
Transportation consists of railroads, bridges and tunnels, airports and seaports as well as commuter rail and light rail and other commuter transportation. Energy consists of gas distribution, pipelines, water and conventional electricity. Energy doesn’t consist of pure electricity generators unless they own or operate significant portions of the local grid.
Finally, telecommunications consists of fixed line networks as well as mobile networks and includes companies that own, operate, manage, maintain or lease to others telephony and data networks, transmission lines or towers, wireless transmission towers and transmission satellites. Telecommunications also includes companies providing voice and data communications if they control significant portions of the network.
Infrastructure related sectors that are captured include delivery services, marine transportation, trucking and airlines as well as materials and engineering companies that provide cement, concrete and asphalt, surveying, engineering and logistics, iron and steel and aluminum. Communication companies that own or use physical networks are also included.
FTSE introduced the FTSE Infrastructure Index Series in 2011 to benchmark the performance of publicly listed infrastructure companies. Within the index series, the FTSE Core Infrastructure Index focuses on core sectors. The market cap of the index is US$1.8 trillion ($2.28 trillion) versus US$1.3 trillion for the global real estate securities index. Combined, these two indices have a market cap of greater than US$3 trillion.
On a regional basis, North America (including Canada and Mexico) accounts for 59 per cent of the index. Asia-Pacific accounts for 21 per cent of the index. Europe accounts for 17 per cent of the index. The other three per cent of companies are from South America.
The investment case for global infrastructure
Looking at the investment performance history of the sector, it compares favorably to shares, bonds, and real estate (see Table 2). Average annual returns over the time period 2000 to 2016 are nearly identical to global real estate securities however risk, as measured by standard deviation, is lower at 13.15 per cent.
As a result, on a risk-adjusted returns basis, global infrastructure outperformed global real estate securities and easily outperformed global shares. Global bonds remain the strongest performer on a risk-adjusted returns basis over the time period measured.
A noticeable characteristic of listed infrastructure is the resiliency of its performance, even during the global financial crisis. During the 2007 and 2008 capital markets storm, global listed infrastructure performed well compared to global shares and even global real estate, posting a -6.7 per cent return and with a standard deviation of just 8.3 per cent.
When examining the relationship between infrastructure and other asset classes, the striking conclusion is that infrastructure behaves very differently as measured by correlation of returns.
Looking at the period of 2000 to 2016, correlations span from a low of 0.02 to international bonds to a high of 0.15 to US shares. At these levels, it is safe to say that infrastructure has a low correlation to other asset classes, including global real estate securities, at 0.14.
Real estate and infrastructure = real assets
Real estate and infrastructure share many similar characteristics. Both represent hard assets. Both tend to act as a strong inflation hedge. Both offer attractive dividend yields. Both have had similar average annual returns over the past 16 years as well as low to moderate correlations to other asset classes.
Combining global real estate securities and listed infrastructure, we can examine the investment characteristics of a ‘real assets’ portfolio and how the two sectors interact (see Chart 1).
At lower levels of risk and return, say at a nine per cent standard deviation, listed infrastructure dominates the portfolio with an 83 per cent weight. At the midpoint of risk and return we find the allocation of the portfolio evenly divided between global real estate securities and listed infrastructure. At higher levels of risk and return, global real estate dominates the real asset portfolio.
The impact of real assets on a mixed-asset portfolio (per cent)
In order to estimate the impact of real assets on a mixed-asset portfolio consisting of shares and bonds, a series of efficient frontiers were created.
Chart 2 illustrates four portfolios: the first is a portfolio consisting of US shares and bonds (US portfolio); the second is a US portfolio with global shares and bonds but without global real estate (global ex-property); the third is a US plus global shares and bonds with global real estate securities (global with GRES); and finally, the fourth is a US plus global shares and bonds portfolio along with global real estate and infrastructure.
As illustrated in Chart 2 there is no benefit from adding global shares and bonds to a US portfolio. This is so because during the time frame analysed, global shares and bonds had lower returns relative to their counterparts in the US while having only slightly lower risk. Moreover, the correlation between US shares and global shares is high. As is the case between global bonds and US bonds. Therefore, no diversification benefits were gained from the addition of global shares and bonds.
The addition of global real estate securities, on the other hand, results in strong diversification benefits. All along the risk spectrum there is a return benefit from the addition of global real estate securities, ranging from a low of +97 basis points to a high of +398 basis points.
As strong as the diversification benefits are from the addition of global real estate securities, the diversification benefits are even stronger as a result of combining global real estate with global listed infrastructure into a real assets portfolio.
The addition of infrastructure to global real estate results in additional return of +120 basis points at lower risk levels and +193 basis points at medium risk levels. In this model there were no constraints placed on any of the assets.
As a result of superior risk-adjusted returns and low to moderate correlations, the real assets portfolio dominated the US and global shares and bond portfolios. Although in the real world investors would likely place constraints on the various asset classes involved in this demonstration, the point is made that global real estate and infrastructure have earned their way into a globally diversified mixed-asset portfolio, resulting in significant diversification benefits.
Todd Canter is global portfolio strategist for the National Australia Bank’s Asset Management (NABAM) Group.