UBS research focus. Infrastructure: a strong foundation. Massive fiscal stimulus boosts infrastructure spending

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1 September 29 UBS research focus Infrastructure: a strong foundation Massive fiscal stimulus boosts infrastructure spending Economic recovery supports end-user demand, revenues Structural trends favor both developers and operators Key are emerging markets, urbanization & sustainability Private sector influence to grow amid high public debt Diverse and growing array of investment opportunities

2 Contents Editorial 3 Highlights 4 Introduction The nuts and bolts of infrastructure 5 Chapter 1 The structural investment case for infrastructure 7 Chapter 2 Infrastructure investments 12 Appendix Listed infrastructure companies 22 Glossary and bibliography 25 Publication details 26 This report has been prepared by UBS Financial Services Inc. ( UBSFS ) and UBS AG Past performance is no indication of future performance. The market prices provided are closing prices on the respective principal exchange. This applies to all performance charts and tables in this publication.

3 Editorial Dear reader, We are about to witness a building boom. A broad range of trends is coalescing in favor of greater spending on infrastructure, in all its various forms. The key factors pushing this surge include: the robust economic growth and rising per capita incomes in the highly populated emerging market countries, a swelling world population coupled with massive migration to cities, and the aging infrastructure assets in developed countries not to mention their aging populations that will require more health and elderly care facilities. Two other factors add momentum to the infrastructure boom that is about to unfold. For one, there is a new sense of urgency about the sustainability and efficiency of how we use our precious resources water, land and energy and a growing desire to limit the effects of climate change and environmental degradation. Secondly, in the past year or so, the global financial crisis has spurred governments worldwide into fiscal activism, forcing them to commit to large spending programs to revive their shaken economies, with infrastructure spending a favored form of stimulus. In this report, we take a close look at the many different types of infrastructure-related investments available to investors. Some offer inflation protection and stable returns, features that are commonly associated with infrastructure assets, while others behave more like equities, with high volatility and considerable cyclicality. We note that many investment options are relatively new, with only limited performance data, so we are careful to point out where we only have a partial picture of risk and return characteristics. Given how diverse the infrastructure theme is, investing in it requires a thorough understanding of each individual investment. This report provides some new analysis of how infrastructure assets performed during the financial crisis and what investors can expect during the next several years. We discuss many trends that we think make infrastructure an attractive investment opportunity, and we explain in broad terms our expectations for how the various types of investment are likely to perform. Our UBS research focus report from March 29 entitled, The financial crisis and its aftermath, forecasts structurally lower growth, higher inflation, rising public debt burdens and lower trend earnings especially in countries facing widespread household and corporate balance sheet deleveraging. Meanwhile, infrastructure spending has emerged as the single-largest component of global fiscal stimulus measures aimed at resuscitating the economy. This spending is now finally winding its way through to the real economy in the form of actual outlays. In addition to the enormous outright spending on projects, we think improving economic conditions should support higher revenues for infrastructure developers, owners and operators. Investment exposure to operators, for example, can benefit from higher inflation expectations, if these materialize, since operators generally can adjust their fees accordingly. And the fragile state of government finances could usher in a new era of greater private sector involvement in infrastructure operations and financing, if not outright ownership. Andreas Höfert Global Head Wealth Management Research Kurt E. Reiman Head Thematic Research UBS research focus September 29 3

4 Highlights Infrastructure: a strong foundation Massive fiscal stimulus boosts infrastructure spending In the aftermath of the global financial crisis, governments throughout the world have pledged vast sums of money for infrastructure spending as a way to boost economic activity. This new spending represents the single-largest category of fiscal stimulus in 29 and 21, even more than the boost derived from income tax measures. Very little of the announced infrastructure funds has been released so far, which suggests that the bulk of the spending should start in late 29 and 21. Structural trends favor both developers and operators Even when government stimulus measures are phased out as the global economy revives, a broad range of trends is coalescing in favor of greater spending on infrastructure, in all its various forms. The key factors pushing this surge include: the robust economic growth and rising per capita incomes in the highly populated emerging market countries, a swelling world population coupled with massive migration to cities, and the aging infrastructure assets in developed countries not to mention their aging populations that will require more health and elderly care facilities. Private sector influence to grow amid high public debt Although fiscal stimulus should spur infrastructure investment in the next few years, this support is likely to wane as government debt levels soar in many countries. Nevertheless, the private sector appears eager to fill the funding gap as cash-strapped governments look to meet their compelling infrastructure needs. The sale or leasing of infrastructure assets could increasingly become a technique to limit public debt growth and raise funds. Therefore, with private capital available, government financing constraints may not limit further investment. These types of public-private partnerships will open up a broader range of investment options. While we see no immediate threat from higher inflation, there are structural risks of higher inflation expectations as the effects of global monetary and fiscal stimulus unfold. As we outlined in the UBS research focus entitled, The financial crisis and its aftermath, in March 29, the main problem for policymakers once the financial crisis has passed will be to ensure that the massive liquidity injections from governments and central banks do not lead to a surge in inflation. Infrastructure assets that are able to increase usage fees in line with inflation offer some degree of protection against the threat that higher prices will erode the purchasing power of an investment portfolio. Many infrastructure sectors, such as seaports and airports, are exposed to cyclical earnings and will likely see some firming in earnings and demand as the recovery progresses, which should support the underlying asset prices. In addition to this cyclical boost to earnings, we would also highlight the potential growth in emerging market countries. We think they will need to invest in most forms of infrastructure as their wealth, their cities and their populations all continue to grow, spurring demand. This should benefit developers of new projects, as well as owners and operators of existing facilities. We advise investors to be mindful of valuations for some sectors, and also to note the inherently higher risk of investing in greenfield operations with no track record for demand. Diverse and growing array of investment opportunities Infrastructure investments are relatively new, and some are highly illiquid. Not all infrastructure investments will benefit in the same way from the various drivers, particularly given the diversity of the investment options as well as the potential for large valuation differentials between them. That said, we see many positive attributes in infrastructure investments at this point in the economic recovery process, as well as over the longer term. Economic recovery supports end-user demand, revenues The past year has seen a rerating of infrastructure asset valuations, after the shock of higher financing costs and lower usage rates during the financial crisis. The assumption that infrastructure asset values are stable was severely tested during the financial crisis and sometimes was found to be flawed. Understanding how various infrastructure assets perform during a period of stress yields useful information about the types of assets to select for portfolios and also gives insight into how to best operate and finance infrastructure projects. In addition, investors can take advantage of less expensive valuations in many sectors and regions. 4 Infrastructure: a strong foundation

