Despite the appeal of passive Index ETFs, something is missing

In a world of ever-increasing fee pressures, Australian investors are turning to ETFs that passively track indices for exposure to listed Real Assets such as infrastructure/utilities and property.

For infrastructure and utilities, the popular indices garnering net flows include the FTSE Developed Core Infrastructure Index and the FTSE Developed Core Infrastructure 50/50 Index, while for property, it is the FTSE EPRA Nareit Developed Index.

However, we worry that investors who are looking for the lower volatility, income-generating potential of listed Real Assets might be missing something very important in their portfolios by being passive.

Below we outline four key reasons why actively managed listed Real Asset strategies that blend both infrastructure/utilities and property in one portfolio, might be a better option for investors seeking better portfolio diversification, inflation protection, and long-term growth prospects. 

#1 - ETFs are highly concentrated to US assets and have very modest exposure to many countries with growing populations

The popular indices mentioned above both offer developed only exposures, with very large portions of the portfolios allocated to the United States. They have only modest exposures to many developed markets with strong population growth such as Australia, New Zealand, Canada and the UK and completely ignore some of the fastest growing and large population emerging markets such as India or Mexico.

Why is this important? One of the key reasons that Real Assets are appealing is their leverage to the megatrend of urbanisation. As urban population grows, so too will demand for Real Assets to service everyday needs. With a growing demand, coupled with the nondiscretionary nature of the services provided, Real Assets then can often have strong pricing power, proven cash flows, and the ability to grow income distributions regardless of the economic cycle.

We have looked at the demographics across cities in all countries, both developed and emerging, where the Real Assets in our investment universe operate, and we have identified Real Asset opportunities in high growth developed cities such as Calgary, Melbourne, Sydney, Auckland, and emerging cities such as Bangalore and Mexico City.

We do see the benefit of an US exposure, but we specifically seek to avoid Real Assets that are exposed to low growth Northern States and cities such as Detroit, and hence our US exposure is more modest and is focused on population growth states such as the Carolinas, Florida, Texas, Georgia, and Arizona.

It is also worth considering that the indices used by ETFs mostly ignore countries like Australia and New Zealand with growing urbanisation, and are therefore not constructed based on the potential future growth. Instead, they are a function of backwards-looking growth that may not continue to hold true.

While we do understand that the liquidity, stability, low fees, and transparency are key attractions for ETFs, our team applies fundamental research by experienced analysts allowing us to find the higher quality opportunities that are suitable for an income portfolio and avoid investing in risky or unsuitable names just because they might have a large market capitalisation.

#2 - Inflation protection for ETFs is questionable for infrastructure and utilities due to concentration in US “nominal return” assets

An area where we question the benefit of passive index ETFs is their so-called inflation protection. And this is again related to the lack of country diversification. Real Assets are generally known for how they can often accelerate cash flows to match, or in some cases outpace, inflation due to regulatory and contractual inflation escalators and pass-through mechanisms.

This is all well and good, but the same regulatory models do not apply in all countries. US utilities predominately use a Nominal Regulatory model. While this provides a very steady allowed rate of return on equity, the rate base can only grow with capital expenditure, not with inflation.

Countries such as Australia, UK, and New Zealand, on the other hand, predominately use a Real Return Regulatory Asset Base (RAB) model. This delivers increases in allowed returns on equity when capital costs increase, but also allows the asset base to increase with inflation, and this is what the returns are based. This helps the Real Return RAB model utilities to have better inflation protection and can see these assets upgrade earnings into rising rates.

With the US typically representing around 60% of the infrastructure index weight, we see this as a missed opportunity to actively focus on the winners in the current environment. Our investment process for Martin Currie Global Real Income deliberately limits any single country exposure to 40% of the portfolio. For Australia Real Income, we allow an up to 20% exposure to non-ASX securities from developed markets, which also limits an overexposure to the US.

#3 - Development Risk in property is largely uncontrolled for ETFs

Another important consideration for investors seeking a lower-risk equities exposure with a focus on income, is the type of growth opportunities that holdings can provide.

We do not think it is appropriate to include any particular security in our portfolio just because it has a large weight in an arbitrary index. We are predominantly looking for Real Assets that own less-risky established ‘brownfield’ assets. We feel it is unnecessary to take on any avoidable development risk in new ‘greenfield’ projects. Our research has repeatedly found lower volatility and better return/yield characteristics in established brownfield assets over the higher-risk development/greenfield assets.

We want to ensure that demand for the assets exists before we invest and we want to see the asset operating, and we will only own it once it has fully proven itself commercially. As such we specifically screen out companies with significant development risk and favour proven income payers with stable cash flows. Other risks we aim to avoid by being active include regulatory changes, political instability, or project-specific risks.

This is a particular problem for the Property indices. Consider, for example, a property group developing offices. Early on, these assets have engineering and construction risks and uncertain capital expenditure, but even when construction is reaching completion, the demand for these assets is uncertain (more so now than ever) and debt levels are at their peak. We are very conscious that companies might build too much capacity or take on speculative developments that may not actually lease out.

#4 - Hard to avoid less attractive parts of market when using single sector exposures

There is one final reason it is also worth considering a strategy that actively blends the real estate and infrastructure/utilities allocations into one portfolio.

By combining listed real estate with listed infrastructure/utilities together, we can access ongoing structural demand from urbanisation while reducing exposure to the less attractive components of each sector – such as higher risk office/commercial properties, low-yield airports, or even ESG-challenged utilities.

By eliminating the least attractive parts of each asset class, we also aim to provide investors with a portfolio that has a higher yield and lower risk than sector specific strategies, with lower correlation to other asset classes. The broader opportunity set helps to limit individual security, sector, and industry concentration risk, and we also can strategically move between the sectors when we see better opportunities to increase returns.

Martin Currie’s listed Real Asset strategies can provide the missing pieces

In conclusion, while passive index ETFs offer a convenient and cost-effective way to gain exposure to listed Real Assets, there are significant drawbacks that investors should consider.

Actively managed listed Real Asset portfolios, such as Martin Currie Global Real Income and Australia Real Income, provide compelling alternatives by addressing key shortcomings inherent in passive investing.

• By offering exposure to less represented developed and emerging markets, we can focus more on urbanisation trends and potential future growth opportunities.
• Moreover, active management allows us to better scrutinise regulatory models, ensuring our investments align with evolving market dynamics.
• Additionally, we aim to mitigate the development risk inherent in property investments, favouring established assets with stable cash flows.
• Finally, a blended approach that combines real estate and infrastructure/utilities allocations offers enhanced diversification and risk management benefits, catering to investors' income objectives while reducing exposure to segments with higher risk of capital impairment in each sector.

Ultimately, we believe that our unique listed Real Asset strategies can offer investors the missing pieces necessary for a well-rounded and resilient listed Real Asset portfolio.

Managed Fund

Martin Currie Real Income Fund

Australian Shares

View

Managed Fund

Martin Currie Global Real Income Fund

Global Shares

View