Infrastructure funds offer a defensive investment

There’s nothing sexy about infrastructure. You can’t download a it or play games with it. It won’t call an Uber taxi, or organize the delivery of groceries to your door.

Not directly perhaps, but infrastructure is involved in every one of those processes. It is the economy’s equivalent of plumbing – not pretty to look at, usually hidden from sight, but serving a vital purpose that is largely unnoticed until it goes missing.

As the world economy enters the late innings of an expansion of record length, infrastructure as an investment has taken on a new appeal. In good times or bad, we all use roads and need electricity or natural gas to heat our homes. We expect our taps to provide clean water, the internet connection to be fast and our hospitals to be fully equipped and nearby.

Investments in these sectors are unlikely to yield large short-term gains, but they are the underlying systems we depend on to improve productivity and stimulate growth. They were once the domain of pension funds, but the proliferation of ETFs has made them more available to small investors.

We have always been able to invest directly in pipelines, utilities, and telecom companies, but ETFs offer a way to diversify by region and sector. A G-20 initiative, called the Global Infrastructure Hub, estimates that US$94 trillion in infrastructure investments will be needed by 2040 to support population growth and the movement of people to urban areas. So, there’s lots of potential.

Infrastructure investments are complex, expensive, and often take a long time to complete. But, unlike consumer goods, they have a very long lifespan. They usually involve governments and, increasingly, public-private partnerships. Ontario’s Highway 407 was a public-partner initiative of NDP premier Bob Rae in 1990.  The Trudeau Liberals created an infrastructure bank in 2015 aimed at attracting private investment to major projects including roads, rail, bridges, and water.

In the plus column, most are monopolies, or near monopolies, and come with captive customers. Revenues are guaranteed, and prices often include inflation-linked increases. The steady cash flows mean dividends flow in all conditions and so they offer stability in turbulent times.

But buyer beware! Along with opportunity comes political risk, as shareholders of Ontario Hydro need no reminding.

In the developed world, we are largely renewing and upgrading to remain competitive or expand capacity to accommodate growth. In emerging markets, the needs are greater and are often about starting from scratch. A 2016 McKinsey study noted that China spends more on economic infrastructure annually than North America and Western Europe combined.

China has been on a decades-long infrastructure spending spree as a way to create employment and build a modern economy. It built 35,000 km of new highway in the so-called five vertical and seven horizontal highway plan between 1991 and 2008 with a toll road network linking Beijing and Shanghai with 200 cities. The recent plan calls for 265,000 km of new road by 2030. In Canada, we have about 113,000 km of national highway in total – and it took 80 years to build.

Nine of the world’s 12 longest bridges are in China. The longest stretches for 102 miles across the Yangtze delta on the Beijing-to-Shanghai high-speed rail link. Our longest bridge is eight miles, linking Prince Edward Island with New Brunswick.

India’s ambitions are no less great, but it is perhaps a decade behind China. One in three rural Indians lacks access to an all-weather road and only one in five national highways is four-lane. Ports and airports have inadequate capacity and trains move very slowly. Despite great gains in lifting a nation out of poverty, 300 million Indians do not have access to electricity.

The 2018-2019 Indian federal budget includes US$21 billion in new spending on railroads and US$225 billion on rural roads, power, and telecommunications. It follows record spending the previous year to build and modernize its railways, airports and roads.

The size and scale of the projects can be dazzling. India’s biggest initiative includes a US$100 billion investment in the Delhi-Mumbai corridor, reputedly the world’s largest infrastructure project. It includes a 1,500 kilometre, six-lane expressway linking the two cities. Alongside the highway will be a freight rail corridor.

The plan envisages two power plants, 24 smart cities – with the latest internet and telecom connections – and six regional airports.

A multi-year initiative elsewhere is improving and widening 45,000 km of highway. This includes a $332 million investment by the Canada Pension Plan, in partnership with Larsen & Toubro, India’s largest engineering and construction firm. Our monthly CPP deductions are helping India to finance new roads.

It is easy to be taken in by the size of these projects and see that as profit potential, but all the usual investing risks apply. Financial reporting can be less transparent and the relationships between governments and the private sector unclear. Your goal is the best rate of return. The investing government’s goal may be to provide employment. For this reason, when it comes to investing in China, the CPP Investment Board – the investment arm of the CPP – steers clear of infrastructure investments that compete with state-owned industries. It is also highly selective about partnerships with state-owned industries because their goals as instruments of government policy differ from those of the CPP.

This is not a reason to steer clear of emerging market infrastructure, but it is important to build these factors into your decision. The returns are higher but so are the risks, so it pays to look under the hood of infrastructure ETFs to see what they own and the performance.

Although many of the ETFs appear to invest in the same thing, the holdings can be quite different. Some invest by country, or region, or by type – pipelines vs. electricity transmission vs. telecom.

For example, you might find John Deere in some funds, but not others. Deere makes construction machinery that is used to build roads and bridges. It also makes diesel engines, drive trains, axles, and transmissions used in heavy equipment and lawn care implements. Whether Deere’s business is all infrastructure comes down to your point of view.