5 The nuts and bolts of infrastructure Introduction The nuts and bolts of infrastructure Essential assets Infrastructure has always been vital to economic activity and social progress, but is often overlooked because the assets are sometimes hidden from view and usually taken for granted. The roots of the word, infra (beneath) and structure, refer to things below the surface. But just because infrastructure often may not be seen, there is no questioning its essential nature. Virtually everything we do today would be impossible without a well-maintained and adequately provisioned foundation of infrastructure. In the classic eighteenth-century economics study entitled, An Inquiry into the Nature and Causes of the Wealth of Nations, Adam Smith outlined the crucial importance of infrastructure in his discussion of the public works which facilitate the commerce of any country, such as good roads, bridges, navigable canals, harbors, etc. While canals may no longer rank among the most widely used public works, infrastructure in the twenty-first century still includes traditional services, such as the provision of clean water and navigable seaports, as well as more recent incarnations, such as electricity and natural gas distribution, air travel, and communications networks. We define infrastructure as the essential physical and organizational structures needed for a society and its economy to function as efficiently and productively as possible. Specifically, this includes structures that support an economy s physical capital, such as those that supply energy, waste management, water, communication, and transportation services, as well as structures that enable the productive development and employment of human capital, such as hospitals and schools (see Fig. 1). Link to improved living standards and economic growth Infrastructure is not only crucial for the basic functioning of society but is also an important driver of economic growth. The most obvious evidence of how upgraded infrastructure improves a society s overall living standards is seen at the household level. Reliable water, sanitation, and electricity systems and good schools and hospitals make people s everyday lives considerably less complicated and more efficient. According to a World Bank study, the estimated cost to Indonesia s economy of insufficient access to clean water amounted to 2.3% of GDP in 26. These costs stem from lost productivity, illness, and lost income from polluted fishing sites, among others. But infrastructure investments also impact economic growth directly. This effect is particularly obvious in transportation, electricity and telecommunications networks. Improving infrastructure in these areas can greatly enhance a country s productivity as it enlarges market access for its companies. For example, the Chinese government announced plans to spend more than USD 55 billion by 21 to build 5 new airports and upgrade more than 9 others. The hope is that inland regions cut off from the coastal economic boom will become more integrated into the global economy. Infrastructure needs around the world While overall demand for infrastructure is rising and needs vary from country to country, they can generally be grouped according to three criteria (see Fig. 2 and Fig. 3): Fig. 1: Infrastructure sectors Sectors Physical capital Energy Water supply Environmental management Communication Transport Human capital Social services Examples Electricity transmission, distribution, storage Water distribution, wastewater recycling, desalination Waste management Satellite networks, fiber and copper cables Toll roads, bridges, rail networks, seaports, airports Hospitals, elderly care facilities, schools, prisons Source: UBS WMR UBS research focus September 29 5

6 Introduction Emerging market countries require more infrastructure. Strong economic growth and rapidly expanding populations characterize this first group of countries. In order to sustain rapid development and avoid bottlenecks that could threaten economic activity, these countries need to commit significant amounts of capital to infrastructure investment. Companies that develop and supply the resources, knowledge and equipment for new infrastructure projects (greenfield projects) are likely to benefit from this trend. Developed countries in need of upgrades and maintenance. After years of insufficient investment in maintenance and upgrades, infrastructure in many developed countries has become decrepit. Infrastructure-related investments in these countries would likely include companies that own and operate infrastructure, as well as developers (brownfield and greenfield projects). Developed countries with strong infrastructure. These countries generally have a well-developed, adequate level of infrastructure, both physical and social. Investments in this group will mainly benefit owners and operators (brownfield projects), although some older infrastructure will occasionally need to be renewed. Considerable improvement in infrastructure needed Improvements in global infrastructure are critical to sustain and increase global economic growth and social development, both in developed and developing countries (see Fig. 4). In a recent KPMG global survey of executives, 9% said that the quality and availability of infrastructure directly affected where they locate and expand their businesses. The majority felt that infrastructure would become even more important to their business in the next five years but expressed concern that investments would not keep pace with their business needs (see Fig. 5). This UBS research focus report discusses the strong underlying trends supporting further spending on infrastructure, as well as the many avenues that have emerged for investors to participate in this long-term development. Fig. 2: Large differences in infrastructure quality Quality of overall infrastructure score Switzerland Singapore Germany France US Canada Japan South Korea UK China Ireland Italy Note: 1 = underdeveloped, 7 = extensive and efficient by international standards Source: World Economic Forum (28) Russia Pakistan India Indonesia Brazil Fig. 3: Infrastructure lifecycle Infrastructure quality Inadequate Poor Good Excellent Source: UBS WMR Developers Emerging markets new infrastructure development Investment Owners and operators Investment Time Developers Investment Developed countries maintained infrastructure Plan Build Operate & maintain Renew or erode Investment Developed countries aging infrastructure Fig. 4: The 12 pillars of competitiveness Basic requirements Institutions Infrastructure Macroeconomic stability Health and primary education (social infrastructure) Efficiency enhancers Higher education and training Goods market efficiency Labor market efficiency Financial market sophistication Technological readiness Market size Innovation and sophistication factors Business sophistication Innovation Source: World Economic Forum (28) Key for resource-driven economies Key for efficiency-driven economies Key for innovation-driven economies Fig. 5: Infrastructure to become more important In % Much more Somewhat Neither more important more important nor important less important Total North America Asia-Pacific Eastern Europe Latin America Western Europe Somewhat Much less less important important Middle East and Africa Note: Compared to today, how important will Infrastructure be to your organization five years from now? Source: KPMG (29), UBS WMR 6 Infrastructure: a strong foundation

7 The structural investment case for infrastructure Chapter 1 The structural investment case for infrastructure Today, infrastructure spending long overdue in developed countries and urgently needed in emerging economies forms the cornerstone of most fiscal stimulus plans. Soaring public debt paves the way for private solutions and interesting investment opportunities. An essential rebuilding block In the aftermath of the global financial crisis, governments throughout the world have pledged vast sums of money for infrastructure spending as a way to boost economic activity. According to a recent IMF study by Horton et al. (29), infrastructure spending represents the singlelargest category of fiscal stimulus in 29 and 21 equivalent to roughly six-tenths of G2 gross domestic product (GDP) in each year and greater than the boost derived from income tax measures (see Fig. 1.1). Very little of the announced infrastructure funds has made its way into actual outlays, which would suggest that the bulk of the spending will appear in late 29 and 21. Long-term structural support for more investment Even when the various government stimulus measures are phased out as the global economy finds more stable footing, there are many reasons to expect infrastructure investment to remain strong. To sustain economic growth globally in the face of an ever-burgeoning population, spending on infrastructure is simply unavoidable. Demographics. According to UN estimates, 29 marks the year when more people will live in urban areas than rural ones (see Fig. 1.2). By the middle of the century, more than two-thirds of the global population will live in cities. Not only will the world grow more urban, there will also be a lot more people living on the planet. The world s population, having just surpassed six billion a decade ago, is set to soar to over 9 billion people by 25, and most of this expansion will occur in developing countries. Combined, these trends are making the need for improved transportation, waste management, energy supply and social infrastructure increasingly urgent. At the same time, the developed world will have to deal with a rapidly aging population, which implies increased spending on social infrastructure, such as elderly care and healthcare facilities. Global convergence. Emerging market infrastructure is constantly being expanded and upgraded in order to keep pace with and sustain economic activity and social needs. In certain cases, the emerging economies have been able to leapfrog some standard types of infrastructure found in developed countries. For example, mobile telephone networks render landlines largely obsolete. But the current phase of economic and Fig. 1.1: Fiscal stimulus emphasizes infrastructure Fiscal stimulus measures in G2 countries by spending category, in % of G2 GDP Unidentified measures Infrastructure SMEs Safety nets Strategic sectors Other expenditure measures Other revenue Personal income tax Indirect taxes Corporate income tax Housing measures Note: Where no hard data for 21 was available, the 29 composition was assumed. Calculations are done using a PPP-weighted average. Source: Horton et al. (29) Fig. 1.2: Larger population becomes older and urban Share of world population, in % World population, in billions Percentage 6+ Percentage urban Source: UN Population Division UBS research focus September 29 7

