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Infrastructure stocks roll with the interest-rate punches

Valuations have improved, says Russell's Adam Babson.

Michael Ryval 12 January, 2017 | 6:00PM
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Infrastructure assets have experienced a lot of volatility in the past 18 months. "Eighteen months ago, energy prices were extremely expensive and then there was a sharp correction and energy-infrastructure companies saw big share-price declines," says Adam Babson, a portfolio manager with Seattle-based Russell Investments who specializes in global infrastructure and real-estate securities. "Last March, we started to see a rebound in energy and infrastructure. Likewise, there was lots of volatility in utilities on the expectation that the Federal Reserve would hike rates -- but they continued to fall during the year despite all expectations."

Donald Trump's election as U.S. president changed all that as government bond yields suddenly spiked on the promise of fiscal spending and tax cuts. "The bottom line is that there's been volatility on both sides for infrastructure categories," Babson says. "Overall, valuations have become more attractive because of the selloff in energy infrastructure and utility categories. Valuations have improved over the course of the past few weeks."

Listed infrastructure assets, which include a wide swath of assets from cellular-phone towers to highways to pipelines and waste-water treatment plants, are close to fair value on a historic basis, says Babson, lead manager of the $1.3-billion Russell Investments Global Infrastructure Pool. "Relative to broader equities, I'd say they are slightly more attractive. But of course a lot depends on your outlook for rates."

Despite their sensitivity to rising interest rates, Babson argues that there are three reasons why the case for infrastructure assets remains intact.

First, there are diversification benefits. Research cited by Babson into 10-year correlations shows that global infrastructure is 0.69 correlated with U.S. stocks, 0.70 with non-U.S. stocks and 0.14 with bonds. "It is a subset of the equities market," says Babson, who joined Russell Investments in 2005. In 2008, Babson initiated formal research in listed infrastructure stocks which led to the construction of a multi-manager model portfolio. "But you do have relatively attractive correlations over time. Our view is that correlations are likely to fall as the asset class continues to become more recognized as a distinct category by institutional investors."

Second, infrastructure tends to outperform in bearish markets. "You can get diversification when you need it most in challenging markets," says Babson. Since 2001, infrastructure securities have outperformed during 13 of the 18 quarters of negative equity-market performance for the period ended Sept 30. On average, the infrastructure sector has delivered a return of 2.8% in excess of global equities returns during negative quarters.

Third, infrastructure assets offer higher income that will offset some of the market volatility. Global infrastructure, as measured by the S&P Global Infrastructure Index, delivered an annualized yield of 3.85% for the period from Dec. 31, 2001, to Sept. 30, 2016. Global equities, as measured by the Russell Global Index, yielded 2.44% in the same period.

Launched in January 2013, the 4-star rated Russell Investment Global Infrastructure Pool is managed by three sub-advisors. About 38% of the portfolio is managed by Sydney-based Colonial First State Asset Management (Australia) Ltd., which relies on growth-at-a-reasonable price stock selection. Another 38% is overseen by Chicago-based Nuveen Asset Management LLC, which tends to be value-oriented. Nineteen percent is managed by New York-based Cohen & Steers Capital Management Inc., which has specialized in real assets for many years.

In addition, the remaining 5% is managed in-house by Russell Investments. "This allows us to be fully accountable for all the risk in the fund," says Babson, noting that the 5% sleeve also helps to adjust exposures from the three sub-advisors.

The pool's geographic allocation differs only slightly from the benchmark S&P Global Infrastructure Index. As of Sept. 30, North America accounted for 50% of the pool, versus 49% for the index; the UK and Europe represented 26.9%, versus 28% for the benchmark.

Because of internal compliance rules, Babson cannot discuss specific holdings. But public documents indicate the top 10 holdings include  Kinder Morgan Inc. (KMI), a major North American pipeline operator, and Groupe Eurotunnel SE (GRPTY), which owns and operates the "Chunnel" that links the UK and Europe.

For the 12 months ended Nov. 30, the Russell pool returned 4.8%, or very slightly above the median fund. On a three-year basis, it had an annualized 10.8% return, versus 8.1% for the median fund in the Global Infrastructure Equity category.

Babson believes the market has over-corrected with respect to rising rates. In the short term, he expects interest rates to trend downward as the market lowers its expectations of the impact of Trump's stimulus packages.

"There are a lot of pressures that will keep interest rates low in various countries. I don't think it's a high-risk environment for owning interest-rate sensitive assets," he says. "It's important to have these diversifying asset classes, like listed infrastructure, to help protect the portfolio and diversify."

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Michael Ryval

Michael Ryval  Michael Ryval, a regular contributor to Morningstar, is a Toronto-based freelance writer who specializes in business and investing.

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