It’s hard to find a locale that doesn’t need a major infusion of money for infrastructure. Emerging markets are undergoing rapid urbanization and rising prosperity. Developed markets including the U.S.—which scored an overall “D+” on the 2013 report card from the American Society of Civil Engineers—need to fix or expand the infrastructure they have.

Big money is being directed at this global challenge. According to a June 2014 report from Pricewaterhouse Coopers and Oxford Economics called Capital Project And Infrastructure Spending: Outlook To 2025, annual global spending on infrastructure is expected to exceed $9 trillion by 2025, up from $4 trillion in 2012.

The analysis covered transportation and utilities, as well as capital projects in extraction, manufacturing and social infrastructure (schools and hospitals). Among its conclusions, it says the Asia-Pacific market, driven by China’s growth, will represent nearly 60% of global infrastructure spending by 2025.
But spending money on infrastructure requires more than throwing spaghetti at the wall and seeing what sticks, even in China. And although investment managers focused on the infrastructure asset class unanimously applaud the diversification, lower volatility and income it offers, how they define and invest in it varies widely.

“There’s a natural need for more infrastructure everywhere,” says Manoj Patel, who, along with Frank Greywitt III, co-heads infrastructure securities for Deutsche Asset & Wealth Management and co-manages the $4.2 billion Deutsche Global Infrastructure Fund (TOLLX).

The Chicago-based co-managers are most concentrated on North America, where the fund had 74% of its assets as of June 30 (53% was in the United States alone). “That’s really where we find a lot of the opportunities,” says Greywitt, given “the energy revolution we’re seeing in the U.S.”

The shale boom is prompting the need for new technology and pipelines to extract and transport cheaper forms of natural gas and liquid natural gas to large cities and to the Gulf Coast for processing, he says. China also factors in significantly to the fund’s U.S. energy strategy, though China-based assets themselves represent just 2% of the fund’s overall assets.

 

“We have this energy boom and they have this new need for supply,” says Greywitt. The Chinese government knows it must change how it sources energy to reduce pollution and, in turn, improve social stability, he says. He also notes that China’s demand for liquid natural gas has risen in the aftermath of the 2011 Fukushima nuclear disaster in Japan.

“Because of the abundance of natural gas in the U.S. and the big price difference,” says Patel, “there will be opportunities for natural gas to be exported and Asia will be a big part of that.” Although liquid natural gas is not yet being exported, U.S. facilities are already being built in anticipation of this.

One company whose shares are held in the Deutsche Global Infrastructure Fund is Cheniere Energy, a Houston-based energy company primarily engaged in liquid natural gas-related businesses. It was the first company to receive approval to export liquid natural gas, says Patel.

The co-managers are also interested in companies that own natural gas pipelines in overseas markets expected to increasingly use this fuel when more of it is exported from the U.S. and elsewhere. “There’s a pretty long runway, so we think there are lots of opportunities for these companies,” says Greywitt.

He and Patel also note that much is happening in Mexico with energy and transportation. The government there has made infrastructure a priority in order to benefit the economy. The regulatory environment has been fairly consistent and energy reforms have been enacted since the current Mexican president took office in December 2012. There are opportunities for private capital to come in, they say. One Mexico-based holding in their fund is energy-focused IEnova, a large builder and operator of pipelines.

No matter the region or sector, the co-managers seek to invest in companies whose rates of return exceed their cost of capital. “Those are the companies that can consistently create shareholder value,” says Patel.

Core Pure Plays
The Russell Global Infrastructure Fund (RGISX), a U.S. mutual fund featuring listed equities, uses a multi-manager approach to achieve balanced risk profiles. The fund’s portfolio manager, Seattle-based Adam Babson, actively manages the fund by hiring and firing managers and adjusting manager weights. The fund holds more than $3.2 billion in listed infrastructure investments.

 

Babson says that several of his peer funds use a fairly liberal definition of infrastructure, and that his is “pure play.” It includes companies that own and operate airports, toll roads and seaports, and does not invest in airlines, shipping firms or global logistics companies, as others do.

“Our first order consideration,” says Babson, “is why the client has an allocation to infrastructure, and what role the asset class plays at the total portfolio level.” Investors turn to the class for diversification, downside protection and relatively attractive yield, he says, and pure plays can offer this because they tend to be highly regulated. Also, thanks to long-term contracts, they often provide steady, reliable cash flows that aren’t hurt by market downturns.
“If you cast the net too wide,” he says, “the unique attributes of the asset class start to get diluted.” His strategy also offers a lower beta—the measure of volatility against the rest of the equity world.