8 Chapter 1 demographic development of many emerging market countries would point to sustained higher demand for transportation, electricity generation, and water-related services (see Fig. 1.3). Advances in globalization will also continue to support infrastructure development, particularly in the areas of airport and seaport facilities to improve cross-border trade flows. Modernization and upgrades. In addition to adding facilities to support an aging society, developed countries also face substantial investment needs in the coming years to replace and improve decrepit infrastructure. The general state of disrepair in the US, for example, has manifested itself with disturbing regularity in recent years in the form of tragic accidents. Several New Yorkers were injured in July 27 when an 8-year-old steam pipe burst in midtown Manhattan. Just a month later, a structurally deficient bridge in Minnesota collapsed, killing 13 people. The American Society of Civil Engineers assigns a near-failing grade to US infrastructure and estimates that USD 2.2 trillion is needed over five years to bring it up to standard. This estimate has risen from USD 1.6 trillion in 25. Sustainability. A more sustainable economic growth path, particularly in fast-growing emerging market countries, requires investments in less carbon-intensive forms of energy and in improved environmental management. Furthermore, climate change will be a driving force for new infrastructure investments. Spending will be needed to meet requirements in clean power generation and the development of a renewable energy supply. This will compel both developed and developing countries to renew large parts of their existing infrastructure. Based on these and other long-term factors, the OECD estimates that infrastructure investment could reach an average of around 3.5% of global GDP annually by 23. Government funding constraints, private options Despite the long list of factors supporting infrastructure investment, it is not clear that governments will be able to afford it after they have carried out the announced stimulus measures. Emerging market countries with high private savings rates, such as India, China and Russia, should experience few constraints on their ability to expand infrastructure according to domestic needs. The situation in developed countries is not as straightforward, however. According to IMF projections, debt-to-gdp ratios in advanced G2 countries will increase by about 4 percentage points by 214 (see Fig. 1.4), which would represent the largest and most rapid deterioration in government finances since World War II. Many governments may want to spend more on infrastructure than is outlined in the fiscal stimulus programs but are constrained by the sharp rise in debt-to-gdp ratios and explosion in long-term entitlement programs as their populations age. Fig. 1.4: Debt burdens to encourage asset monetization Projected debt-to-gdp ratios for selected countries, in % China Germany France UK US Italy Japan Source: Horton et al. (29), IMF, UBS WMR Fig. 1.3: Energy use and private transportation in emerging markets lags by a wide margin Total primary per capita energy consumption, in kilowatt hours, 26, in thousands Vehicle ownership per 1, people, India Brazil China Eurozone Russia US India China Brazil Russia Eurozone US Source: Energy Information Agency, UBS WMR Source: International Road Federation, UBS WMR 8 Infrastructure: a strong foundation

9 The structural investment case for infrastructure Growth accounting: how infrastructure contributes to economic growth Attempts to show how infrastructure spending influences economic growth are quite complex and often rely on crude estimates. Modern growth theory aims to attribute economic growth to a variety of different factors but in very broad terms. The simplest and most robust model, developed by Robert Solow, pins down three major factors that increase economic output: expand the labor force add more capital (in the form of infrastructure and machinery) make labor and capital more productive. As an example, Fig. 1.5 shows the extent to which labor force growth, capital accumulation and total factor productivity 1 have contributed to economic growth in the US and in China. As would be expected, capital accumulation and growth in total factor productivity are the main drivers of the Chinese growth miracle. Theoretically, the importance of infrastructure and the consequent increase in the capital stock is its ability to enhance productivity when installed in an intelligent and efficient manner. Unfortunately, it is nearly impossible to further disentangle the growth effects of infrastructure investments and other forms of capital spending, such as commercial real estate, machinery and residential real estate, since national economic statistics rarely distinguish between different types of capital formation. A recent OECD study (Égert et al. 29) concludes that network infrastructure, especially telecommunications and electricity, have a strong positive effect on economic output. The positive economic effects are greatest when the stock of physical infrastructure is low. 1 Total factor productivity is the change in output that can not be explained by changes in the supply of capital and labor. In a simple sense, it can be regarded as the level of technology that allows labor and capital to work together. Perhaps the importance of infrastructure is most visible when it becomes impaired. Fig. 1.6 shows the evolution of per capita GDP over several decades and specifically the effect of the destruction of the capital stock and infrastructure on economic activity in Germany and Japan following World War II. The Marshall Plan financed the rebuilding of roads, railways and ports, which enabled Western European economies to realize fast rates of economic growth during the 195s and 196s and then eventually return to their long-term growth trajectory. Per capita incomes in emerging market countries, most notably China, are in the beginning stages of converging with those of developed economies. By opening their economies and investing heavily in capital and infrastructure, emerging markets have been able to grow at an annualized rate five percentage-points faster than developed economies over the last 15 years. We expect this catching-up process to continue, in part because of further investment in infrastructure in the emerging regions. Fig. 1.6: Loss of infrastructure reduces output Per capita GDP, in 199 Geary-Khamis dollars, logarithmic scale, in hundreds China Germany Japan US Source: Groningen Growth and Development Centre, Maddison (29), UBS WMR Fig. 1.5: Chinese growth mainly a function of productivity and capital formation Factor composition of US economic output, in % Factor composition of Chinese economic output, in % Labor Capital TFP GDP Source: Groningen Growth and Development Centre, Maddison (29), Penn World Table, UN Population Division, UBS WMR Labor Capital TFP GDP UBS research focus September 29 9

