VINCE SCULLY | from Life Sherpa

Vince Scully from Life Sherpa is my special guest in this episode where we uncover the essential role infrastructure plays in stabiliaing and diversifying your investment portfolio. From the bustling roads to the energy that powers our homes, infrastructure investments can enhance your portfolio’s risk-adjusted returns and improve its Sharpe Ratio. But what does this all mean for the individual investor?

We journey through Vince's past life as an infrastructure deal maker at Macquarie Bank, and gain valuable insights into how infrastructure deals are structured and the risks involved. Learn about the influence of government regulations, the importance of cost of capital, and the impact of real interest rates on infrastructure investments.

Vince also sheds light on the nuances of listed versus unlisted assets and the implications for retail investors. This episode is packed with practical advice on incorporating infrastructure into your investment strategy, understanding the dynamics of the market, and making informed decisions that align with your financial goals.

For more financial wisdom and investment insights, visit LifeSherpa.com.au

TRANSCRIPT FOLLOWS AFTER THIS BRIEF MESSAGE

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EPISODE TRANSCRIPT

Bridging the Gap: The Role of Infrastructure in Diversifying Your Portfolio

Chloe: Shares for beginners. Phil Muscatello and Finpods are authorised reps of money Sherpa. The information in this podcast is general in nature and doesn't take into account your personal situation.

Vince: By adding infrastructure into your portfolio, you will lower your overall volatility by less than you'll give up in your returns. So your risk adjusted return earn goes up and when you look at the, uh, impact on the returns, it's very low. So what that means is your sharp ratio, that is the, uh, return per unit risk you're taking goes up and that's generally a good thing for long term investing. So infrastructure is an important part of anyone's portfolio.

Phil: G'day and welcome back to shares for beginners. I'm Phil Muscatello. What's really going on? When politicians talking about building bridges, roads and airports? Why are emerging sectors like renewable energy and digital assets part of the infrastructure basket? And what the hell is infrastructure? Joining me today to talk about all this is Vince Scully from life Sherpa. G'day, Vince.

Vince: G'day, Phil. It's great to be back, great to.

Phil: Have you back on. And it's really nice to hear that you do have a bit of a background before life Sherpa, um, in this infrastructure place, so you do have a little bit of expertise in this area.

Vince: Yeah, presumably almost a decade's worth.

Phil: Okay, so we're going to be looking at your previous life as an infrastructure deal maker at Macquarie bank. But let's just start off with the definition of infrastructure. What is it?

Vince: Great question. I like to think about infrastructure as being all those things that a modern society needs to function. So I think roads, railways, power stations, things that make sure that when you plug your appliance into a socket, the electricity flows, the water you drink, the train that takes you to work, the plane that takes you on holidays, all those things. Even the things that make sure that the data that you consuming to listen to this podcast gets to you uninterrupted. That's all. Infrastructure.

So tell us about your time at Macquarie bank and the infrastructure deals you did

Phil: So tell us about your time at Macquarie bank and the infrastructure deals you were involved with at the time.

Vince: Yes, I joined Macquarie bank in what was in fact, it was an unlisted company at the time and I joined a group that was called a, uh, Financial Products Group, which was effectively structured finance. And structured finance is a broad term that compasses just about any form of financing that's not a straight line and usually it's got a tax benefit in there somewhere.

Phil: And this is because Macquarie is an investment bank, unlike, um, Commonwealth bank or the other banks there.

Vince: So Macquarie had a banking license at the time. It didn't really have a retail bank and it came out of Grand Samuel, what in the UK is called a merchant bank, which is broadly synonymous with investment bank in the US. And it got its license, but it was still unlisted and still very much made most of its income from fee income generally for arranging transactions, whether that was commodities, foreign exchange, research and development syndicates, car leases, aircraft. It was one of the three biggest aircraft leasing businesses in the world at the time. I mean, I recall in my very early days rocking up to Frankfurt to, uh, pitch a deal to Lufthansa as a very junior analyst, I might admit. And the three shortlisted bidders were all australian. So we had, um, Macquarie Bank, Alco, which died during the GFC in 2008, and Babcock and Brown, who died a couple of years after, generally died for similar causes. And we were the three shortlisted bidders. So that was an, uh, interesting experience that these little Aussie companies can punch above their weights on the world stage. So that was really innovative financing. Around that time, there was a growing interest in governments in getting infrastructure financed off the government's balance sheet. The Sydney harbor tunnel transaction had been done and completed and it was open at that point and the m two motorway transaction was happening at the time.

