Top fund managers: RARE Infrastructure Value Fund, Hedged

This week we feature a fund that looks for predictable earnings from infrastructure assets over the long term.

Summary: The RARE Infrastructure Value Fund – Hedged offers steady income and a long-term focus. The fund invests in listed infrastructure assets around the world, which have predictable earnings and stable cash flows because they are monopolies. The fund focuses on risk adjusted returns, preferring to invest in companies with lower financial risk.

Key take out: The fund suggests investors take a three to five year investment horizon, but argues that infrastructure should be part of a portfolio over the long term.

Key beneficiaries: General investors. Category: Investment portfolio construction.

Stable, predictable earnings, and good cash flow in both economic booms and downturns, make infrastructure an appealing asset class. But Australian investors need to take a global approach, given the limited local listed opportunities that exist.

Fund manager RARE Infrastructure, founded in 2006, has delivered a return of 14 per cent per annum over the last five years in its Value Fund – Hedged.

Investing in primarily listed infrastructure companies means RARE offers a higher level of transparency compared with unlisted investments and, as senior portfolio manager Nick Langley explains, liquidity means it can fund redemption requests with relative ease.

As we continue to face a low interest rate environment, infrastructure investments offer investors both capital growth potential and steady, consistent income. For the past five years RARE has paid out more than 5 per cent in income distribution.

RARE Infrastructure senior portfolio manager Nick Langley. Source: RARE Infrastructure.

DD: Why do you think infrastructure assets are good investments?

NL: Infrastructure earns returns on its asset base – which are assets that provide essential services to communities or economies, like water, electricity grids, roads, rail and airports.

They are very long term assets and they have predictable earnings and stable cash flows because, in our case, they are monopolies – which means they are hard to replicate and they are regulated. A regulator tells you how much you can earn, so if you earn too much you have to give some back to your customers, but if you don’t earn enough you are able to increase your prices.

Because the assets provide essential services your earnings are inherently stable. For example, if it’s an electricity network, even though you have the costs of maintaining the network you’ve always got that asset and people will use it no matter whether it’s a boom or bust time.

On our side we are exposed to the underlying assets, meaning we don’t take any of the competitive services risk. We don’t get extraordinarily high returns like 20-30 per cent plus in the good times, but in the bad times we still get our fair share, with a good yield, and that’s why it’s a great investment for a long term investor.

What do you think is a single factor that’s driven your performance over the last three years?

We are in quite uncertain times from an equity investor’s perspective. If you compare investment in infrastructure to the resources sector, up until two years ago the prior three or four years you would have done extraordinarily well out of the resources sector, but in the last couple of years you would have done very poorly.

So our assets are essential in good and bad times, meaning steady earnings. The other aspect is with a low cash rate and low bond yield environment infrastructure has been attractive because it pays a high dividend yield.

Can you tell us a bit more about the investment process including why you only invest in listed assets?

The genesis of RARE was to try to replicate the risk/return profile of unlisted infrastructure using the listed market. It doesn't matter if it’s privately owned or owned through the listed market, it is regulated in the same way, has the same earnings profile over time and should have the same investment characteristics.

By owning them through the listed market we have the downside of equity market volatility, but we can offer transparency in terms of pricing and daily liquidity for clients. This helps investors that want to add to the fund or move their infrastructure allocation – which is a difficult process to do with unlisted assets.

We have over 200 companies in our investment universe and we do a detailed, bottom up financial and risk analysis, including visiting companies and their assets, their regulators, customers and suppliers. If we are looking at buying a company we think about the return we can earn over the next five years from the perspective of income (in the form of dividends) we are going to get paid and capital growth.

When creating the portfolio we only like to hold about 40 companies and won’t own more than six per cent of any. Our portfolio construction is a little bit unique compared to others in the space because we focus not only on the returns of companies but also on the risk profile. RARE actually stands for Risk Adjusted Returns to Equity, so when we construct the portfolio we ask ourselves what are we going to get in terms of a return from this company and how much risk are we taking on for this return.

What kind of risks are you okay with taking?

We are comfortable with taking most regulated risk and we rank which countries and regions around the world have better regulation than others. Volume risk, like passenger risk in airports and traffic risk for toll roads, is also okay because it links with data like GDP and population growth which are relatively predictable over longer periods of time. We tend to prefer companies that have lower financial risk, be that overall lower leverage or a level of debt that corresponds with what the regulator allows them to have, which was really important during the GFC.

To be honest we are old infrastructure guys and think of portfolio construction a little bit like how electricity gets generated. You’ve got your base load which will always form the core of our portfolio – companies that just produce year in year out, are very defensive and have a very stable earnings profile. Then you have the next layer of companies where the earnings are pretty certain, they might miss like one year in five, but you’re pretty comfortable with their earnings. At the very top you’ve got a small amount of emerging market exposures, which tend to be higher growth but might be a little bit more volatile – we have a mandate that we can’t have more than 25 per cent of the fund here.

You have gas and electricity companies making up nearly half the portfolio. Have you always invested that much in those sectors and what companies do you like at the moment?

Regulated utilities generally sit anywhere between 45 to 70 per cent of the portfolio. These are defensive in nature and so we were at the high end of that range in late 2011 when everybody thought the European economy was going to crash and break apart, and in late 2008 in the depths of the GFC.

Right now, growth is more important and so we like natural gas companies like Sempra Energy in the US, which owns gas networks on the West Coast and are building a big LNG facility. So still defensive, but have quite good growth associated with them as the gas industry in the US is growing. Because they are a utility and they own the underlying assets, they haven’t suffered from the fall in oil and gas prices because they earn their money based on their assets.

Why do you hold so few Australian companies?

Only about 5 per cent of portfolio is in Australia because the companies here are very expensive at the moment. We used to own a lot of Transurban and Sydney Airport and what you are seeing here is investors are buying them because they are stable and have a nice dividend yield, so in a low bond yield environment they look quite attractive. But we expect over the next five years for bond yields to start to normalise and when that happens those companies are going to sell off. That five-year period is important because that’s our investment horizon, so if we buy today and we think we are going to be selling in a higher bond yield environment then we are going to take a loss on that investment.

What percentage of your portfolio do you think people should invest in a fund like this?

It depends whether people are in accumulation or draw down phase. It is an equity product, so in the shorter term you get some volatility, but in the longer term it’s got fabulous characteristics for retirees who are looking for income, because you’ve got an inflation link coming through in the returns, high income and reasonably stable capital growth.

What we are seeing from our client base is they’re investing anywhere between 5 per cent and 15 per cent of their portfolio in infrastructure. At the moment we’ve got a number of our planning platforms sitting around 5 per cent but looking to increase around 8 per cent and beyond.

We tell investors to have a three to five year investment horizon. Our view is that infrastructure should be a part of client portfolio and it should sit in there at a reasonable weighting pretty much into perpetuity.

Daniella D’Ambrosio is a writer at brightday. The RARE Infrastructure Value Fund - Hedged is available on the brightday platform.

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