10 Chapter 1 A fiscal curse and a cure-all Given stretched government finances, we expect privatesector involvement to grow and public-private partnerships (PPP) to become much more commonplace, especially in those countries where fiscal deficits and debt levels constrain traditional government project financing (see box on page 9). Private sector involvement in Asia varies considerably between countries. For example, private sector infrastructure activity in China is still relatively small. However, government finances are far from stretched in China. In Indonesia, the Philippines and Thailand, private sector partnerships, such as toll roads, are much more common. But for countries where high debt loads limit infrastructure spending, the sale or leasing of infrastructure assets could increasingly become a technique to limit debt growth and raise funds. A recent KPMG study confirms that business leaders believe more cooperation between the public and private sectors to finance infrastructure projects is needed (see Fig. 1.7). Some high-profile plans to privatize infrastructure assets in the US, such as Chicago s Midway Airport and Pennsylvania s Turnpike Authority, were shelved in recent months, but other smaller deals are reaching completion as governments seek to monetize assets and offload operational responsibility. Therefore, government financing constraints may not limit further investment when private capital is available. Where will infrastructure investment activity occur? In 26 and 27 the OECD published one of the most comprehensive studies on the outlook for global infrastructure investment. While the research project was concluded before the financial crisis hit, many of its findings are still valid. In fact, the boost from recent fiscal stimulus packages may have even expedited some of the infrastructure spending that was earmarked for later years. However, estimates of infrastructure spending are highly complex and involve numerous rough calculations and assumptions using often patchy data or informed guesswork. At the least, these estimates suggest the magnitude and direction of infrastructure spending plans. With that caveat in mind, we find it significant that OECD researchers expect worldwide annual expenditures in the water and electricity sectors to double by 225 (see Fig. 1.8). Spending on electricity generation and on oil and natural gas services boosts overall energy infrastructure spending even higher. This contrasts with the expenditure forecasts for the telecommunications sector, where investment is likely to decrease sharply as a result of technological advances and the more mature phase of capacity expansion. Land transport investment looks set to grow only incrementally but it is in any case a significant area. Adding the many infrastructure sectors together, the OECD estimates that cumulative infrastructure spending during the next 2 years could well eclipse USD 7 trillion slightly greater than a year s global GDP. Estimates for social infrastructure spending are even more complicated, and, accordingly, the OECD report ventured no forecast for this sector. Despite the importance of social infrastructure, the assets are often highly dispersed, intangible and difficult to identify. Particularly in emerging market countries, but also in developed countries where infrastructure maintenance has been neglected in recent decades, spending on social infrastructure is urgent. In future research, the OECD plans to more closely survey transcontinental infrastructure, such as airports, seaports, and pipelines. Fig. 1.7: Private sector support for PPPs In % Strongly agree Agree Neither agree Disagree Strongly nor disagree disagree Note: Government should work to a greater extent with private industry to finance infrastructure improvements. Source: KPMG (29), UBS WMR Fig. 1.8: World infrastructure spending needs Estimated average annual spending needs by sector, in billions of USD Rail Telecom Electricity Road Water Note: Water estimates are for OECD countries, Russia, China, India, and Brazil. Electricity estimates include only transmission and distribution, which comprises roughly 53% of the total sector expenditures. Source: OECD (26), UBS WMR 1 Infrastructure: a strong foundation

11 The structural investment case for infrastructure Conclusions From a macroeconomic perspective, infrastructure is an important driver of economic growth. If infrastructure investments are smart and efficient, they enhance growth by adding to the capital stock of an economy and making it more productive. That infrastructure is set to grow in importance is supported by a number of long-term trends in demographics, environmental sustainability, and economic growth, particularly in the emerging markets, and by increasing crossborder trade. While estimates for infrastructure needs vary across regions, important investments are required both in developing and developed countries in order to maintain and improve the living standards of the population and to support further economic growth. The fiscal stimulus packages that have been launched by governments around the world, particularly by China and the US, should have an important impact on infrastructure spending. But while fiscal stimulus should spur infrastructure investment, this support is likely to vanish when the global economy eventually recovers, although the need for improved infrastructure will remain. Nevertheless, the private sector appears eager to fill the funding and operational voids as cash-strapped governments look to meet their compelling infrastructure needs. Public-private partnerships becoming more important Besides full or partial privatizations, the outsourcing of operating services to private companies has been the most important engagement of the private sector in infrastructure. Several countries have recently transferred the ownership of infrastructure assets or operation services to the private sector. Privatizations (the sale of state-owned companies) and liberalization (fostering competition in previously monopolistic markets) have shaped several infrastructure sectors over the last two decades. The OECD estimates that approximately USD 1.4 trillion of assets in OECD and other countries was privatized between 199 and 26, including telecommunication, utility, transport, and oil facilities. Nevertheless, a substantial amount of infrastructure assets in public hands may be privatized in coming years as cash-hungry governments deal with severely challenged budgets. In recent years, private-public partnerships (PPP) have emerged as an efficient model to integrate private capital and knowledge in large-scale infrastructure projects. The UK, Australia, Ireland and several other countries have gathered valuable experience with this form of interaction. One of the advantages of PPPs is that risks associated with infrastructure projects can be shared in an efficient manner. PPPs also allow for enhanced competition in the public sector and are usually more open to innovation and lead to more cost-efficient construction and operation of infrastructure assets. However, there are also several drawbacks in using PPPs. Firstly, the cost of capital to the private sector might be higher than to the public sector to compensate for increased counterparty risk. However, several examples suggest that higher financing costs are often offset by lower overall project costs. Secondly, the contractual agreements between private companies and the government are complex and can become too costly for smaller infrastructure projects. Finally, PPPs are only suitable when usage can be controlled easily, as in the case of toll roads or water systems. UBS research focus September 29 11

12 Chapter 2 Chapter 2 Infrastructure investments Infrastructure investments are relatively new, and some are highly illiquid. Despite the limited performance data, we see many good investment opportunities emerging. But the sector is very diverse and understanding its differences is a necessary first step. A diverse offering emerges Whether infrastructure behaves as a distinct asset class, with identifiable diversification benefits, is a topic for discussion among investment professionals. The answer seems to depend on how broadly the investment universe is defined. In recent years, innovative financial products have expanded the pool of investible assets that fall under the infrastructure heading. Some investments offer inflation protection and stable returns, features that are commonly associated with infrastructure assets, while others behave more like equities, with high volatility and considerable cyclicality. We split the infrastructure investment universe into two very distinct camps (see Fig. 2.1): unlisted infrastructure owners and operators, and listed firms engaged directly in infrastructure operations and development or access to these companies through funds that are listed on a stock exchange. The investment products of the two categories differ, as do the levels of commitment they demand of investors in terms of liquidity, knowledge and investment size (see Fig. 2.2). Fig. 2.1: Infrastructure investment grid Different types of infrastructure exposure High Liquidity Low Source: UBS WMR Unlisted fund of funds Unlisted funds Direct Behaves like infrastructure Listed stocks of owners and operators Infrastructure exposure Listed funds and exchangetraded funds Listed stocks of developers Indirect Behaves like equity We see many favorable attributes in various types of infrastructure assets, but each carries its own specific set of risks. Understanding the specific types of investments will help form realistic performance expectations. But, as with any evolving investment area, expectations are often rooted in assumptions rather than in several years of actual performance data. In order to choose the most appropriate infrastructure exposure for a portfolio, investors should be able to select from a range of options. In the case of unlisted infrastructure, investors have a narrower information set for making decisions than with other more liquid, mainstream investments. Bright new entrant, limited track record Deciding which assets to include in a portfolio over the long haul and in which proportion will determine the portfolio s long-term risk and return characteristics. Cash, bonds and equities are widely regarded as the traditional assets in most portfolios. However, new asset categories have emerged in recent years such as commodities, real estate and other so-called NTAC (nontraditional asset classes) that demand consideration when deciding on the strategic asset allocation of a well-diversified portfolio. Infrastructure is a new entrant into the NTAC pool, and gauging its risk and return profile is particularly difficult given the limited performance track record of infrastructure investment vehicles and the few available benchmarks. To summarize the limited data situation, we note the following points: There is virtually no performance data on unlisted infrastructure investments. Data on listed infrastructure is only available since 1995, and most of the available listed infrastructure products have been launched only since 27. Listed infrastructure performance data cannot be used as a proxy for unlisted infrastructure. When analyzing the performance data of listed infrastructure, even small adjustments to the chosen timeframe can 12 Infrastructure: a strong foundation