Phil: And were those. The earlier way of financing was basically governments would.

Vince: Yes. So the Sydney harbor tunnel transaction was as good as it gets, a government bond. So the government contracted a, ah, consortium of Transfield and a japanese company called Kumagai and Obayashi were both in the market and the funding, um, was repaid by the tolls. So the government offloaded the design and construction risks to the construction consortium, but the financing risks still largely lay on the government's balance sheet. So that was a relatively straightforward deal that was a private transaction, didn't involve the stock markets. The M two motorway and Transurban in Melbourne were probably the first big stock market transactions. And there you had abbey groups, which I don't think, which doesn't exist anymore, built the M two motorway and shares were listed on the stock exchange. Transurban, of course, similar. Transurban now is the owner of almost every toll road in the country and many toll roads offshore. So it's very much an australian success story. It's a significant component of global infrastructure indexes and very much an australian success story. Australia was an early participant in this market. The UK certainly got into its privatizations. Uh, british gas was privatized in the airports, were privatized in the 80s. But in terms of constructing new infrastructure, Australia was a very early player. M. You would think that the US would be a big player as the world's biggest stock market, the center of world capitalism. But its capital markets didn't really support private funding of infrastructure because it had a very deep and liquid municipal bond market which allowed you to issue tax free bonds. So governments had a significant capital cost advantage over the private sector. So didn't really happen all that much. They started introducing high occupancy vehicle lanes on their freeways in the late ninety s. I think Transurban did fund one in Washington DC, I think. So it's a tunnel?

Phil: I think it was a tunnel, I believe. Yeah.

Vince: Well, there was certainly the Detroit to Windsor tunnel, which I think might have been the first.

Phil: And if you wanted to go, uh, if you didn't want to pay the toll, you'd have one lane which would be sitting in traffic, and if you wanted to pay the toll.

Vince: So these high competency vehicle lanes are very controversial in the US, but was the initial institutional investment in their roads. Similarly, not many of their airports are privatized. So the US is a peculiar market in this sense. Its infrastructure market is really around electric utilities, pipelines, electricity generation, that sort of thing. Whereas Australia, we have a very broad privatized sector, uh, from electricity to ports, to roads to airports, telecommunications. Telecommunications. So Australia is quite a deep infrastructure market. So uh, when you look at our stock exchange, if you look at the ASX 200, for example, there's quite a bit of infrastructure in there, but still we're a small player stock market wise in the world. I think we're about 4% of the MSCI at the moment.

The biggest competitive advantage for an infrastructure operator is generally their cost of capital

Phil: Anyway, let's get back to the couple.

Vince: Of the deal, back to the early deals. Uh, the early transactions were what were referred to as boot transactions, which doesn't stand for better off overall test, as most people in the media would think today, but it stands for build, own, operate, transfer. And there the government generally contracted with a private party to build and fund the asset, operate it for a period, often called a concession period, and at the end transfer it at no cost to the government. So that had the effect of transferring the risky bit of the uh, development. So uh, if you think about building a toll road, it's pretty difficult to accurately predict how many cars are going to use your road in four years time. So if you got to set out to design and build it, and four years down the track, your revenue is going to start flowing in from toll paying motorists and truck drivers. So you have to be able to predict what that traffic is going to look like. And history tells you that most prospectus forecasts have been over optimistic. You've also got the uh, uncertainties of the cost and timing of construction. Just look at the new tunnel in Melbourne. Huge issues around contaminated uh, ground and where liability for fixing that comes from. So the cost of construction is a big risk and then how much traffic is going to use it. But once you have 2345 years history, traffic doesn't vary very much. And the government regulates the toll so it goes up by inflation or inflation plus sometimes. And putting the toll up generally doesn't affect the traffic all that much. So we haven't really seen big dips in traffic apart from COVID I mean Covid was certainly one that put the quality of infrastructure assets to the test. So when your traffic falls 20% on your toll road, your whole operating system is going to struggle. Yeah, but the revenue is going, your airport closes. To all intents and purposes people stop riding your train. But that's a very unusual, that's very much a black swan event overall, over time. Infrastructure is a remarkably stable revenue stream, generally indexed to inflation or GDP growth. And the operating costs are very low. So the cost of operating a road or a tunnel once it's built are very low. You got to collect the toll, you got to keep the fans running. There's not a lot of work. So your operating costs tend to be 10% or less of revenue. So the big thing that drives your profitability is the cost of your capital. So structuring your, what we call the capital stack. So equity is the most expensive piece of that. That's the bit that's listed on the stock exchange. Then you have various levels of subordination on the debt. And the senior debt, which is the stuff that gets paid first, is usually very, very cheap. And so the biggest competitive advantage for an infrastructure operator is generally their cost of capital.