The first stop, as always, is to see if this type of investment fits into your long term investment plan and how much risk you feel able to take.

The ETFs below offer mainly developed market opportunities. There is a crossover in their holdings, but one is almost exclusively focused on Canada and the U.S. while the other has a more international flavour.

BMO Global Infrastructure Index (TSX: ZGI).  Closed Friday at $36.40.

 Background: This was the first ETF launched by Bank of Montreal in 2010 and is a good-sized fund with $222 million in assets. It offers reasonable liquidity and passively follows the Dow Jones Brookfield Global Infrastructure North American Listed Index, with weightings based on the market capitalization of the stocks in the index.

Chris McHaney, a director and portfolio manager with BMO Asset Management, says the fund fits as part of a balanced portfolio. He believes it provides a blend of conservative growth and a steady stream of income.

McHaney says the ETF has a low correlation with the stock market, which means it does not move in sync with the ups and down of the broader market. Revenues and profits are consistent in all conditions and so the underlying share prices is less volatile. In good times and bad we always need these products.

“It’s a good diversifier and fits into any long-term portfolio including RRSPs,” McHaney says.

Performance: The ETF has been a solid performer, with an average annual rate of return since inception of 12.29%. It is up 7.47% year to date and has a five-year average rate of return of 8.48%. That compares favourably with the S&P 500 Index, which also has a five-year average annual return of 8.48%.

The fund has a trailing 12-month dividend yield of 2.81% at its recent price and a management expense ratio of 0.61% .

Holdings: ZGI has 92% of its holdings in Canadian and American companies and a 98% weighting in utilities, energy transmission, and real estate. Companies must have a market capitalization of at least US$500 million and must trade on North American exchanges or as American Depository Receipts (ADRs), which are U.S. listings of non-North American companies.

ZGI had 45 stocks as of Jan. 31, broken down as 67% in the U.S., 25% in Canada, 6% in the U.K., and 2% in Latin America. The holdings were 40% in utilities, 27% in energy, and 31% in real estate.

The largest single holding is Canadian pipeline utility Enbridge (11.3%). It’s followed by American Tower (10.2%), a Boston-based owner of wireless and broadcast communications infrastructure. Other top holdings are Crown Castle International., a U.S. cell tower firm (7.35 %); National Grid PLC, a British utility (6.03%); and Canadian pipeline operator TransCanada (5.94%). The top five holdings make up 37% of the ETF.

McHaney notes that the bulk of the real estate holdings are in companies that own cell phone towers and so stand to benefit from upgrades to handle so-called 5G, or 5th generation cellular transmissions.

He agrees that emerging markets needs for infrastructure are great but believes the opportunities closer to home are as appealing. The investable companies are mature, well-financed, their affairs are transparent, and they have proven track records.

 Action now: Buy. This ETF is a conservative way to invest in Canadian and American firms that form the backbone of the North American economy.

iShares Global Infrastructure ETF (NDQ: IGF)  Closed Friday at $43.12. All figures in U.S. dollars.

 Background: This ETF was launched in 2007 and holds 86 global stocks in the transportation, communication, water, and electricity services sectors. Five Canadian energy firms are included in the holdings.

Performance: This ETF was launched in the lead up to the 2008 financial crisis and lost almost half its value between May 2008 and June, 2009. In the decade since, it has been a steady performer with a 10-year total return since to Dec. 31 of 92.87%. This includes the increase in its share price and distributions. The ETF fell 10.2% in 2018 as a fears of rising interest rates dampened enthusiasm for utilities.

Holdings: While ZGI focuses on North America, IGF is more broadly based, with holdings in Latin America, Europe, Australia, and a small position in China. The top five countries account for 71% of holdings led by the U.S. (37.4%), Australia (9.5%), Canada (8.7%), Italy (8.2%), and Spain (7.5%).

The sector weighting are utilities (43%), transportation (39%), and energy (18%).

The top five stocks as of Jan. 31 are Australian industrial firm Transurban Group (5.26%), Spanish industrial Aena Sme SA (4.7%), Enbridge (4.42), American utility Nextera Energy (4.19), and Italian industrial Atlantia (4.09). The top 10 holdings account for 35.6% of the value of the ETF.

The ETF has net assets of $2.4 billion, an expense ratio of 0.47%, a p/e ratio of 18.3, and a trailing 12-month yield of 3.25%.

Action now: Buy. This ETF is more broadly diversified than ZGI, with a smaller portion of holdings in North America. It is also less heavily weighted towards energy, adding a transportation component. Like ZGI, it offers the potential for capital appreciation and dividend income. It adds balance to most portfolios with the addition of exposure in Europe and Australia.

Choose this ETF if you want more international exposure. Go with ZGI if you would prefer to focus on North America.

(This article first appeared in the Feb. 18, 2019 issue of the Internet Wealth Builder investment newsletter.)