13 Infrastructure investments result in large and meaningful changes to the results. One historical cross-section of data yields different conclusions about the risk and return profile than would a different time period. This sharp disparity occurs because the available data is too limited to be able to smoothen the effects of the outliers. Making matters worse, most of the performance data in existing research studies predates the financial crisis. Therefore, incomplete and statistically insignificant data renders much of the discussion about risk and return characteristics theoretical. Unlisted infrastructure The purest form of infrastructure investment is a direct one into a portfolio of infrastructure operators, a type of private equity investment available through an unlisted fund or fund of funds (see Fig. 2.3). We note a few important characteristics of this type of investment: These funds will normally offer diversified exposure to a selection of infrastructure projects, but it is important to distinguish between funds that offer exposure to new building (greenfield) and existing projects (brownfield). The fund managers will often assign their own management teams to the projects or enter into agreements with local experts. Investors should bear in mind that direct infrastructure investments are usually highly illiquid, carrying capital lock-up provisions of 15 2 years. Such commitments are usually better suited to institutional investors but may at times also complement the investment needs of individuals. While there is a good chance that unlisted funds will become more available to individual investors, high capital commitments and low liquidity are likely to persist especially as compared to more mainstream investment options. Investors should also pay close attention to the management fee structure of unlisted infrastructure funds, which in some cases can approximate the fees of private equity investments. The investment appeal of unlisted infrastructure can only be assessed by evaluating its underlying pool of assets (in contrast to using stock prices to assess the value of listed infrastructure), and how the value of these assets would change throughout the business cycle. We limit ourselves to the most important drivers, such as inflation, GDP growth, the credit cycle and regulation. Keep in mind that the sensitivity to these factors depends heavily on the stage of development of any single infrastructure asset. Earlystage infrastructure assets, such as newly built toll roads, will be much more sensitive to these drivers than mature assets with proven demand patterns. Business cycle. Demand for truly essential infrastructure services exhibits very little sensitivity to the phase of the business cycle. Those infrastructure segments that take on the form of a natural monopoly, such as water systems or social infrastructure, are largely unaffected by whether the economy is expanding or contracting. Conversely, revenues of seaports and airports exhibit much more cyclicality because usage rates are tied to overall economic activity. Credit cycle. Most infrastructure assets have an operational life spanning several decades (see Fig. 2.4). They can therefore be regarded as long-duration investments. Institutional investors, such as pension funds, increasingly look to match the cash flows of infrastructure assets to their long-term liabilities (i.e., pension payments). In that sense, infrastructure exposure can prove beneficial alongside traditional long-term government bonds. However, infrastructure projects are often financed with a substantial amount of debt, leaving them exposed to credit cycle dynamics if the maturity of the debt is less than the service life of the infrastructure asset, which is Fig. 2.2: Infrastructure investment vehicles Different means to get exposure to infrastructure Unlisted funds Owners & operators Owners & operators Listed equities and listed funds Developers WMR view Delivers relative asset price stability, strong inflation hedge and stable cash flows Low correlation to other asset classes Investable universe likely to expand as governments search to monetize assets Equity market risk Decent relative and absolute performance potential amid lackluster outlook for risky assets Liquid access to companies that are exposed to infrastructure operators Some demand stabilization beginning to emerge as recovery takes hold Equity market risk Liquid access to companies that are exposed to infrastructure development Developers benefit from strong investment needs in emerging markets and assorted fiscal stimulus packages Investment vehicle Investment funds Fund of funds Single stocks Mutual funds Exchange-traded funds Single stocks Mutual funds Source: UBS WMR UBS research focus September 29 13

14 Chapter 2 often the case. As a consequence, highly leveraged infrastructure projects (those that are financed primarily with debt rather than equity capital) are more likely to exhibit high correlations to the business cycle through exposure to fluctuations in debt funding costs. Regulation. Regulation is a key performance driver of infrastructure assets and is more important for infrastructure than for a broad portfolio of equities and bonds. While a stable legal system is well established in developed markets, expropriation remains a significant risk in countries with less developed legal institutions and property rights. In addition to outright expropriation, the potential exists for governments to amend concession agreements at the expense of operators, leading to a lower return on capital and lower asset prices. For example, it is not uncommon to see windfall taxes imposed on infrastructure assets that generate returns deemed excessively high. tect against the erosion of purchasing power. Infrastructure assets offer inflation protection to the extent that concession agreements permit owners and operators to increase user service charges in line with changes in the overall price level. While we find that infrastructure owners and operators offer inflation-protection features, these often depend on regulatory decisions and reviews. In addition, revenue formulas are not always tied one-to-one to consumer prices and may not cover increases in operating costs. A further risk is that usage rates can fall when prices rise and economic conditions deteriorate. While largely hailed as one of the most important features of infrastructure, inflation protection is best judged on a case-by-case basis. Generally, the value of infrastructure assets can be expected to rise during inflationary environments. Existing infrastructure assets become more attractive as the replacement costs increase. In the current environment, as inflation expectations appear poised to rise following massive monetary and fiscal stimulus, inflation-protected (real) investments offer enhanced appeal. Only in a deflationary environment can real assets be expected to perform poorly. Fig. 2.3: Comparison of different infrastructure investment fund offerings Investment type Purpose/approach Benefits Limitations Unlisted funds Manager selects direct infrastructure Direct access to infrastructure revenues. Bond Performance depends heavily on manager skill investments. Tend to focus like payments. and selection. Fees charged for management and either on greenfield or brownfield. access are usually high. Lock-up periods and large minimum investments required. Concentrated exposure to the infrastructure theme. Only available to institutional investors. Only monthly or quarterly valuation. Unlisted fund of funds Investment funds (open end) Inflation. Although not an imminent concern, we do forecast higher inflation expectations during the next decade, which is broadly in line with the investment horizon of most direct infrastructure projects. This would tend to increase demand for assets that can pro- Exchangetraded funds Source: UBS WMR Provides access to many underlying investments, including full lifecycle infrastructure projects. Gain diversified exposure to listed infrastructure. Generally differentiates between investments in owners and operators and developers. Tends to differentiate regionally. Offer diversified exposure to listed infrastructure; benchmark approach. Index methodology selects exposure to infrastructure owner and operator companies. Tends to differentiate regionally. Direct access to infrastructure revenues; bondlike payments; more diversified than a single fund. Liquidity, accessibility, daily valuations, and low minimum investment requirements. Compared to unlisted products, listed infrastructure funds can be more diversified with a higher amount of underlying investments. Diversification regionally and by subsector hedges investors against regulatory and interest rate risks. Compared to an ETF, active management can provide more targeted exposure to infrastructure stocks and limit exposure to utilities. In addition they can change to more favorable subsectors throughout the cycle. Liquidity, accessibility, daily valuations, and low minimum investment requirements. Compared to unlisted products, ETFs are more diversified with a higher number of underlying investments. Diversification regionally and by subsector hedges investors against regulatory and interestrate risks. Lower management fees compared to listed funds. Very high level of transparency. Performance depends on manager s skill; fees usually high; lock-up periods and large minimum investments required. Only available to institutional investors. Only monthly or quarterly valuation. Performance depends heavily on manager skill and selection. Fees charged for management and access are usually high compared to an ETF, but cheaper than unlisted infrastructure. Limited performance history. High beta with equity markets compared to the non-listed space. High beta with equity markets compared to the non-listed space. Major indices have a large (5% 9%) utilities exposure. Will have a rather static sector exposure not adapted to market cycle. 14 Infrastructure: a strong foundation

