The role of infrastructure in pension fund portfolios continues to take on increased investment importance. The diversification benefits of this emerging asset class were evident in 2008. The sector may attract more institutional investors as governments increase their levels of infrastructure commitment partly as a response to the global economic downturn.

Etera, the €4.9bn Finnish mutual pension insurance company, provides a microcosm of infrastructure’s relative out-performance in 2008. It reported an overall loss of €1bn following a loss of 17% on investments. Yet its investments in infrastructure returned 4%, says Kalevi Hemila, Managing Director at Etera. The equity allocation, dropped from 37% to 21% over the year, posting a loss of 40.9%.

The Finnish government may increase its commitment to new infrastructure projects which may help open the way for alternative investment sources, says Hemila. Etera has seen its allocation to infrastructure grow from 12% two years ago to 18% today. Most of this increase is a reflection of the steep losses it suffered on its equity investments, yet it recently invested €30m in two infrastructure funds, Icecapital and the Macquarie Group.

In the US, the €3.4bn Public Safety Personnel Retirement System of Arizona has disclosed that it will increase its real asset allocations, including infrastructure and commodities, from 1.6% to a 5% target. Pension fund allocations to infrastructure funds have grown in the last three years, though from an almost zero level (Australia is an exception), according to a January 2009 OECD working paper on pension fund investment in infrastructure. “Asset allocation weightings are still low on average, but there are a number of prominent examples of single pension funds that have made substantial allocations, though not necessarily actual investments.”

Infrastructure targets rise

Calpers adopted a new investment policy in 2008 with a 3% target allocation of assets in infrastructure. The target return is a net 5% above inflation over five years. Other US pension funds with infrastructure allocations or intentions include Calsters, the Washington State Pension Plan, Alaska Permanent Fund Corporation, and the World Bank, notes the report. The €300bn Dutch pension fund APG has a target 2% dedicated to infrastructure in its strategic investment plan 2007-2009, though its current actual investment level is well below that target. Other European pension investors include the Danish ATP and PKA, Dutch PGGM, UK’s USS, BT and Railpen in addition to local authority pension schemes such as LPFA. In Canada, OTPP and the Ontario Municipal Employees Retirement System have been long-time investors in the asset class. Among the reserve funds, the Irish National Pension Reserve Fund (NPRF) has a 2% target allocation to infrastructure in 2009, while the French FRR has also added infrastructure  to its strategic asset allocation.

When the global infrastructure boom began, return expectations were often given as 15%, notes the OECD report. Much of these expectations were fuelled by leveraging the returns of the underlying portfolio as high as 40-80% for mature assets and 30-75% for early-stage assets. More recently, these expectations have been coming down. JP Morgan Asset Management expects the lowest expected internal rates of return for toll roads (8-12%), the highest for airports (15-18%) and broadcast networks (15-20%). “Return expectations started to come down even prior to the credit crunch as more investors crowded into the market… Returns are predicted to stabilise around 5-6% in the long term.”

Prior to the credit crisis, Graeme Newell and Hsu Wen Peng analysed the risk-adjusted performance of listed infrastructure from 2000 to 2006 and found the asset class to outperform equities during the same period. Globally, the annualised average return for these funds was 18.2% over a seven-year period with a Sharpe ratio of 1.07 compared to a return of 5.8% for equities with a Sharpe ratio of .17, they noted. Yet Newell and Peng also highlight a number of risk factors. Among them infrastructure’s complex and highly geared structures (up to 90% gearing), impact of interest rates on debt servicing, high management fees, uncertainty of patronage estimates (such as toll roads) and regulatory changes.