The four subadvisors in the Russell Global Infrastructure Fund have global investment mandates. The fund tends to hold more in emerging markets than its benchmark does, but it also invests in developed markets in many regions.

Babson declined to discuss specific fund holdings, but shared some sector and geographic trends Russell is following. It sees transportation-related opportunities in China, which is building new highways and rail networks, and in Latin America. The latter, he says, is “experiencing an evolution in improving energy delivery.” In India, there is an enormous need for improved water infrastructure, as many parts of the country still do not have reliable access to potable water.

Of course, investing in infrastructure has its risks. “Regulatory risk is something all disciplined investors pay a lot of attention to,” says Babson, who notes this can be more of an issue in emerging markets. He is also very conscious of interest rate risk. In a rising rate environment, he feels it may make sense to be underweight in pipelines and regulated utilities. However, airports and toll roads are geared more to a global recovery and are less interest-rate sensitive, he says.

 

Other Options
“When people think of infrastructure, they intuitively think of highways, bridges and railroads,” says Robert Goldsborough, an analyst for passive strategies on Morningstar Inc.’s manager research team. “It’s the real-world version of SimCity.”

At Morningstar, Goldsborough covers the largest exchange-traded fund focusing on infrastructure, the iShares Global Infrastructure ETF (IGF), and also keeps his finger on the pulse of other funds in the category. “We’re in the fairly early innings right now” when it comes to the development of new infrastructure investment vehicles, he says.

As of June 30, the iShares ETF held 76 companies. Its largest exposure is to utilities and industrials, particularly transportation. “I think the fund makes sense,” Goldsborough says. “It’s diverse, its volatility is very manageable and its fees are reasonable.”

There are also smaller ETFs to choose from, including the SPDR S&P Global Infrastructure ETF (GII) and the FlexShares STOXX Global Broad Infrastructure ETF (NFRA). Investors can also look at municipal bond funds that include issues for roads, bridges, municipal power plants, tunnels, water and sewers, he says.

Goldsborough expects to see strong demand for infrastructure in the long term. “Emerging market spending is not going to go away,” he says, noting that the emerging middle class needs places to live and transportation to get to work.

He is keeping an eye on regulatory issues but doesn’t see anything of imminent concern. Debt is cheap now, which helps, but rising interest rates could constrain infrastructure spending, he says.

Guy Scott, a co-portfolio manager of the Janus International Equity Fund (JAITX), is also closely watching the global infrastructure playing field.

Denmark-based A.P. Moller-Maersk A/S, the world’s leading port operator and container-shipping company, was the fund’s largest position as of June 30. Its economies of scale make it very well positioned for the expansion of global trade, Scott says.

The fund is also invested in what he calls “drivers of infrastructure,” including Volkswagen AG, the largest foreign automaker in China by market share, and luggage maker Samsonite International SA, a beneficiary of increasing travel among China’s growing middle class.

 

In general, Scott isn’t optimistic about global infrastructure spending over the next year or so. Europe is still recovering from the economic crisis and loan growth is low, he says, and “China’s property market got ahead of itself in terms of urbanization trends.”

However, he anticipates significant infrastructure spending in China over the long term. Its urbanization rate—the number of people living in cities divided by its total population—is projected, he says, to jump from a current 52% to 70% by 2030 as 15 million people move each year from rural areas to cities. “That’s like every year building a city with the population of [greater] Los Angeles,” he says.

Scott expects attractive opportunities among companies that invest in public-private partnerships. It’s a popular business model in Europe, and many states have approved legislation to allow them, he says. The partnerships build, run and assume risk on infrastructure projects, reducing the burden for governments. He is monitoring several publicly traded European infrastructure companies—Ferrovial, Vinci and Skanska—that invest in these partnerships.

Infrastructure isn’t for everyone. The T. Rowe Price Global Infrastructure Fund, launched in 2010, was supposed to give investors growth and yield with inflation protection. But, says company spokeswoman Kylie Muratore, the fund “showed limited inflation protection and greater volatility and market risk.” Its assets also grew very slowly. In early 2014, the company merged the fund with the Real Assets Fund, and its exposure to infrastructure is now minimal.

Overall, though, fund-flow tracker EPFR Global has observed a strong upward trend in infrastructure fund flows over the past year. So investor interest in the sector is rising.

“At the end of the day when you look at the assets, they offer stable and predictable cash flows,” says Patel. “Their returns have broadly been in line with global equities, but their volatility has been 25% to 30% lower.”