As the OECD has noted, “Australian pension funds have been pioneers in this [alternative assets] field since the 1990s and their financial industry invented the label infrastructure as an asset class.”
However, it wasn’t just a case of the happy coincidence of 1990s infrastructure privatisations; myriad influences have brought about the embrace of alternatives.
Time to review traditional models
There was a realisation that the traditional asset allocation model—with 60 per cent of the portfolio dominated by listed equities and 40 per cent deployed to defensive assets significantly weighted to government bonds—which had served members well over many years, needed to be reviewed.
After all, no investment idea is sacrosanct. The future is rarely a simple extrapolation of the past and growing numbers of superannuation funds recognised that the traditional asset allocation model needed to evolve. They realised that a clutch of structural, economic and financial factors were likely to inhibit future listed equities and sovereign bond returns.
Some of the headwinds include the massive global debt overhang (the combination of public and private debt across OECD countries is larger today than before the Great Recession); an ageing population that places a likely lower ceiling on economies’ growth potential; lower productivity growth; and the prospect of rising interest rates after a three-decade bond rally.
Although still low by historical measures, gradually rising interest rates will be hostile to bond returns as capital values fall. In addition, as many countries, led by the US, enter the late phase of the post-Great Recession economic cycle, the prospect of falling earnings’ growth rates and higher interest rates are significant headwinds for equity market returns.
The picture adds up to a widely accepted conclusion that risk-adjusted returns from major traditional asset classes over the coming five years will underperform their longer run trends.
Rather than sticking with the status quo, some of Australia’s and the world’s largest pension funds have been responding by gradually adding alternatives to portfolios in an effort to achieve greater diversification as well as potentially better risk-adjusted returns.
Said differently, the increasing appetite for alternative assets—direct infrastructure, direct real estate and private companies—is about improving the efficiency of the portfolio by shifting the efficient frontier higher, allowing for a higher return for the same risk, or for lower risk at the same return. This contrasts with attempts to “buy” higher returns by taking more risk; that is, merely moving along the efficient frontier.
Rising interest rates less problematic for alternative assets
A sceptic could argue that an upturn in the interest rate cycle could be negative for alternative assets too; that it’s not just an equity or sovereign bond issue.
There’s a four-point response to this argument:
- Interest rates over the next few years will still likely be lower than the historical average.
- Higher interest rates may be positive for some infrastructure assets, as asset owners are compensated by pricing adjustments or by exposure to macroeconomic tailwinds driving interest rates higher.
- Active owners of alternative assets can improve the operational performance of their assets or expand them and thereby improve returns that can potentially offset interest rate increases.
- Superannuation funds, insurers and other institutional investors are increasingly drawn to the long duration and higher income return characteristics of particular direct infrastructure, real estate and private companies, and consequently are applying lower discount rates to these assets. Of course, lower discount rates support asset valuations.
Interest rate rises likely to be modest
Interest rates do look to be on the way up. Consider the combination of recent hikes in the US Federal Funds rate and high prospect of several more, which will move US interest rates higher. Likewise, the gradual wind-down of the European Central Bank and the Bank of Japan’s purchases of long-dated bonds will result in a more conventional yield curve.
However, it’s very hard to envisage the kind of steep interest rate rises seen in the 1970s and 1980s. In fact, as public and private debt (including household debt) is so high, central banks are mindful of the threat to economies from markedly higher interest rates.
Australia is a case in point. Household debt is at a record level as Australians are borrowing ever larger sums to get into the country’s housing market. It’s led to a situation where the Reserve Bank of Australia is challenged if it cuts and challenged if it hikes.
Ability to offset the effects of rising rates
Modestly higher interest rates are not necessarily negative for all alternatives. If increasing rates stem from a higher short-term inflation outlook (for example change in nominal rates) then forecast cashflows of assets with linkages to inflation, such as toll roads, could increase to offset the increase in discount rates.
By the same token, the revenue of regulated assets, including utilities as well as assets subject to regulatory frameworks, would be expected to increase when real rates increase, offsetting an increase in discount rates.
To explain this further: regulatory frameworks common in the UK, Europe and Australia typically involve the calculation of the “Allowable Revenue” of regulated assets based on a determination of an appropriate Weighted Average Cost of Capital (WACC).
A key component of a regulatory WACC is the prevailing risk-free rate (typically with reference to long-term government bond yields). This means that rising interest rates increase the future revenue of regulated assets after the WACC is reset, which occurs on a periodic basis as defined by the respective regulator.
Utilities (electricity, gas and water transmission, and distribution assets) are typically regulated assets. Likewise, some transport assets also have regulatory protection mechanisms. For example, the Port of Melbourne is subject to quasi-economic regulation, following an initial CPI-cap period. Other examples of regulated transport assets include Heathrow Airport and HS1 in the UK.
While less common, similar cost of debt ‘pass through’ mechanisms can also be established through contract arrangements. This has been observed for some Public Private Partnerships (PPPs), which have included an interest rate adjustment mechanism within the periodic service payment.
What all this distils down to is that regulatory regimes have mechanisms to offset rising interest rates over time, and these mechanisms are a feature of many infrastructure assets. So somewhat counter-intuitively, rising interest rates are not necessarily headwinds for assets held over multiple regulatory periods.
Likewise, inflation—which has been thought of as an ogre since the terrible stagflation of the 1970s—is not hostile to all infrastructure either. For example, ports, airports and toll roads may experience increased revenue in a rising interest rate environment, if the interest rate increases are being driven by a wave of strong economic growth.
Active asset management can improve performance
Unlike listed equities, where even the largest shareholder generally owns a relatively small portion of a company, alternative assets like infrastructure are often owned outright by just a handful of owners.
This, in combination with a philosophy of active asset management, can enable owners to meaningfully impact strategic, operational and financial performance of portfolio companies and thereby improve returns even in a higher interest rate environment.
A good fit with funds’ liabilities
Last but not least, superannuation funds have been drawn to alternatives assets for their liability-matching attributes. The stable predictable cashflows and long duration of some direct infrastructure, real estate and private company assets are a good fit with superannuation funds’ liabilities.
As we enter an era of baby boomer deaccumulation or consumption of savings, the traditional 60/40 equity/bond asset allocation model is evolving. The higher weightings to alternative assets by Australia’s pioneering superannuation industry provide an alternative pathway to meet this significant challenge.
