By Darius McDermott, managing director of FundCalibre
Infrastructure has been at the sharp end of higher interest rates. With the lion’s share of its returns coming from high, inflation-adjusted income, it proved particularly sensitive to tightening monetary policy and it has been a grim period for a sector that should be a dull-but-reliable part of a portfolio.
But there are clear signs of a fightback as monetary policy turns. The utilities sector has outpaced the S&P 500 by 8.6% since the start of the year, with much of the performance coming over the past three months, and it is a similar picture for other listed infrastructure assets. Can its strength continue?
Unpicking the infrastructure sector is complex. Recent performance for open-ended listed infrastructure funds has generally been unexciting, but not awful. Over the past three years, the average fund in the IA infrastructure sector has delivered 12%, which puts it behind most equity funds, but ahead of most bond funds, which is what might be expected for an income-generative but lower growth asset class.
Open-ended funds invest largely in infrastructure securities. The real pressure – and the greatest sensitivity to interest rates – has been felt in infrastructure investment trusts, which tend to invest directly in infrastructure projects. These have felt the strongest selling pressure, as investors who had ‘leant’ their investment to infrastructure while fixed income yields were low jumped back to bonds.
See also: Keir Starmer: ‘We will rip up the bureaucracy that blocks investment’
The ongoing battle over cost disclosure has also been a problem. European regulation had required investment trusts to report their costs in a misleading way. This made it difficult for cost-conscious investors, such as wealth managers, to include them in their portfolios. As these investors sold out, demand faded and discounts widened.
This meant the AIC infrastructure and infrastructure securities sectors have delivered a far worse performance than the IA infrastructure sector (-8.3% and -11.4% versus 12% over three years). While the different investment make-up of open-ended versus closed-ended will always be a factor, the gap between the two approaches is extreme.
With the cost disclosure problem now resolved, there is hope that investors will start to come back and the discounts will normalise. Performance between open-ended and closed ended funds is running neck and neck for the year to date (6.4% and 6.1% for the two AIC sectors versus 6.3% since the start of the year**).
Any volatility in infrastructure investment is uncomfortable. Many investors buy the asset class for its dependable characteristics, generating a reliable inflation-adjusted income stream and steady growth from a portfolio of critical long-term assets such as toll roads, airports, schools and utilities. However, the speed and scale of interest rate rises was unusual, and unlikely to be repeated. That should auger a new era of stability for the asset class.
Government support
From here, there are real long-term tailwinds for infrastructure. Governments across the world recognise that renewing infrastructure is the key to unlocking productivity. Infrastructure development is also needed for the long-term decarbonisation of the economy, with initiatives to facilitate electrification.
Peter Meany, manager on the First Sentier Global Listed Infrastructure fund, said: “The shift from coal generation to wind, solar and storage, supported in the US by the Inflation Reduction Act; along with the need for increased resiliency spend, should drive meaningful capital expenditure growth for this sector. Increased capex should in turn drive higher rate base and earnings growth for regulated utilities. This theme is being amplified by growth in demand for electricity – the first time in decades that this has been seen in many developed markets.”
This is evident in the UK, with initiatives such as the ‘Great Grid Upgrade’. Will Argent, manager of the VT Gravis UK Infrastructure Income, fund said the UK’s new political landscape looks set to kick-start a number of opportunities for infrastructure investors.
See also: Four views: Are better times ahead for global listed infrastructure?
“Labour has set its sights on ambitious targets, with decarbonising the electricity grid by 2030, and achieving net zero by 2050 at the forefront of the party’s agenda,” he added. “Early steps, like the creation of Mission Control led by Chris Stark, and the establishment of Great British Energy, signal a strong commitment to achieving these objectives.”
Digital infrastructure is also a major growth area, and is necessary for the long-term growth in areas such as AI. It is data-dependent and requires significant computing power to generate insights. This is leading to exponential growth in areas such as data centres. Property analytics group CRBE says data centre growth is currently running at 24% in the US, 20% in Europe and 22% in Asia. It believes this is likely to accelerate across all markets in the year ahead.
It says: “Artificial intelligence (AI) advancements are projected to significantly drive future data centre demand. High-performance computing will require rapid innovation in data centre design and technology to manage rising power density needs.”
Funds such as Schroder Digital Infrastructure are plugged into this theme. It invests in three main themes: macro towers, fibre optic cables and data centres. The fund has an investable universe of approximately 300 stocks and REITS, of which it picks 40. However, digital infrastructure exposure is not limited to specialist funds. Data centres are also increasingly part of diversified infrastructure funds as well. First Sentier, for example, holds data centres alongside more traditional infrastructure assets such as toll roads, airports, railroads, utilities and renewables, energy midstream and wireless towers.
Then there is the change in direction on interest rates. Argent says that higher interest rates have been a major headwind: “While infrastructure investments have continued to deliver on their promise of non-correlated, sustainable income, the high-rate environment has been a considerable headwind. Investors and stakeholders now eagerly await a further reduction in rates, which would reinvigorate the sector’s allure.”
See also: Square Mile’s Fund Selector: IA specialist funds to watch
The early signs are good in the wake of the Federal Reserve’s unexpectedly large cut in September. Many listed infrastructure assets had already started to rally ahead of the announcement and that rally has accelerated since. Nevertheless, it is only in the foothills of a recovery and there appears to be plenty of value still to go for in the sector.
The question of whether to look at open or closed ended funds is a thorny one. If an investor wants direct holdings in infrastructure assets, closed-ended funds are the only realistic option given the liquidity constraints. Discounts are wide and may narrow given the changes to the cost disclosure regime and improving sentiment.
However, the volatility may have deterred investors, who may prefer to stick with the open-ended options. A middle option may be the Gravis fund, which invests in a portfolio of investment trusts and can help manage the volatility.
Either way, the future for infrastructure funds looks brighter. Investors will be hoping that they revert to their normal role – the boring backbone of a portfolio.