Phil: What is that? Is this the money that they're borrowing from banks?

Vince: Um, if you think about my toll road example, once you've built it and you've spent your billion dollars, give or take. Give or take, the operating costs are very low. So what's the thing that drives your profit? It's interest payments on this big debt that you've got. So shaving a couple of basis points, that's hundreds of uh, a percent off your cost of capital makes a huge difference to the profit. And so quite often you'll see infrastructure assets going through refinancings, and transurban's got a big one coming up. So usually that's a sign that profits are going to go up as they refinance at a lower rate. Revenue is higher, it's more stable. You've got a longer history and you should be able to get a better deal on your debt. Problems can arise, though, if you have to refinance at a time when markets are tight or interest rates have gone up. So you might find that refinancing a, ah, five year old fixed rate debt is now going to cost you more. So if you're investing in infrastructure, you need to look at a balance sheet and you need to look at the timing and structure of their debt packages. That's what makes the difference. That's certainly for the more stable infrastructure, things that are a bit more revenue dependent. Railways, for example, the number of people who ride your train, you can do something about that, especially airport railways. Like if you can capture an extra 1% of the people who travel through the airport, that can make a huge difference to your profitability.

Phil: What's an example of a railway infrastructure in Australia?

Vince: Well, the two big ones that were privately funded was the, uh, Sydney Airport Railway and the Brisbane Airport Railway. So Sydney Airport Railway was a really interesting transaction. It was an extension of one of the lines through the rapidly gentrifying industrial inner south, I suppose, Alexandria, Zetlin, Green Square, all of which were decaying industrial assets at the time, and new stations at the airport through to Wooley Creek.

Phil: And then onwards to Leppington.

Vince: And wherever it goes to after that, wherever these tills lines goes. And so because they were three running trains, the private sector obviously couldn't run the trains because mixing that in with the existing networks really hard. So that was funded by a levy on, um, station usage. So when you get off at Green Square, the two airport stations, there's a third one, mascot. Mascot. You pay an extra charge compared to any other station.

Phil: I thought that was only for the airport stations, only for the domestic.

Vince: It was originally because there's a lot.

Phil: Of people who get off at mask, ah, walking.

Vince: Maybe that's changed, but certainly it was originally intended to be the fourth. It may have changed since the deal was done, because it's been in liquidation or in receivership twice in its lifetime. And that was really predicated on the growth of residential in those inner south suburbs, which took forever. So this was done for the Olympics in 2000, and the, uh, growth in those areas really didn't happen till the last decade, really. So it struggled for that.

Phil: The brew state government policy, I believe, too.

Vince: Yeah, potentially. And the Brisbane Airport railway, of course, being a spur line, there were new stations and so the private sector operator contracted with Queensland Rail to run trains on its infrastructure and it set the price and it's fully integrated with gold, uh, coastline. So that's a, uh, more traditional airport line. Airport lines tend to work well in private sector, so Heathrow Express, Gatwick Express, for example, in the UK, work well because you can generally charge a premium. Typically you need a different sort of carriage because you've got a sport baggage and people aren't doing it every day. So there's a fair bit of traffic investment in airport railways around the world, but that's sort of getting back to the point around funding cost, that when you look at investing in infrastructure, you've got assets that are, uh, highly regulated, generally, electricity distribution, water distribution, roads and some airports. I'll come back to airports later. And there the government sets the price of the goods. So generally there's some sort of review process where the operator makes a submission to a regulatory body, often the ACCC in Australia, and it will set a price based on expected usage and an agreed return on capital. So your job as an infrastructure operator is to lower your cost of capital so that you get a bigger spread between what the regulator gives you and what you're actually paying, and increasing the volume above what the regulator has estimated for the next pricing period. And then there's a game that someone that gets clawed back in the next price resetting. But they are very stable businesses and behave a lot like a, ah, traditional utility. So if you've ever played monopoly, the four utilities, good steady income, but they're not the one that's going to break you by buying Mayfair. Um, so good stable sources of income linked to inflation and linked to GDP growth, generally. So very stable returns, you then move on to the more what used to call patronage based, and that's patronage in the usage sense, not patronage in the sense of government patronage, where your success as an operator depends on you increasing your sales in volume terms. So if I'm a water utility, I want to incentivize you to use more water, but not so much that I've got to build increased capacity. So there's a bit of a game to be played.