15 Infrastructure investments From a conceptual perspective, we would tend to agree with assertions that place the risk/reward tradeoff for infrastructure assets somewhere between equities and government bonds, with low correlation to both. The global financial crisis demonstrated that certain infrastructure assets can periodically link up with other risky assets. Earnings declined most for cyclically exposed infrastructure assets, and several highly leveraged assets imploded amid sharply higher refinancing costs, while correlations with other risky asset classes, such as equities and corporate bonds, increased. However, in an environment with a lackluster outlook for risky assets, unlisted infrastructure offers decent relative and absolute performance potential. In a recent survey by Preqin, a consultancy, a large share of fund managers targeted minimum internal rates of return on invested assets of between 1 and 18% (see Fig. 2.5). As a consequence, strategic allocations to unlisted infrastructure can make sense from a portfolio diversification perspective. Over 1 unlisted infrastructure funds are collectively looking to raise over USD 1 billion, according to Preqin. This amount is greater than the combined infrastructure fundraising since 25 (see Fig. 2.6). Heightened competition among investment funds to deploy fresh capital to purchase infrastructure assets could keep prices and valuation multiples elevated. But there are many reasons to expect new investments to be purchased at attractive levels. The financial crisis and the credit crunch exposed the risk of investing in highly leveraged assets of all kinds, including certain infrastructure projects. And indications would suggest that infrastructure assets are less expensive than they were in the boom years before the financial crisis. The investment universe will likely broaden if cashstrapped governments begin to sell or lease assets to reduce budget deficits, as we expect. Most importantly, we expect funds to employ more conservative project financing practices with their future investments. This means that more of a fund s equity capital will be used to purchase assets, which effectively reduces the supply of capital competing for new deals. Although this could reduce expected internal rates of return for some funds that had hoped to amplify performance through leverage, there is still ample room for funds to achieve a risk-adjusted premium to other risky assets. Characteristics of listed infrastructure Listed infrastructure funds and stocks Like most infrastructure assets, listed infrastructure companies are relatively new on the scene. Many of them are recently privatized, and the segment as a whole is highly fragmented, having seen very little consolidation over the years. The universe of listed infrastructure companies ranges from firms that own assets, such as toll roads and waste management systems, to single utility operators. Therefore, one option for investors seeking access to listed infrastructure is a diversified portfolio of such companies. Other alternatives include infrastructure investment funds, which hold a portfolio of listed infrastructure companies selected by specialist managers, and infrastructure-based thematic exchange-traded funds (ETFs), which are structured according to a preset screening methodology that invests in listed infrastructure companies (see Fig. 2.3 on page 14). Given the wide latitude in interpreting infrastructure, it is important to understand whether the investment aligns to the desired goal. Listed infrastructure firms are extremely different animals compared to unlisted infrastructure assets (see Fig. 2.2 on page 13). First and foremost, they are listed stocks and therefore have a fairly high correlation with equity markets. Thus, many of the arguments in favor of infrastructure, such as low correlations with risky assets and the often-touted inflation hedge, begin to fade. Fig. 2.4: Long lifespan for most forms of infrastructure Estimated infrastructure service life, in years Water and sewer systems Hospitals Schools Highways and streets Electrical structures Communication structures Railroad replacement track Source: Bureau of Economic Analysis, UBS WMR Fig. 2.5: IRR targets of unlisted infrastructure funds Split of targeted net to investor internal rate of return, proportion of funds, in % Note: Based on a database of 175 unlisted infrastructure funds in March 29. Source: Preqin UBS research focus September 29 15

16 Chapter 2 That said, we should not dismiss listed infrastructure too easily, as it does enjoy some advantages. As already discussed, unlisted infrastructure investments usually require large capital outlays, offer very low liquidity, and are not available to all investors. By contrast, infrastructure firms listed on a stock exchange are widely accessible and have greater liquidity. And listed infrastructure prices reflect market valuation virtually every second of the trading day, whereas with unlisted infrastructure funds, valuations are made on a monthly, and sometimes even only a quarterly, basis. Listed infrastructure equity subsectors According to the specific subsector, the sensitivity of listed infrastructure earnings to the business cycle differs substantially. Similarly, the equity price volatility of the different subsectors also deviates quite considerably from that of the broad equity market, a relationship commonly expressed as beta (see Fig. 2.7). Seaports, airports and construction companies rank as the higher-beta infrastructure subsectors, reflecting a higher degree of earnings sensitivity to GDP trends than the overall market. Low-beta subsectors, such as energy infrastructure, water infrastructure and toll roads, have relatively stable and high cash-generation potential, as well as less earnings volatility. Many stocks of these low-beta subsectors outperformed during the broad equity market selloff that followed the onset of the financial crisis. However, this trend slightly reversed when equity markets started to recover in March 29. Regional differences in the operating model, the degree to which leverage is employed, and the types of regulation that emerge can also have an important impact on the relative performance of listed infrastructure subsectors, both within a subsector and between. We selected a global universe of listed infrastructure companies according to a number of different criteria (see the Appendix on page 22 for a regional and sector breakdown of these companies). We focused on companies with a market capitalization greater than USD 1 billion. The number of companies that were returned in our search varies quite considerably between subsector and region. For example, our list contains no listed toll roads and airports in the US, but many railway companies for commodity transportation, Fig. 2.6: Slowdown in infrastructure fundraising Infrastructure funds raised, in billions of USD Q1 29 Developed markets Emerging markets Source: Emerging Markets Private Equity Association, Preqin, Probitas Partners Fig. 2.7: Variability of the listed subsector betas Infrastructure subsector betas Seaports Construction Communication infrastructure Source: Bloomberg, MSCI, UBS WMR Social infrastructure Airports Water infrastructure Toll roads Railways Energy infrastructure Fig. 2.8: Traffic volume stabilizing after sharp decline Change in US vehicle miles traveled, annualized, in % 8 Fig. 2.9: Sharp swings in airline traffic US international and domestic air carrier revenue passenger miles, annualized, in % OPEC oil shocks Note: Shaded regions represent US recessions. Source: US Department of Transportation, NBER, UBS WMR Source: Bureau of Transportation Statistics, UBS WMR 16 Infrastructure: a strong foundation

