The power of infrastructure investing in uncertain markets

A lot of us feared this: After years of boom, global financial markets are becoming tumultuous and uncertain, just as large cohorts of older investors want increased income and greater certainty from their investments. “The usual suspects” of traditional fixed income and equities are unlikely to satisfy the yawning appetites of these millions of investors.

Where can they turn?

I have written here about the benefits of alternatives and their income-producing potential. Given the recent market turmoil, one subset is looking especially attractive: infrastructure.

Infrastructure’s investment characteristics can be compelling, including the potential for lower volatility than traditional growth assets, attractive income yields and a natural hedge against inflation.

Among infrastructure assets, some are unlisted, the domain of institutional investors, and others listed, broadly available to all equity market participants. Listed products will be our focus here.

(Related: Alternative growth strategies for a low-growth world)

As a standalone asset class, listed infrastructure was introduced in the last 10 years, mainly by Australian managers. American investors may be less familiar with it for the simple reason that many infrastructure assets in the U.S., such as toll roads and airports, are not offered as listed equity investments. Europe and Asia historically have led the way, although that is changing, slowly.

With awareness growing, listed products should present significant opportunities in 2016. Pension funds – and retail investors – in the U.S. are becoming increasingly interested. As a relatively new asset class, indices appear fairly rudimentary. We believe an active management approach by specialist managers can make a significant difference.

The underlying performance of infrastructure assets is relatively uncorrelated to the equity markets. People use electricity, fly through airports and drive on toll roads regardless of what stock markets do. Valuations do tend to be moved by market sentiment, however, so volatility can create opportunities to access solid investments at great prices. Given the resilience of the underlying assets, these securities could help mitigate the effects of broader market pullbacks.

Infrastructure products are easy to explain to experienced investors. Most provide essential services and operate as monopolies. Think large-scale, capital-intensive, public service projects that individual companies can rarely undertake solo: highways, airports, ports, railroads, pipelines and electricity utilities. Large amounts of capital are required, up front, to build these assets. The owner then recoups its investment by charging consumers fees to use it.

Subsequent cash profit margins can be quite high and when managed well can remain stable over time. For investors, this translates to strong, dependable, dividend potential.
Investors should not expect large short-term gains, like the 30-40% some saw in U.S. stock market booms. Nonetheless, attractive gains can be attained with the right investments and the right manager over the medium term.

That makes infrastructure more attractive in the current rate environment than many fixed income securities – including tax-advantaged municipals, which generally offer lower returns and are inversely correlated to interest rates, which nearly every pundit is forecasting will rise, if slowly and steadily.

This asset class will not provide a lot of surprises. In general these are steady, defensive, even boring, investments. As long as people continue to travel via toll roads, trains and airports, and consume water or utilities in predictable ways, well-chosen infrastructure products should be able to deliver dependable returns.

(More insight: How to work infrastructure funds into clients’ portfolios)

The most regulated infrastructure products can by law increase consumer prices to keep pace with inflation, making them all the more attractive. Regulatory or contractual structures also allow many assets to pass through interest-rate changes as adjustments to user fees. These attributes can give investors confidence that rising interest rates will be reflected in increased future cash flows over the medium and long term.

Yet when interest rates rise, regulated assets most often are oversold, owing to sentiment rather than fundamentals. Depressed prices can make solid underlying assets more attractive.

Financial advisers should be cautious and comprehend the risks they are assuming, including regulatory, asset operating and economic risks, such as passenger or traffic growth.

Understanding the ways infrastructure assets are defined and how regulatory, concession and contractual frameworks operate to determine revenue can help protect investors from surprises. Even assets with excellent underlying fundamentals can be turned into bad investments by excess leverage, overpaying for acquisitions or poor management strategy.

Infrastructure investing is often less a game of picking winners than one of avoiding losers. We recommend looking for infrastructure managers that are philosophically risk-averse and whose focus is on investing in high-quality assets, rather than chasing returns.

Good infrastructure products are unlikely to wildly outperform equity markets – but nor are they likely to create serious losses in a portion of investors’ portfolios that should be defensive. They can be highly attractive to investors seeking solid income from relatively lower-risk investments.

Thomas Hoops is executive vice president and head of business development at Legg Mason Global Asset Management.