The importance of diversification for capturing the essence of infrastructure
Max Cappetta, CEO, Redpoint Investment Management
Infrastructure investing is increasingly popular within retirement savings plans and it’s easy to understand why. An allocation to infrastructure can potentially deliver lower volatility and a higher dividend yield than global equities, and a diversifying addition to a multi-asset class portfolio.
These benefits are natural outcomes of investing in a globally diversified portfolio of companies who manage core infrastructure assets and deliver essential services. Across the global economy these companies include water and electrical utilities, toll road and rail transport operators and those that own gas pipeline, telephony and satellite networks.
Investors in listed companies may be concerned that listed infrastructure companies can fall in price right along with any other listed shares in moments of market stress. Technically speaking this occurs when your portfolio has a beta of 1 to global equities. If your portfolio doesn’t fall or rise as far as the market this generally means the beta is below 1 and is broadly considered ‘defensive’. Creating a portfolio with defensive characteristics using infrastructure is as much about picking suitable companies as it is about seeking a diversified mix of different infrastructure activities.
Our research shows that specific subgroups of infrastructure activities (see Chart 1) carry distinct risk characteristics. While each sub-group has a lower beta (ie: is considered more defensive) than listed global equities in general, they also exhibit different risk characteristics relative to each other. The different volatility outcomes delivered by most infrastructure strategies can be explained by the different exposures which they have to these six subgroups.
Chart 1: Breaking down core infrastructure
Source: Redpoint and FTSE Russell.
Chart 2 highlights these differences with listed Utility (U) companies having lower volatility (and a lower beta to global equities) relative to sub groups of Transport (T) and Networks (N). This analysis highlights that while Transport and Network subgroups have similar betas to global equities, the Network sub-groups are inherently riskier than Transportation. The volatilities shown in the chart are the residual volatilities of the subgroups after removing the common effect which is driven by their respective relationship with global equities in general.
Chart 2: Residual volatility vs global equity beta
Source: Redpoint, analysis period 30 November 2007 to 30 June 2016.
Another dimension of risk is the correlation between subgroup returns, as reflected in Chart 3 below.
In theory, the lower the correlation in Chart 3, the less similar the returns and the better the diversification benefits of combining the two subgroups should be. The negative correlation between energy networks and non-rail transport subgroups are particularly attractive. As per the volatilities in Chart 2 the correlations shown are between the residual returns of each subgroup after removing the common effect which is driven by their relationship with global equities in general. This highlights that there are true diversification opportunities across the subgroups which are not simply driven by their respective relationship with global equities in general.
Chart 3: Infrastructure subgroup correlations – residual returns
Source: Redpoint, analysis period 30 November 2007.
A well-diversified portfolio of infrastructure securities can take advantage of each subgroup’s global equity beta, volatility and correlations to attempt to deliver a strategy with lower volatility than more concentrated approaches – and this can be rewarded with less negative returns in periods of market stress.
Geographic and company diversification matters too
Ensuring that infrastructure portfolios are properly diversified at a subgroup level is just part of the story. Investors also need to ensure that they diversify their portfolios geographically. While there may be well run infrastructure companies in Australia, it arguably makes sense to consider companies in other countries that may simply be better investments. Furthermore, with a global perspective investors can access companies operating in sectors not represented on the ASX, such as satellite owners and water utilities.
Another key consideration is that index strategies and typical active strategies generally deliver relatively concentrated portfolios. While popular global infrastructure benchmarks appear diversified with 75, 100 and more than 150 constituents, depending on the index, market-cap weighting often results in fewer than 20 stocks accounting for more than half of the relevant index’s weight in each case. Typical active strategies are generally concentrated by design, with most active managers holding far fewer stocks than any of the indices. As a result, both index and typical active strategies generally place a significant bet on the performance of just a few companies. Redpoint believes that diversifying across individual infrastructure companies to reduce this concentration risk delivers better outcomes in the long term.
Well-managed companies delivering core infrastructure services across the world are arguably well positioned to grow as an investment for retirement savings. Having a global perspective – diversified across a range of different subgroups and companies – arguably assists investors capture the essence of this asset class.
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