Infrastructure Investing: An Attractive Alternative for Pension Funds

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Many pension funds have increased their allocation to alternative investments in an attempt to both reduce risk through diversification and to generate higher risk-adjusted returns. Historically, the alternative asset class, which includes private equity and private and public real estate, has provided positive returns with low correlations to traditional public asset classes. However, as the opportunity for worthwhile investments in this asset class has become more difficult to come by, the need for new investment options has increased. Pension fund investors continue to look to other avenues for high yielding and diversifying investments. The extension of the alternative asset class has included investment in hedge funds, commodities and infrastructure.

Infrastructure investing, which includes investment in bridges, toll roads, airports, pipelines, utility towers, and educational and healthcare facilities, is the most recent addition to this category and potentially the most attractive to pension fund investors. Investment in these real infrastructure assets is becoming a more popular investment choice because of the diversification benefits and the predictable and reliable long-term cash flow streams.

Pension funds have made various attempts to minimize funded ratio risk - for example, by matching assets more closely with liabilities. Infrastructure investments provide an opportunity to more closely link the asset cash flows to liability cash flows. Investment in infrastructure such as toll roads or bridges may have high upfront costs, but provides many benefits to the long-term investor. The following are key characteristics of infrastructure investing that align with the needs of a pension fund investor.

Diversification Benefits

An investment in infrastructure assets can act as a risk reduction tool for a plan due to its low correlation to the traditional public market asset classes. This can serve to reduce the volatility of returns and unsystematic risk of the overall plan. In the table below, we summarize the correlation across three major public asset class benchmarks and two infrastructure benchmarks over a 3 year period ending October 2007.

Correlation of Public Market Asset Classes vs. Infrastructure Benchmarks (3 Years as of October 2007)

Source: JPMorgan Investment Analytics and Consulting

As shown above, the two infrastructure benchmarks have low correlations with the other public asset classes as represented by the Russell 3000 Index, the MSCI World ex US Index, and the Lehman Aggregate Index.

Consistency and Reliability of Returns

Another benefit to infrastructure investing is the fixed income nature of the return stream. Similar to many real estate investments, a large part of the return from infrastructure investments is generated as income rather than investment appreciation. This provides a greater reliability of the returns over time. The consistent positive cash flow matches nicely with the needs of the long-term investor. Also, the returns for many of these investments can be partially hedged for inflation. Due to the monopolistic structure of many of these assets, the demand for the asset tends to be relatively price inelastic, so price increases linked with inflation should do little to deter demand or use of the asset by the public. The use of utilities, mass transit facilities and public buildings are typically unaffected by infrastructure cost increases.

In the table below, we summarize the return and standard deviation of three public asset class benchmarks and two infrastructure benchmarks over the 1 year, 2 year and 3 year time periods.

Risk and Return Data as of October 2007

Source: JPMorgan Investment Analytics and Consulting

As shown in the above table, the risk and return profile of the infrastructure benchmarks look very favorable relative to three other public market benchmarks over the 3 year time period.

Investment Time Horizon

A critical characteristic of infrastructure for pension funds is the long-term lives of many of the investments. Since pension funds are long-term investors due to the long-term nature of their liabilities, investing in assets that generate cash flow over the long term aligns nicely with the pension fund's primary goal of meeting its cash flow obligations.

Variety of Investment Options

There are many global options for investment in infrastructure that run across a wide spectrum of choices related to utility and facility operations. The numerous investment types provide flexibility in attempting to match asset cash flow to liability cash flow. Investments will have varying maturities based on the specific investments.

Global pension fund investment in infrastructure has been growing steadily and dates back to at least the early 1990s. The expansion and development of global economies such as China and India also provide a window for market growth. As emerging market economies develop and prosper, there will be a growing need for improved infrastructure, which will fuel the opportunities for future investment.

Low Risk Investment

One of the more attractive characteristics for investing in infrastructure is the low risk of the investment. Typically, infrastructure assets have high barriers to entry, and in some cases, a monopolistic positioning within the society. For example, the investment in a major toll road is not likely to have to compete for income from another major roadway. The lack of competition limits the risk that the asset will become supplanted by another asset.

Concerns about Infrastructure Investing

Infrastructure investing is a relatively new arena for pension funds, so it is important to understand the drawbacks to investing in this asset type. There are two major concerns regarding infrastructure investing. The first concern is whether the consistently positive and relatively low-risk returns can continue. Although this is a concern across all asset classes, it is more difficult to gauge the potential volatility of infrastructure investing because of the limited history of returns in this asset class. The second concern relates to the regulatory impact of these global investments. Many infrastructure assets are impacted by local regulations, which can be unpredictable. Investments in global and, in some cases, emerging markets can be dependent on somewhat unstable regulatory oversight.

Conclusion

As infrastructure investing grows across the global pension market, it may change the landscape of investment in the alternative asset class. The infrastructure investment options seem to provide the appropriate characteristics for the long-term pension investor. The low correlation and potential for consistent long-term cash flow, along with the growing global opportunity for investment, makes infrastructure investing a viable option for pension fund investors. However, it is important that the investor understand the specific investments because of potential regulatory impact. If a detailed due diligence is performed, we may see a shift in assets within the alternative asset class.