Opportunity in the World’s Roads, Railways, and Water Systems

Thus far this year, earnings releases and economic reports have shown a mixed bag for some global infrastructure firms, with both positive and not-so-positive news. Traffic volumes on toll-road operators in Europe have unexpectedly rebounded nicely, while Chinese toll-road operators have struggled amid government regulation and general complaints from citizens about excessive tolls.

While we believe that the longer-term story of growth in global infrastructure remains intact, short-term hiccups for infrastructure firms in certain parts of the world can offer investors possible opportunities in an asset class that has solid growth potential and income-generating abilities. For investors seeking a broad, diversified, inexpensive way to invest in infrastructure firms, a suitable option is  iShares Global Infrastructure (IGF).

Broadly, infrastructure firms are the private companies that construct and manage infrastructure assets such as toll roads, ports, railroads, water and wastewater systems, and power generation and distribution plants. IGF holds 75 global companies in the infrastructure industry, cutting a broad swath across the industrials, utilities, and energy sectors. (Morningstar categorizes this exchange-traded fund as being in the "miscellaneous" space.) Indeed, over the years, academics and investors alike have debated whether infrastructure truly is a distinct asset class. Many have come down on the side that the best way to characterize the industry, asset-class-wise, is that infrastructure should be defined narrowly as consisting solely of unique infrastructure assets that are not already considered part of other established asset classes, such as commercial real estate. This ETF holds firms whose assets are not necessarily included in other asset classes, along with some that very much are part of other asset classes.

Given that much of this ETF's portfolio is devoted to stable, yield-producing sectors such as utilities and master limited partnerships, IGF not surprisingly pays a healthy dividend of 3.4%. We consider IGF's dividend to be sustainable. In addition, we expect dividend payouts to be stable as the companies held in this ETF are not especially highly leveraged and thus don't face substantial balance-sheet risk. This fund is exposed to a modest amount of cyclicality. Its five-year volatility of return of 13.6% makes it slightly more volatile than the S&P 500 Index.

This ETF is suitable as a specialty satellite holding for investors seeking access to a basket of infrastructure firms that trade both in the United States and overseas.

Fundamental View
No one would dispute that there's always demand for improvements to the world's infrastructure. Spending on global infrastructure depends on two things: local economic growth and government spending. Both dynamics can be at risk based on certain macroeconomic trends. Local economic growth, especially in emerging-markets countries, can drive infrastructure investments. In developed-markets nations, by contrast, local growth by definition is slower, but regular infrastructure upgrades often are necessary and desired. However, many developed-markets countries' increasingly growing government debt loads will necessarily constrain governments from pushing forward with some of the infrastructure programs that they may want. That may mean lower infrastructure spending in the future. At the same time, a battery of private operators of infrastructure assets has arisen to fill the void, and governments have been increasingly open to the notion of privatizing assets.

Industrials firms, largely those operating in the transportation infrastructure world, make up the biggest slice of this ETF, soaking up 40% of assets. Examples of transportation infrastructure firms are toll-road developer and operator  Transurban Group (TCL), which is IGF's single largest holding, Atlantia SPA, Abertis, Groupe Eurotunnel, and Japan Airport Terminal. Many of these companies operate toll roads in Europe, Australia, and the United States. In general, toll-road operators possess a concession to operate a road and then are bound by price caps that are tied to inflation. Several firms with meaningful exposure to debt-plagued, economically ailing European countries have seen traffic volumes finally rebound after previous declines. Abertis recently posted the strongest traffic growth in Spain in the past seven years. Similarly, Atlantia reported surprisingly strong traffic on Italian roadways in early 2014, as well as strong growth in other countries where it operates toll roads, such as Brazil and Chile. (Both Atlantia and Abertis have tried to make up for their exposure to Europe by diversifying into other areas such as Latin America.) Separately, Chinese toll-road operators held in this ETF, such as China Merchants Holdings, Hopewell Highway Infrastructure, and China Resources and Transportation Group, recently experienced a drag as the Chinese government responded to complaints about tolls being too high by waiving tolls for cars on national holidays. That said, we expect continued increases in auto ownership and the rise of the middle class in China to boost revenues for toll-road operators in China.

