In the weeks leading up to my recent family vacation, I flew in and out of a number of major Canadian cities. As a fairly frequent business traveller, I am used to seeing airports in various states of repair and generally have not paid much attention to these works in progress. On one of my trips to Montreal, I found myself in a state of shock at the state of one of the large bridges heading from the airport to downtown. I am no expert in bridge safety, but it clearly needed an engineering review and retrofit.
Spending some time in late August travelling across Southern Ontario provided additional examples of real life infrastructure projects. What stunned me about these projects was not the sheer number but their magnitude. I will not touch on the political aspects of infrastructure spending, nor will I delve into the pros and cons of private/public partnerships although I know that these can be important considerations for some investors.
Looking at infrastructure from a pure investment perspective, there are merits to its inclusion in a pension portfolio, and, as always with investing, some risks that require consideration prior to making any investment. Arguments for including infrastructure include weak correlations with traditional asset classes, a sustainable yield pick-up over traditional bonds and built-in inflation protection. The importance of the last point should not to be underestimated for mature defined benefit plans indexed to inflation.
Most Canadian plans have some measure of current exposure—directly or indirectly—to infrastructure. This comes via the plans’ holdings in bond and/or equity investments issued by organizations engaged in the management of airports, roads, bridges, power generation and other types of infrastructure assets. Most large plans have the size and resources to facilitate the inclusion of dedicated infrastructure solutions in their investment program. Smaller plans face inherent constraints implementing dedicated infrastructure investments. Large or small plans face the risks of convergence and “crowding out” from having too many asset classes.
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Convergence is a term that simply means that many investors are chasing the same assets, regardless of their traditional investible space or sometimes referred to as “style box.” For example, hedge funds, private equity firms, real estate companies and infrastructure firms are often in competition to buy the same infrastructure assets these days. This is further complicated by traditional equity managers being able to invest in publicly listed income trusts dedicated to infrastructure or purchase the publicly listed equities of firms dedicated to infrastructure. This doesn’t mean that infrastructure does not have its own unique risk-return profile or “box,” but it can cloud sponsor expectations in a speciality manager structure. Specifically, a sponsor’s general expectation would be that one specialist manager would not invest in the same space as another specialist manager (i.e., have the same holdings and possibly amplify the risk-return profile of the plan versus the general principles of diversification).
Can a plan have too many asset classes and therefore be overdiversified? We believe so, and caution should be used when evaluating correlations. The reality is that few asset classes have consistently very low correlations with other asset classes, so plans automatically run the risk of assets actually competing with each other for the same return space rather than providing true diversification benefits.
A way to deal with convergence and over crowding risks is to have fewer investment managers with broader and less constrained mandates. (Did a consultant really just say that?) Each manager would be given an asset allocation framework consisting of strategic core asset classes subject to normal, minimum and maximum allocation ranges. These could be, for example, Canadian equity, foreign equity, domestic bonds and specific alternatives. The asset-allocation framework would also include tactical asset classes split up by managers that have demonstrated skills and are allowed to invest as opportunities present themselves. These asset classes could include a wide variety of options including infrastructure and riskier high-yield credit opportunities.
Infrastructure has definitely arrived and will remain part of the investable universe for years to come. Investors can get caught up trying to include every asset class on a specialty manager basis, when it may be possible to have one manager do a number of things on a core/tactical basis. Call it “active” management, in the sense that it is less constrained investing consistent with pension goals and objectives but not quite entering the land of hedge funds.
Peter Arnold leads the Canadian Investment Consulting Practice for Buck Consultants, an ACS Company, a full service human resources and benefits consulting company. He is responsible for the development and delivery of all investment and defined contribution consulting services in Canada.
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