EDHECinfra Post
Part 3: A factor revolution in unlisted infra
Publication date: 2019-07-01

A version of this blog was originally published on top1000funds.com.

This blog marks our third and final article on the EDHECinfra/G20 survey of infrastructure benchmarking practices. This time, we take a look at the role of infrastructure investment benchmarks for the purpose of risk management. More than 300 respondents took part in the survey. They included representatives of 130 asset owners, accounting for some $10 trillion, more than 10% of global assets under management. Most respondents said they needed benchmarks to manage the risk in their infrastructure investments.

Infrastructure investment as a collection of risk factor exposures

In a portfolio context, risk management aims to control and optimise the risk taken for each unit of expected reward. This is termed the excess return or spread. As such, this puts the focus squarely on the sources of remunerated risk found in various securities. It is these factors that explain and predict the price, and therefore the returns, of these securities.

Priced risk factors…

Priced risk factors are the result of fundamental economic and financial mechanisms. However, they are usually proxied using the characteristics of investments that systematically explain or drive asset values.

For instance, movements in interest rates will have an impact on most asset values. But not all assets find themselves equally exposed to interest rate risk, depending on their expected life and payouts. An important aspect of risk management is to understand the underlying risk exposure created by a given strategy or mandate.

Moreover, as discussed in the second article in this series, the construction of an infrastructure portfolio can be a lengthy and uncertain process and investors’ risk exposures can be expected to evolve significantly overtime.

…and evolving risks

Infrastructure investors also face evolving risk exposure at the universe level. Essentially, the underlying investible universe keeps changing. This can occur as new countries embrace infrastructure privatisation. It can also result from nations turning their back on certain types of concession contracts or revising regulations or subsidies.

This is reminiscent of the sub-optimality issues found in cap-weighted market indices. Standard stock indices exhibit both sector and style biases (concentrations). These imbalances can make them either relatively inefficient or relative unstable in terms of risk exposures.

Moreover, these biases tend to change over time. This can also have the effect of making standard cap-weighted indices unsuitable as benchmarks. In the long run, implicit risk exposures drift in a manner that investors cannot control. The solution to this issue is to build benchmarks that have constant sector and geographic weights or, even better, target a constant exposure to certain risk factors.

The absence of infrastructure investment risk management

None of these issues are currently taken into consideration in the risk management process of infrastructure investors. Let’s review the problems:

In the EDHECinfra survey, most investors said they use the same benchmarks for risk management as they do for strategic asset allocation and performance monitoring. That is, nearly 70% of investors in unlisted infrastructure continue to use absolute-return benchmarks for the purpose of risk management. They are essentially relying on benchmarks that do not represent their risks. This points to a very limited infrastructure portfolio risk management function amongst these investors.

Unsurprisingly, they are aware of these shortfalls:

  • Just 10% of respondents said that their choice of benchmark is proving adequate for risk-management purposes. Among the vast majority of respondents there is a consensus this practice present a number of challenges.
  • More than 50% are concerned that their benchmark does not allow measurement of diversification indicators such as effective number of factors/constituents.
  •  Half worry that these benchmarks do not measure exposure to traditional risk factors such as size and momentum. These can be found in multiple asset classes involving equity investment.
  • Likewise, around 40% of equity investors said that current benchmarks do not allow for stress testing or default risk mapping. Equally, they don’t measure contributions to asset-liability-management objectives.

Investors in infrastructure will benefit from understanding underlying risk factor exposures

As also discussed earlier, for infrastructure investors the choice of strategic benchmark effectively embodies two challenges:

  1. the creation of the portfolio to which the benchmark refers, a lengthy and potentially costly endeavour; and
  2. for this portfolio to also out-perform its benchmark.

Hence, from a risk management perspective, infrastructure investors need to know more than than that they simply added another bridge or another airport to their portfolio. They need to know which risk factors they are becoming exposed to through each new investment.

A decomposition of risk exposures by individual factors would create more control in the way investors build their infrastructure portfolios over time. After all, factor exposures exist in all investments. It would also would also permit optimising the portfolio to achieve the desired risk exposure determined at the strategic level.

Moreover, the dependencies between multiple asset classes created by common risk factor exposures will partly determine the total portfolio risk.

For instance, interest rate or credit risk is a feature of multiple asset classes like fixed income and also infrastructure. This will include infrastructure equity, since leverage is typically high in infrastructure companies and repayment period very long. As a result, the current value of any stream of future dividends to unlisted infrastructure equity investors is partly driven by the movement of interest rates (discount rates) and the possibility of being “wiped out” by a default.

Eventually, understanding how each asset-class component of the portfolio loads on various cross-asset-class risk factors is the key to a successful the risk-measurement and management process.

Better models allow better risk management

Because investments in infrastructure are illiquid, they are not easily or rapidly changed. Optimising a portfolio can therefore more easily be achieved done though more liquid asset classes. Hence, if the infrastructure portfolio creates a certain exposure to interest rate risk, along with, say, bonds, because the former is the most illiquid, an investor owning both types of assets can optimise their total exposure to interest rate risk by buying or selling bonds, while taking the interest rate risk exposure of the infrastructure part of the portfolio into account.

Such approaches remain uncommon in the unlisted asset space. However, the need for better ways to measure the sources of performance is becoming increasingly apparent amongst investors and regulators. This requires calibrating a robust statistical model of expected returns using observable and predictable inputs.

For instance, the EDHECinfra methods of valuing unlisted infrastructure assets use a multifactor model of expected returns. This enables the impact of various priced risk factors such as interest rate risk, size (illiquidity), credit risk, investment (capex intensity) etc. to be measure over time.

In due course, it will become possible to approach the risk management of unlisted infrastructure as a series of choices to gain exposure to a combination of risk factors. This evolution will occur as better benchmarks, representing the actual risks taken by investors, gradually replace the unsatisfactory ones used today. The respondents of the 2019 EDHEC/G20 Survey have strongly suggested that these are what they really need for strategic asset allocation and performance monitoring in the investible infrastructure universe.

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