17 Infrastructure investments while listed railways are prevalent in Japan for personal transportation. We restricted our communications infrastructure universe to the satellite industry and operators of communications facilities, such as telecom towers. And within utilities, we concentrated on electricity transmission and distribution, as well as gas pipeline and distribution companies, as we consider these more reflective of infrastructure. Ultimately, we chose to exclude integrated utilities and power generation companies, as well as large telecommunication providers, because of their dominant size, relative maturity, and unregulated business models. Transportation Toll roads. Typically among the less cyclical infrastructure sub-sectors, toll road growth is globally linked to traffic growth, mainly in emerging markets, and financial restrictions in developed and developing countries. Despite a long-held perception that toll roads are defensive investments, they are not immune to large swings in the macroeconomic environment. Traffic usage varies on a geographic basis, mainly owing to the traffic profile, consumer habits, the toll road network s maturity and the presence of alternative means of transportation. Traffic volumes decline during periods of sharply higher oil prices but are otherwise not highly correlated to oil price swings (see Fig. 2.8). Inflation and interest rates affect toll road companies financial performance, but the extent depends on the regulatory framework (the ability to benefit from inflation-linked tariffs) as well as the companies leverage ratios and debt structure. Toll roads can enjoy monopolistic positions, such as turnpikes and highways, but there are also examples of competing road systems, such as bridges and tunnels. Airports. Spurred by globalization, airports have been one of the fastest-growing infrastructure subsectors, which has led to a substantial increase in demand for airport services worldwide. Growth in the airport industry has been driven by strong sector trends in Asia and the Middle East. We expect the robust global air traffic growth to continue, and airport operators should remain beneficiaries from these long-term trends. Due to its monopolistic nature, the industry is highly regulated. Global investment needs are high, responding to passenger growth, outdated facilities, demand for new security systems, and new aircraft models. Capital expenditure should continue at high levels, reflecting the expected high passenger growth trends of the industry, bigger planes as well as the proliferation of the airline hub model. However, airports are exposed to sharp swings in airline traffic volume and are therefore one of the most cyclical infrastructure subsectors (see Fig. 2.9). This is due to the high volatility of airline passenger numbers, as well as events such as war, terrorism and pandemics. Listed US airports employ a high degree of leverage, which can increase revenue cyclicality even further. Seaports. Most seaports and terminals worldwide are either government-owned, controlled by private companies or in the hands of private equity and infrastructure funds. Activity in Asia, which is home to 12 of the 2 most active ports globally, dominates the sector. In the coming years, port conditions will become particularly tight in the Far East, South Asia, the Middle East, South America, Oceania, and Eastern Europe. Container throughput should continue to grow strongly, driven by globalization, with the Far East handling far and away the most activity. However, a sharp reversal in the volume of global trade could lead to delays or cancellations of expansion projects. Volumes were pressured during the recession as global shipping ground to a virtual standstill, with negative effects on pricing, margins and profitability (see Fig. 2.1). Overall, the port industry is among the more cyclical subsectors within the infrastructure group. Railways. There is a broad global effort underway to build, upgrade and expand railway networks. Aggressive investments in new railways are expected in emerging markets, particularly in China, while developed countries like the US aim to improve aging railways. Investments in railways are generally increasing globally, with enhancement of the existing networks the goal in many countries in Fig. 2.1: Shipping prices collapsed Baltic dry index of shipping costs, in thousands 14 Fig. 2.11: Different types of utilities Integrated utilities span over the entire supply chain Only transmission and distribution utilities are regulated Transmission & Distribution Power station Liberalized Regulated Supply Liberalized Source: Bloomberg, UBS WMR Source: UBS WMR UBS research focus September 29 17

18 Chapter 2 Europe and in Brazil. Key challenges include potential moves by governments to renegotiate contracts or block tariff increases, as well as consumers unwillingness to pay higher ticket prices for improved rail services. Most private railway companies are in North America, with a primary role in transporting freight, and in Japan, where railroads have long been favored by the government due to a lack of fossil fuels and subsequently became the backbone of urban passenger transportation. Utilities and energy Energy. Transmission and distribution (T&D) utilities are generally defensive assets, which have a low-risk profile thanks to being fully regulated businesses (see Fig. 2.11). They are less cyclical than the broader market and other utilities, they offer good earnings visibility, they have no exposure to commodity price risks, and (normally) pay attractive dividends. In most developed and developing countries, we see significant investment needs for transmission and distribution assets, which limits the regulatory risks of this infrastructure subsector, in our view. T&D companies are often relatively highly geared and, although we do not see funding as a major issue for this subsector, debt financing has recently become more expensive. Growth expectations are modest and are limited to regions where electricity demand is still growing and to new electricity/gas production facilities (wind parks, new gas fields). In general, we view T&D companies as relatively safe investments, where cash flows and earnings are highly predictable. Water. As we wrote in the UBS research focus report, Mind over matter, in August 28, global water usage is unsustainable and water scarcity as well as worsening water security have become economic constraints in major growth markets, such as China, India, and Indonesia, as well as commercial centers, such as Bangkok, Buenos Aires and Los Angeles (see Fig. 2.12). We expect private investment to play an increasingly critical role, but the investment opportunities in water are uneven across emerging markets. With only two global water companies (Veolia and Suez) active in the liberalized water sector, these companies have proven to be less resilient to the global recession than expected. This was mainly due to uncertainties about the companies growth prospects, higher cost of capital, potential for delayed tariff increases and the implementation of stricter quality standards. Water companies that operate in regulated markets, such as many in the UK, appear to be more stable, but face the recurring risk of regulatory changes. Communication infrastructure The global communications infrastructure industry is highly fragmented and includes mobile telecom tower, cable and satellite companies. Many of these telecom operations are still owned by the large, formerly state-owned incumbents or mobile operators. Meanwhile, cable operators try to gain market share in the fixed-line business, trying to force both investments and competition. The telecom tower subsector has a favorable industry profile due to continued growth, high entry barriers, and the prevalence of long-term contracts. The global satellite industry is also characterized by high entry barriers and is regarded as a highly concentrated field, with the top four operators generating 7% of global revenues. Overall, the communications infrastructure sector is a less regulated industry, with modest growth opportunities but some pricing and competitive pressure. Social infrastructure We split social infrastructure into the following subsectors: hospitals, elderly care facilities and prisons. Most of the stocks in this sector outperformed the broader market to date in 29 after significantly underperforming in 28 due to leverage concerns. In addition, some healthcare facility companies tapped the credit markets to strengthen their balance sheets. Most of the listed health-related companies and all of the listed prisons are located in the US. Reform of US healthcare is a key issue for the sector, which, if it succeeds, could help to reduce debt and support volume growth through higher utilization rates. At the Fig. 2.12: Water grows scarcer Water runoff divided by world population, in thousands of liters per person per day Available runoff and reservoirs Source: Postel et al. (1996), UN Population Division, UBS WMR Abundance Stress Scarcity Absolute scarcity Fig. 2.13: Regional breakdown of infrastructure indices Share of the total index portfolio, in % US Japan Germany MSCI World UBS Global Infrastructure & Utilities Macquarie Global Infrastructure 1 S&P Global Infrastructure S&P Emerging Markets Infrastructure Source: Bloomberg, FTSE, Macquarie, MSCI, S&P, UBS WMR France UK China Hong Kong Australia Brazil Czech Republic Other developed Other emerging 18 Infrastructure: a strong foundation