Electric utilities make up another 20% of the assets in this ETF. Some large electric utilities held in this ETF are  Duke Energy (DUK),  National Grid (NGG), and  Southern Co (SO). The U.S. utilities sector has made up significant ground this year after trailing the broader U.S. equity market by a wide margin in 2013. Utilities companies' fundamentals have remained strong, and Morningstar's equity analysts believe that investors currently are pricing in 4% U.S. Treasury yields, so we don’t expect substantial moves downward from utilities if rates hit that level. This ETF also holds a swath of European utilities, which our analysts believe already price in the worst-case economic scenarios and offer significant upside if the European economy improves.

Several other large industries represented in this ETF are oil and gas companies, which make up about 20% of this fund's assets. These include natural gas pipeline operators such as  Enbridge (ENB),  TransCanada (TRP), and  Kinder Morgan (KMI). Many of these companies generate meaningful dividends. The global landscape at present is one of surging oil supply (driven largely by the U.S. crude oil-production increases) but tepid petroleum demand. Meanwhile, North American natural gas pipeline operators are operating in an environment of stable natural gas demand and weak gas supply. The upshot to these dynamics probably is twofold: natural gas price support and the likelihood that OPEC will work to maintain supply discipline.

Diversified utilities, such as  GDF Suez (GSZ),  Exelon (EXC), and  Public Service Enterprise Group (PEG), make up the remaining 20% or so of IGF's assets.

Portfolio Construction
IGF tracks the performance of the S&P Global Infrastructure Index, a market-cap-weighted benchmark that contains large infrastructure companies from around the world. The index includes companies involved in utilities, energy, and transportation infrastructure, including the management or ownership of oil and gas storage and transportation, airport services, highways, rail tracks, marine ports and services, and electric, gas, and water utilities. IGF follows a full replication strategy, which means it holds every company in the index. U.S.-domiciled companies make up 32% of the fund's assets, and the vast majority of the assets in this ETF are invested in companies based in developed markets. However, the firms in this ETF operate in developed and emerging markets alike. IGF holds 75 companies and has an average market cap of $16.5 billion.

Fees
IGF charges 0.47%, which is reasonable for a subsector ETF that holds a large number of firms that trade only outside of the U.S. IGF has tracked its index reasonably well over time. During the 2013 calendar year, 99.38% of the fund's dividends were qualified, while during the 2012 calendar year, 92.7% of IGF's dividends were qualified.

Alternatives
There are several very small ETFs devoted to global infrastructure, with the largest ones being FlexShares STOXX Global Broad Infrastructure (NFRA) and SPDR S&P Global Infrastructure (GII) (IShares also issues a small emerging-markets-only infrastructure ETF, iShares Emerging Markets Infrastructure (EMIF)). Since May 2013, the SPDR fund has tracked the same index as IGF and as a result also holds 75 companies; however, it has a lower price tag (0.40%) than IGF. (Prior to May 2013, GII had tracked an index managed by FTSE.) At the same time, the SPDR has a fraction of the assets that IGF does and is much less liquid. Meanwhile, the FlexShares ETF, which costs 0.47%, holds more companies (more than 155 in total) than IGF and GII. In addition, the index that NFRA tracks takes a more expansive definition of infrastructure companies than the iShares fund and the SPDR, including holding telecommunications companies such as  AT&T (T) and  Verizon Communications (VZ), trash haulers like  Waste Management (WM) and  Waste Connections (WCN), health-care providers such as Healthsouth (HLS) and  Tenet Healthcare (THC), and North American railroads like  Union Pacific (UNP),  Canadian National Railway (CNI), and  Kansas City Southern .

Over the 18 months, several other new infrastructure ETFs have launched, but none has meaningful levels of assets or liquidity.

There also are several actively managed, open-end funds devoted to global infrastructure. Morningstar does not cover any of these funds, but investors interested in active management might want to take a look at several of these. The largest is Russell Global Infrastructure (RGISX) (1.24% expense ratio). Other good-sized funds include Morgan Stanley Global Infrastructure (0.87%) and DWS RREEF Global Infrastructure (TOLSX) (1.24%) The DWS and Morgan Stanley funds have been the best performers. IGF's performance has lagged all of these funds over the past three- and five-year periods and has posted in-line performance over the past year.
 

 

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