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Why the asset class has appeal in the current environment and the risks to consider
Thursday 13 Aug 2020 Author: Russ Mould

Traditional portfolio asset allocation tends to start with equities and bonds, with a bit of a cash buffer thrown in, before thoughts move to areas that are designed to provide some diversification, in the theory (or hope) that their performance does not correlate with (or mirror) that of the other options.

These ‘alternative’ areas can include commodities, commercial property or even private equity funds but one area which may still be flying a little under the radar is infrastructure.

This is surprising in some ways, since infrastructure, as an asset class has performed well for a decade or more. Looking at it from the perspective of only listed firms in this field, infrastructure stocks have outperformed all of the major geographic indices bar the super, soar-away US, which continues to benefit from the barnstorming run generated by Facebook, Alphabet, Amazon, Apple, Netflix and Microsoft.

While we must all accept that past performance is no guarantee for the future, the past 15 years’ data may give investors some confidence that infrastructure is at least no flash in the pan. In addition, the asset class has several other facets which means it may be worthy of consideration as a part of a balanced, diversified portfolio, especially for those investors who have a long-term time horizon and are seeking income.

Four factors

A selection of companies, held directly or via a fund, that own or operate assets which can range from ports to airports, toll roads to pipelines and essential water and electricity utilities may not appeal to everyone – the thought of owning a stake in an airport in particular right now could leave many investors feeling green at the gills.

But, beyond the tempting past performance record, which appears to show strong total returns over the past 15 years and with lower volatility than most equity benchmarks, there are four other reasons why infrastructure may suit the overall strategy, target returns, time horizon and appetite for risk of certain investors.

• The rise of environmental, social and governance factors. The COVID-19 outbreak, a global recession and resulting collapse in the oil price that leave investors contemplating this year’s dividend cuts from BP (BP.) and Royal Dutch Shell (RDSB) are all good near-term reasons which explain the poor share price performance of the oil majors.

But on a longer-term basis, many investors are now steering clear of ‘Big Oil’ not just for financial reasons, and concerns over peak demand and the risk of stranded assets, but ethical ones and issues relating to carbon footprint. Infrastructure funds can help here, as there several specialists in the area of renewables and battery or energy storage technology, notably among UK investment trusts.

• Fears of inflation. Some investors may not be convinced by talk of inflation, at a time when the pandemic is still weighing on the jobs market and consumer confidence and demand destruction
and a period of weak economic growth remain clear risks.

But central bank money-printing schemes, ballooning government deficits, supply-chain disruption (if production is brought back home from China, for example) and firms jacking up prices to cover extra Covid-related costs could yet combine to create a surprise.

The US five-year forward inflation expectation indicator is ticking higher, for example, especially if you adjust for the five-year US Treasury yield. This would be a game-changer, as the last 30-40 years have all been about disinflation, and would perhaps make investors appreciate the index-linked nature of many infrastructure firms’ revenue streams.

• Property woes. Commercial property has long been seen as a useful and welcome source of portfolio diversification. Some investors may now fear, however, that the relentless rise of online shopping and the pandemic’s effect upon office working and gatherings at leisure sites like restaurants, bars and clubs are going to deal rental incomes and asset values a severe blow.

• The reach for yield. Several REITs have cut their dividend and over £40 billion of cut, cancelled, suspended or deferred dividends in the UK stock market alone since March leave income-seekers in a bind, especially as government bonds offer little joy either. Infrastructure could again play a role here, as shown by the investment trusts which specialise in this area – though it must be noted that there are open-ended funds which operate here, too, and even a couple of passive, exchange-traded funds (ETFs) which track the performance of a basket of listed infrastructure stocks.

Note the yields on the investment trusts range from 2.1% to 6.6% for renewables specialists and from 3.2% to 6.2% for infrastructure experts.


Risks

As ever, however, there is no free lunch. Infrastructure stocks (and the collectives which own them) need to offer a yield to compensate investors for the risks involved, which can include regulation, political interference and top-line growth that is usually modest at best. In addition, the UK-listed investment trusts come with an annual fee and they also currently trade at lofty premiums to their net asset value.

At least some of their potential is factored into valuations already and, by paying that premium, investors are effectively giving away some of their future returns. Patience will therefore be required if anyone does feel infrastructure is a suitable option for them, once they have done their own research.

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