As someone who straddles both the academic and finance worlds I’m always interested in research that can help better inform asset managers. My main interest is in infrastructure finance, having been involved in the field in some way or another over the last 15 years. So, I’m always interested in reading new research on infrastructure finance, hoping it might provide a better understanding of the asset class. It was with this interest that I read the paper titled ‘A global investment opportunity in non-listed infrastructure for institutional investors’($) by Muhammad Jufri Marzuki and Graeme Newell from the University of Western Sydney.
Upon reading it, it dawned on me that infrastructure finance always seems to be tilling the same soil. This paper conducts a study that’s very similar to other studies, specifically those written by Peng and Newell (2007)($), Newell and Peng (2008)($) and Newell, Peng and De Francesco (2011)($). All of which examine the risk-adjusted returns of unlisted infrastructure in a portfolio using the exact sample methodology: comparing Sharpe ratios and then doing asset optimization.
Providing some evidence of the returns and correlation of unlisted infrastructure is necessary, after all, this is a newer asset class and data is often difficult to obtain. But it appears to me that we could be raising the bar for research for the asset class. Here I list several interesting questions inspired by the above research that I don’t feel have been appropriately addressed.
The nature of appraisal indices and infrastructure returns
All the studies mentioned above employ appraisal-based indices to describe the risk and returns of infrastructure. Whilst these indices are common for unlisted assets, appraisal-based indices have a number of weaknesses.
The major issue with appraisal-based indices is that the returns can be smoothed owing to valuation behaviours of the funds that are supplying the appraisals. Accountants only sign off on the valuations once a year, so large shocks to valuations, like we have seen recently, will take some time to work through and be reflected in the index. Jenkinson et. al. (2013) explains that there is a time of the year effect on valuations, with the largest change in valuation found typically in the last quarter of the financial year. Furthermore, Jenkinson et. al. (2013) show that managers that are raising follow on funds generally report higher returns during the fund-raising period, with lower returns once the funds are raised.
The Jenkinson et. al. (2013) research is based on private equity, but infrastructure is a direct descendent of private equity investing, so I would argue that similar effects would likely be found in appraisal-based infrastructure indices. (By way of disclosure, I do work at EDHECinfra where I lead the collection of data for infrastructure debt and equity indices as well as conduct research on infrastructure). That returns can be gamed by managers will lead to questions about the suitability of these indices. This can have an impact on the expected risk and return of infrastructure, which then impacts the decision to allocate to the asset class.
Infrastructure’s relationship with inflation.
One of the major selling points for infrastructure is that it can provide returns linked to CPI or other economic variables. However, when testing for the linkage between inflation and returns I don’t believe we have been asking the right questions. In finance, research examines the ability of assets to protect against unexpected inflation. The research above does not address this issue, rather it looks at correlations between CPI and returns. This gap in our understanding is significant as such research would provide asset allocators a better idea of how to position portfolios if there’s fear of an inflationary environment arising in the future. The paper I have seen most recently that has done a good job of this is by Boon et. al. (2020)($). Here the authors examined what industries provide the best inflation hedges. Through their research they found coal, oil and gold provided the best whilst meals, textiles and clothes provided the worst. It is interesting to note that sectors such as utilities or transport were not found to provide the best inflation hedges. This is something I think is worth examine further as it is core to the infrastructure investment narrative.
Considering the investment costs of unlisted infrastructure.
Often research is conducted on a gross returns basis. This refers to returns before fees. However, no investor would be receiving that level of return. The costs of investing in infrastructure assets, on an unlisted basis, can be significant. This can include the costs of building a team, or hiring managers to do it for you. In private equity, fees from managers are not insignificant. Robertson and Sensoy (2013)($) find that the present value of fees can make up to 16.5% of a fund’s value over the life of the fund. To not include that information when writing about infrastructure returns could result in overallocation and subsequent disillusionment with the asset class.
Obtaining this information is difficult given this is a private asset class, but I believe we are doing the asset class a disservice if we ignore this. Over the last few years, we have indeed made strides in improving the quality of research available in the industry, but I think we have to move forward with our understanding of the infrastructure asset class. The three questions raised here would be a start to improving our understanding. Data is obviously a major impediment on our ability to answer these questions. However, I don’t believe that excuse is acceptable anymore. With more and more investors allocating funds to infrastructure, we owe it to them to answer these questions to ensure they can make well informed decisions.