Two infrastructure ETFs for your portfolio

Relying on “rules of thumb” in the share market can be dangerous. Some investors gravitate to simple relationships in investing and use them to guide decisions.

Consider the effect of rising interest rates on infrastructure and other “bond proxies”. The view is that companies with bond-like features benefit when rates are low, and vice versa.

Some infrastructure companies have higher leverage, and so face rising debt costs as rates increase. Rising rates also reduce the future value of cash flows and diminish an asset’s net present value. Rising rates also make infrastructure yield less attractive.

That’s the theory. In reality, the relationship between infrastructure and interest rates is less clear-cut than it seems. This misunderstanding creates opportunities for long-term investors who buy after periods of infrastructure-sector underperformance.

In the short term, infrastructure stocks are more sensitive to higher interest rates than mining, energy or consumer discretionary stocks, for example. Therefore, infrastructure could lag as more central banks lift rates this year to tame inflation.

Some US investment banks tip the US Federal Reserve will lift rates another six times this year, or another 1.5%, with further rate rises extending to 2024. So, infrastructure and other bond-proxy stocks probably face a few years of rising rates.

However, many infrastructure companies locked in cheap debt for long periods when rates were near zero, making them less exposed to rising rates.

Moreover, the relationship between strengthening economic demand, higher inflation, rising rates and infrastructure is looser than some investors realise.

On valuation, rising interest rates increase the discount rate and reduce the value of future cash flows. But stronger economic demand can increase those cash flows for airports, toll roads and other infrastructure companies with user-pay assets.

Infrastructure companies with regulated assets, such as energy and gas transmission networks, often have annual price increases that are inflation-linked. This means long-term valuation of their assets should be less affected by changes in bond yields because they are less exposed to the risk of higher inflation crimping margins.

I could outline other anomalies between interest rates and infrastructure. Suffice to say that investors who avoid infrastructure because they believe it will underperform as rates rise have too simplistic a view.

Four factors stand out. First, owning regulated infrastructure assets that can pass on price rises to consumers appeals with inflation at a 40-year high in the US.

Second, heightened geopolitical and economic risk over the next few years will strengthen the case to own physical assets, such as infrastructure. As the world becomes more volatile, we’ll still need airports, toll roads and gas pipelines.

Third, infrastructure typically has higher yields than most other sectors. As inflation rises, investors will have to work harder to maintain real yields (after inflation). The big investment risk this decade could be loss of purchasing power as prices rise.

Fourth, there is rising demand from pension funds and other investment giants to buy listed infrastructure. Sydney Airport’s takeover is an example. The market’s largest investors understand the value of infrastructure and want to buy more of it.

I’ve long argued that retail investors should allocate a small part of their portfolio to alternate assets, including infrastructure. They should look globally because Australia has limited choices in listed infrastructure. Also, they should take a fund approach to improve diversification and focus on funds that own listed infrastructure stocks.

I understand the case for investing in unlisted infrastructure: slightly higher returns over time than from listed infrastructure. The trade-off is having to lock your money away for longer periods, something that appeals less in volatile markets.

Investors can take a passive approach to infrastructure through Exchange Traded Funds (ETFs) or use active infrastructure funds. Australia has some excellent active managers in this asset class – and has been a global pioneer in infrastructure investing.

It’s an interesting time to increase portfolio exposures to infrastructure. The MSCI World Infrastructure Index (USD) – a barometer of global infrastructure stocks – has underperformed over the past decade. Over five years to end-February 2022, the index return 6.45% annually. The MSCI World Index returned 12.64%.

However, on a year-to-date basis, the MSCI World Infrastructure Index is outperforming. Its return is almost flat, while the MSCI World has lost 7.64% during that period. The MSCI chart below shows the performance gap between infrastructure and global equities.

Source: nabtrade

I’m betting on that gap to close further over the next few years as more investors gravitate to higher-quality, higher-yielding global infrastructure assets. The performance gap became too large after COVID-19 when growth assets were in vogue.

Here are two ways to increase portfolio allocations using infrastructure ETFs.

1. Vanguard Global Infrastructure Index ETF (VBLD)

I have written favourably on VBLD, an ASX-quoted ETF, over the past few years for this Report. VBLD has a one-year return of 23.3% to end-February 2022. Like all ETFs, VBLD aims to provide the same return as its index and is bought and sold on the ASX like a share.

VBLD tracks the FTSE Developed Core Infrastructure Index, which includes 133 global infrastructure stocks. Most of the ETF is invested in electricity companies, railroads, pipelines and utilities. By country, two-thirds of the fund is allocated to the US.

The ETF’s top-10 holdings include high-quality infrastructure companies, some of which have exposure to assets (railroads, for example) that are not available on the ASX.

The average Price Earnings (PE) multiple in the VBLD is almost 24 times and it had a trailing yield of 3% at end-February 2022.

VBLD’s annual fee is 0.47%. It comes from one of the market’s best-regarded ETF issuers in Vanguard and is a simple, low-cost way to add infrastructure exposure to portfolios.

Vanguard Global Infrastructure Index (VBLD)

Stock chart of Vanguard Global Infrastructure Index (VBLD)

2. VanEck FTSE Global Infrastructure (Hedged) ETF (IFRA)

IFRA invests in 134 global infrastructure securities. The ETF’s main appeal is that its benchmark index invests in companies where at least 65% of revenue is exposed to core infrastructure assets like utilities, energy and telecommunications.

IFRA looks like it has been designed to appeal to long-term investors who want exposure to more defensive core infrastructure assets. Since its inception in 2016, IFRA has an annualised return of 7.25%.

Returns have been much stronger in the past year: 16.1% over 12 months to end-February 2022. VanEck has reported stronger interest in IFRA in recent months as more investors look for defensive physical assets with reasonably high yield.

A return since inception of 7.25% might seem underwhelming for investors who seek higher equity-like returns. But for conservative investors, such as retirees, a return like that far exceeds that from cash or bonds, without having as much equity-like risk.

IFRA’s other attraction is its currency hedging against the Australian dollar. Investors who seek pure infrastructure exposure – and don’t want to take a view on currency – should consider currency-hedged ETFs.

IFRA is a smaller ETF than Vanguard’s offering. But both ETFs provide exposure to an asset class that has more appeal amid heightened volatility in global financial markets, and an uncertain geopolitical outlook.

IFRA’s annual management fee is 0.52%.

VanEck FTSE Global Infrastructure (Hedged) ETF (IFRA)

Stock chart of VanEch FTSE Global Infrastructure (Hedged) ETF (IFRA)

Tony Featherstone is a former managing editor of BRW, Shares and Personal Investor magazines. All prices and analysis at 24 March 2022. This information was produced by Switzer Financial Group Pty Ltd (ABN 24 112 294 649), which is an Australian Financial Services Licensee (Licence No. 286 531This material is intended to provide general advice only. It has been prepared without having regard to or taking into account any particular investor’s objectives, financial situation and/or needs. All investors should therefore consider the appropriateness of the advice, in light of their own objectives, financial situation and/or needs, before acting on the advice. This article does not reflect the views of WealthHub Securities Limited.