19 Infrastructure investments moment, roughly 16% of the US population is uninsured, and the reforms aim to reduce this figure to only 3% 4%. In our view, the sector is slightly cyclical but much less so than construction. Outside of the US, there are few listed companies, in Germany, France, South Africa and Australia. In the future, we expect more companies in other countries to go public, mainly driven by high government debt levels. Construction The construction sector forms one of the largest shares of GDP (roughly 9% 12%) in both developed and developing countries. The companies in the sector can be split into three subsectors residential, nonresidential, and infrastructure and derive demand from all sectors of the economy. The construction industry is highly cyclical and, as would be expected, succumbed to the global recession. Within the construction sector, however, companies involved in infrastructure are less cyclical than those operating in the other subsectors. As we wrote in Chapter 1, massive government stimulus programs announced in the aftermath of the global financial crisis and targeting infrastructure spending are being implemented. Financial concerns weighed on some companies in the sector, but were eased by several completed rights issues. Infrastructure indices Infrastructure indices are used to measure the performance of a portfolio of listed infrastructure stocks. Some indices serve as benchmarks for listed infrastructure funds and may also form the basis for infrastructure-based exchangetraded funds. To better understand how they have been constructed and how they have performed, we analyzed some of the most well-established infrastructure indices: the Macquarie Global Infrastructure 1 index, the S&P Global Infrastructure index and the UBS Global Infrastructure & Utilities index. Although each of these indices have the word global in their title, it is important to be aware that their exposure is predominantly from developed countries (see Fig. 2.13). Thematic indices on emerging market infrastructure are also available, such as the S&P Emerging Markets Infrastructure index. Another immediate observation is that the indices have very different sector profiles (see Fig. 2.14). This is primarily a function of the index s definition and methodology. Some use a broad definition for infrastructure, including even unregulated utilities in the portfolio, while others restrict the definition to a narrower subset. An ETF on the Macquarie Global Infrastructure 1 index might underperform the broad market during the early stages of an equity bull market because the index has a large exposure to utilities, which is a highly defensive sector. Listed infrastructure indices have performed well during the past several years, both in absolute and relative terms (see Fig. 2.15). The UBS Global Infrastructure & Utilities index rose by more than 15% on an annualized basis in the last five years, compared to returns of just under 1% for the MSCI World equity index and mid-single-digit returns for bonds. Consistent with the broader universe of Fig. 2.14: Sectoral breakdown of infrastructure indices Share of the total index portfolio, in % Industry Subindustry MSCI World UBS Global Macquarie S&P Global S&P Emerging Infrastructure Global Infrastructure Markets & Utilities Infrastructure 1 Infrastructure Capital goods Construction & engineering Energy Integrated oil & gas 7..6 Oil & gas drilling Oil & gas equipment & services Oil & gas storage & transportation Media Broadcasting.1.1 Cable & satellite.1 1. Telecommunication services Alternative carriers.1.3 Wireless telecommunication services Transportation Airport services Highways & railtracks Marine ports & services Railroads Utilities Electric utilities Gas utilities Independent power producers Multi-utilities Water utilities Other Other exchange traded funds 7.6 Source: Bloomberg, FTSE, Macquarie, MSCI, S&P, UBS WMR UBS research focus September 29 19

20 Chapter 2 emerging market equities, the S&P Emerging Markets Infrastructure index has outperformed the other infrastructure indices by a wide margin during the past five years, as well as most other asset classes. Yet, using these indices to understand how infrastructure performs in a portfolio context is difficult because, in most cases, the data is too limited. Only the UBS Global Infrastructure & Utilities index goes back as far as 199, which allows for useful comparisons to other assets. The correlation of the index with global equity markets is 67%, which is rather high compared to figures published in academic studies. But keep in mind that these studies generally do not include the financial crisis, which led to an increase in correlations across risky assets (see Fig. 2.16). When setting the sample window to begin in 21, the correlation with global equity markets rises. In the case of the S&P Global Infrastructure indices, the correlation is nearly 9%, since the impact of the global financial crisis has more significance the shorter the time period. Not surprisingly, these indices also have an extremely tight correlation with the utilities sector. Investors will have to decide whether they want to build utilities exposure through infrastructure indices or directly with a utilities index, assuming that investors seek this exposure in the first place. Listed developers While most of our discussion has focused on infrastructure owners and operators, there is another segment that appears poised to benefit from the structural demand for infrastructure investment: listed developers. Investing in infrastructure developers recalls the experience of the 19th century gold rush in the California. Very few prospectors actually found gold and became rich. However, those who sold the picks and shovels to the miners made decent profits. Infrastructure developers bear almost no resemblance to the owners and operators that are traditionally associated with the infrastructure theme. For example, developers tend to experience far more earnings cyclicality than owners and operators, which means that their risk-adjusted returns are generally consistent with the overall equity market. And companies involved in the infrastructure development supply chain may have a broadly diversified business and therefore a more muted exposure to the trend of greater infrastructure investment. While we find developers attractive as a group, since they benefit from vast infrastructure needs in emerging markets and from fiscal stimulus packages, it is important to select companies with as pure exposure to the theme as possible and to also understand the dynamics in the remainder of their businesses. Fig. 2.15: Performance of various asset classes Average annual performance during the past five years, in % Bonds Global bonds US corporate bonds US high-yield bonds Equities MSCI World MSCI Emerging Markets NTAC Commodities Global listed real estate Infrastructure S&P Emerging Markets Infr. S&P Global Infrastructure UBS Global Infrastructure & Utilities UBS Global Infrastructure Macquarie Global Infrastructure 1 Note: S&P Emerging Markets Infrastructure index data begins in December 24. Source: FTSE, GPR, JP Morgan, Macquarie, Merrill Lynch, MSCI, S&P, UBS WMR Fig. 2.16: Performance of infrastructure indices Return index (November 24 = 1) MSCI World UBS Global Infrastructure S&P Global Infrastructure Source: FTSE, Macquarie, MSCI, S&P, UBS Portfolio Analysis System, UBS WMR UBS Global Infrastructure & Utilities S&P Emerging Markets Infrastructure Macquarie Global Infrastructure 1 2 Infrastructure: a strong foundation

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