Infrastructure and other enduring assets complement stocks and bonds

March 2, 2017

Compelling investment opportunities have become harder to find.

Right now, many equity markets appear expensive, and fixed-income valuations seem even more stretched. Meanwhile, macroeconomic uncertainty has grown palpable, leaving investors confused and tempted to chase yesterday's hot idea.

For investors seeking allocations that have the potential to deliver steady long-term returns, with relatively muted ups and downs along the way, we believe enduring assets fit the bill. They tend to represent great businesses with attractive risk/return profiles. The equities of these companies have also demonstrated long-term resilience against inflation and interest-rate risk while generating attractive yields.

Enduring assets are physical assets whose economic lives are typically measured in decades. The opportunity set includes shares of companies with electric, gas, and water networks, power generation plants, and oil and gas pipelines; it can also extend to transportation infrastructure such as highways, railroads, and port facilities, and even telecommunications infrastructure.

Infrastructure and other enduring assets offer an attractive risk/reward profile

The market perennially underappreciates enduring assets. While these equities may not be as exciting as more cyclical sectors, such as information technology or consumer discretionary, they offer several benefits we view as more valuable over time. These companies tend to have great businesses in that their returns are typically high relative to their level of risk.

While their returns may not keep up with those of riskier, higher-beta holdings during strong bull markets, we believe that the risk/reward equation for enduring assets strikes a favorable balance; for many stocks in this universe, companies' returns on investment are set by government regulations or long-term contracts. Moreover, the industries they typically operate in are considered public goods, beneficial and necessary for society. That status, along with the durable characteristics of the underlying assets (the actual roads, power plants, grids, and so on) means that underlying returns are more likely to persist. Finally, in many cases returns are indexed, or linked, to inflation, creating a potential inflation hedge.

Income-generation potential is attractive

Interest-rate sensitivity of enduring assets is modest over the long term

One of the chief concerns about enduring assets is their perceived sensitivity to interest rates. While there can be some short-term impact on equity prices during periods of rising interest rates-particularly sharp, unanticipated increases-historical data suggests that enduring assets can rebound quickly. Over previous U.S. Federal Reserve (Fed) interest-rate cycles, the enduring assets universe has historically outperformed equities before and after rate hikes, performed in line with equities throughout a full cycle, and outperformed bonds, on average, before, during, and after rate increases.

Enduring assets serve as a potential source of investment income

Enduring assets can also potentially generate attractive levels of income. As of the end of 2016, the yield on this universe was more than 1% higher than equities and nearly 2% higher than bonds.

While today's spread over bonds is partly a reflection of central bank policies that have pushed yields steadily lower the last 10 years, it is also indicative of valuations, which suggest that bonds are more expensive. The takeaway is that enduring assets have consistently generated competitive income relative to bonds and above-average income relative to equities, making them a potentially valuable complement to a broader bond or equity portfolio.

In our view, the fundamental way to make money in the markets has not changed: Identify the best potential long-term investments and allocate to them appropriately based on risk tolerance, current and future income needs, and time horizon. Amid a confusing, volatile market, we believe enduring assets are an attractive option for long-horizon investors and should be considered as a strategic portfolio allocation. Given their historical outperformance versus equities and bonds, the favorable risk/reward profile of the business models, resilience following interest-rate increases, inflation-hedge potential, and income-generation potential, these infrastructure assets can potentially give investors one less thing to worry about.

Important disclosures

The enduring assets universe consists of 55% utilities, 15% energy, 10% telecommunications, 10% real estate, and 10% industrials. The Bloomberg Barclays Global Aggregate Bond Index tracks the performance of global investment-grade debt in fixed-rate treasury, government-related, corporate, and securitized bond markets. The MSCI All Country (AC) World Index tracks the performance of publicly traded large- and mid-cap stocks of companies in 23 developed markets and 23 emerging markets. Total returns are calculated gross of foreign withholding tax on dividends. It is not possible to invest directly in an index.

While the fund is not managed to track a benchmark, its multiple strategies and focus on investments in certain sectors may lead it to lag broad market rallies. The fund is non-diversified and holds a limited number of securities, making it vulnerable to events affecting a single issuer. Master limited partnerships and other energy companies are susceptible to changes in energy and commodity prices. Natural resource investments are subject to political and regulatory developments and the uncertainty of exploration. The stock prices of midsize and small companies can change more frequently and dramatically than those of large companies. Fixed-income investments are subject to interest-rate and credit risk; their value will normally decline as interest rates rise or if an issuer is unable or unwilling to make principal or interest payments. Investments in higher-yielding, lower-rated securities include a higher risk of default. Foreign investing, especially in emerging markets, has additional risks, such as currency and market volatility and political and social instability. The use of hedging and derivatives could produce disproportionate gains or losses and may increase costs. Liquidity-the extent to which a security may be sold or a derivative position closed without negatively affecting its market value, if at all-may be impaired by reduced trading volume, heightened volatility, rising interest rates, and other market conditions. REITs may decline in value, just like direct ownership of real estate.