A Critique of the Listed Infrastructure Sector

A Critique of the Listed Infrastructure Sector

A new study by EDHECinfra (EDHEC’s infrastructure institute based in Singapore), has a striking point of view on the whole “listed infrastructure” sector, which it says is based on the “fallacy of composition.”

In economics and in logic, the term “fallacy of composition” refers to the general prejudice that if X is true of A, and B, and C, and something else (Z) is composed of A, and B, and C, then X must be true of Z. It ain’t necessarily so.
A common counter example runs this way. It may well be true that if John, watching a baseball game in the bleachers, stands up, he will get a superior view of the game underway. If may also be true that if Mary stands up, she likewise will see better. And if Joe stands up, he will see better. When the whole crowd is seated, that proposition may be true of each and every member of the crowd. But it clearly doesn’t follow that if they all stand up, they will all see better.

Why It Is a Fallacy

In that case, John will see the baseball game more clearly if he alone stands up precisely because he will be the exception in a generally seated crowd. When he is no longer the exception, when everyone is standing, then there is no advantage to standing. Thus, inferences from the parts to the whole are unavailing.
In finance, a close analogy to the ballpark example suggests itself. There might be many strategies that work for a first mover, but that are quickly exhausted. Once exhausted, they yield no benefit either to the first mover or anyone else.

This brings us back to the EDHEC study. Infrastructure investment has long been “the preserve of large sophisticated investors,” EDHEC contends, “but is now rapidly becoming more mainstream and asset owners of all sizes are considering investing in infrastructure.” There are lots of people standing up to watch the game. Further, the notion that infrastructure is a superior investment, insofar as it rests on anything at all, rests on an institutional memory of those earlier times, and on … the composition fallacy.

EDHECinfra tested 21 different indexes of listed infrastructure stocks. They found that they are all highly correlated with the relevant market index, with either equivalent or greater risk than the broader market.

No Discernable Effect

By adding one (any!) of those indexes to a portfolio, an investor achieves … nothing. No “discernable effect on their mean-variance efficient frontier” back testing for the last 15 years.

Private infrastructure entities do in fact, the study acknowledges, have unique characteristics: but they are not by definition available through the stock market.

The study was prepared by Frederic Blanc-Brude, Tim Whittaker, and Simon Wilde.

The Intuitive Narrative

Investors are beguiled, these authors posit, by an intuitively appealing but false narrative, one that posits:

• That an infrastructure asset class exists, which is distinct from other industrial holdings because of the low price-elasticity of infrastructure services;

• That the value of investment in this class is mostly determined by income streams that promise to extend into the distant future, beyond any particular business cycle; and that consequently

• This value exhibits low return covariance with other financial assets.

Index providers have played upon this intuition, as have “a number of active managers” who propose to invest in the hypothetical asset class, listed infrastructure.

There are three ways in which one might define listed infrastructure for the purpose of testing that narrative and such claims. One might simply create a rule based filtering of stocks based on industrial sector classifications, one might stick to the indexes defined and maintained under this head by the index providers, or one might create a basket of stocks working not from industrial sector but from the centrality of long-term public-private contracts.

The first and second of these prove to be of no use, the authors say. The third proves to be of some use, but not in the way the tellers of the beguiling narrative supposes.

On The Source

EDHECinfra was started in February 2016 by the EDHEC Business School. It exists in order to address the issues faced by infrastructure investors, and it currently has a team of 10 full time researchers.

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One Comment

  1. Brad Case
    July 25, 2017 at 8:57 am

    Very interesting, but it appears to me that the conclusion is intellectually worthless. (A version of the paper is available at http://edhec.infrastructure.institute/wp-content/uploads/publications/blanc-brude_2016c.pdf.)
    The basic argument goes like this: (1) for any asset that is traded in a liquid market, there is no excuse for incorrectly measuring volatility, correlations, beta, and therefore alpha; (2) for any asset that is not traded in a liquid market, there is a very good excuse for poorly measuring such performance metrics; (3) specifically, measured periodic returns are lagged and smoothed relative to true returns over the same periods, and therefore we get downward-biased measures of volatility, correlations, and beta and therefore an upward-biased measure of alpha; (4) et voila!
    Comparing a downward-biased measure of volatility for illiquid (private) assets with a correct measure of volatility for liquid (listed) assets makes the illiquid asset appear less risky even when it isn’t; comparing downward-biased correlations with correctly-measured correlations makes the illiquid asset appear to have lower correlations even when it doesn’t; comparing downward-biased betas with correctly-measured betas makes the illiquid asset appear to have less systematic risk even when it doesn’t; comparing upward-biased alphas with correctly-measured alphas makes the illiquid asset appear to provide better risk-adjusted returns when when it doesn’t.
    One subtle thing to note in their methodology: they measure returns of listed infrastructure over monthly periods whereas their web site shows returns of private infrastructure measured over annual periods. There’s a downward-sloping term structure for both volatilities and correlations (relative to stock or bond markets), so measuring them using monthly data gives listed infrastructure high values for both whereas measuring them using annual data gives private infrastructure low values for both.
    Private real estate managers and private equity managers have been using the same techniques for years to make their assets appear to have better risk-adjusted returns than their listed counterparts. It’s intellectually dishonest.


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