Is it time for pension plans to do away with absolute return benchmarks in infrastructure?
BY Staff | July 10, 2020
For years, institutional investors have used absolute return or cash-plus benchmarks to measure infrastructure performance, but it’s time to put these in the past and adopt market-relevant benchmarks based on fair value and representative data, according a new paper by the EDHEC Infrastructure Institute.
“From the viewpoint of the state of the art in financial research, there is no reason to use absolute return benchmarks: backed by empirical evidence, we argue that infrastructure investments are not market neutral and that investors in infrastructure cannot escape the fact that the prices they pay for assets are formed in a market, where systematic risk exists,” the paper said.
The coronavirus pandemic has highlighted that, in certain situations, infrastructure assets aren’t as independent from the business cycle as they’re assumed to be. And some types of infrastructure companies like airports and toll roads are correlated to the business cycle even in good times. “For instance, in the 630-plus companies tracked in the EDHECInfra broad market universe, over the past 20 years we observe more then 150 events of default or dividend lockup, several dozen events of bankruptcy and more than a dozen events of termination by the public sector,” the paper noted.
The importance of properly measuring risk in unlisted infrastructure assets was brought to the forefront by the coronavirus, the paper added. “While infrastructure is often touted as being different from the rest of the economy, it does not follow that it is uncorrelated with economic activity. Instead, infrastructure companies are the backbone of the economy, which means that they are exposed to deep-seated risks that investors should not ignore.”
Further, while alternatives to an absolute return benchmark have traditionally been limited, it’s now possible to use a bottom-up, mark-to-market approach for creating market indices of unlisted infrastructure, according to the paper. For instance, the EDHECInfra has developed indices that are representative universes and measure fair value. “This change from an absolute reference to a relative one would provide a better appreciation of the risks and performance of infrastructure investments and, as such, would allow taking more informed investment decisions.”
The paper studied two peer groups of infrastructure investors, one comprised of large asset managers and the other of large asset owners, both representing about 20 per cent of broad market universe by market capitalization.
When comparing the performance of both peer groups to the broad market index, the research found both peer groups performed better than the market as a whole, but in different ways. “The average large asset manager appears to generate more alpha while taking systematic risks in line with the broad market, while the typical large asset owner is more exposed to market risk (higher beta) and generates lower alpha,” the paper said. “During the Covid-19 lockdowns however, the large asset owner peer group performed in line with the market while the large asset manager peer group did much [worse], in part due to [its] higher exposure to investments in the merchant transport sector.”
When using an absolute return benchmark, it wouldn’t be possible to understand the performance of these investors or to compare them, the paper said. “We show that investors can use market benchmarks to understand their performance during the COVID-19 lockdown episode meaningfully, but also to measure out-performance over the long run. With absolute return benchmarks, all investors will underperform in 2020, which is just as uninformative as the pre-COVID-19 situation, when all infrastructure investors beat their absolute return benchmark every year.”
Proper benchmarks can also help investors to distinguish between unlisted infrastructure market beta and portfolio alpha, the paper noted.
Overall, it’s key for asset owners to understand how infrastructure assets are exposed to risk. Doing so will involve documenting these risks and benchmarking performance relative to a market index or a custom benchmark that represents the risks. “With proper benchmarks, numerous applications are possible that will bring unlisted infrastructure forward as a fully-fledged asset class. Courageous and insightful investors will opt for transparency and relevance by letting go of absolute benchmarks that are now outdated.”