Australian airports are regulated on what's known as a single till system

Airports are really interesting in this one, and they do vary across the world. So in Australia, only the aeronautical revenue, that is the revenue from planes landing and taking off, is regulated. So the government regulates the price of landing a plane at Sydney airport and regulates the number of landings there can be, but it doesn't regulate the car park revenue or the rent on the shops or all those other facilities that airports make money from. And that contrasts with the UK system, where the UK airports are regulated on what's known as a single till system. And single till says, we're going to look at your overall revenue, whether it's from parking or shops or cafes or baggage storage or whatever else, and we'll look at that as a whole. So there they go. And look at, well, based on this throughput and this expected cost of capital, and the two terms you need to be familiar with, there is, there's the thing called a rab, or regulated asset base, which is supposedly the efficient cost of the assets you're employing. So you shouldn't get a return on assets that are unnecessary and then the regulated cost of capital, which is what the regulator thinks you should be paying for your debt. And there's a lot of Rgbaji and expert reports that go into working out what that number is, and that's the price you get to charge for all of those services. So clearly, investing in Sydney airport is a riskier asset than Heathrow, for example, and both suffer from similar capacity restrictions, whereas a Brisbane airport, for example, it's a, ah, growing airport, so you're paying more for growth, so you're betting on a lot of the price that you're paying is about future growth. So that's obviously a much, much riskier exercise.

Phil: So they've got more capacity, but they've also got demands coming in.

Vince: Well, a Brisbane catchment air is growing. There's more flights, there's more ability to grow. The downside is they have to build a new Runway, which is, I don't know what that budget is, but it's probably close to a billion dollars. And they then have to attract the traffic to use it.

Phil: And also all of the argy bargie over where the flight part's going to be as well, because there's going to be public backlash too.

Vince: That's right.

Phil: Remembering what it was like in Sydney.

Vince: So that makes Brisbane a much riskier asset and therefore you should expect to get a higher return. M on the other side, there's more future growth, so people will pay more for a higher multiple of today's revenue. So not all airports are created equal. And you've got to know what you're looking at, which is an interesting thing when it comes to your super. So the regulator, in this case, APRA, says an unlisted infrastructure asset can be treated as 50% defensive, 50% growth. So when you look at the reported asset allocation of your superfund and remember, asset allocation drives 90% of your returns, you will find that they will report a lower growth percentage than a traditional fund manager would holding the same asset, which gives some really interesting anomalies. So, Brisbane airport, traditionally unlisted, owned by industry, IFM M, and a number of other institutional investors, unlisted, 50% defensive, 50% growth. And yet, compared to the then listed Sydney airport, which we've just gone through, and said Sydney, less risky than Brisbane, Sydney would have got reporters, 100% growth. Brisbane reporters, 50% growth, 50% defensive. So these, uh, are things that lay traps for young players. So if you're really trying to do like, for, like, comparisons, it's pretty hard. So the day that these super funds bought Sydney airport and delisted it, suddenly the asset is now not 100% growth. It's 50 50, and nothing's changed on the ground, the same planes are landing the next day, the same passengers are paying the same amount of money for their coffee in the terminal, the same number of people are parking in the car park, and yet, suddenly, it's reclassified as 50% offensive. And so uni super, which owned 19% of the listed Sydney airport, suddenly moves half of that to defensive. So I'm not suggesting anyone's doing anything untoward here. That's just an accounting. It's an accounting, uh, reporting thing. Everyone's complying with the law, but it means that you need to scratch deeper than the headline reported asset allocation, especially at that broad brush growth defensive split. But the question is, well, that's all very interesting, but where does that fit in my portfolio? Infrastructure is, I would classify as a low beta asset. Now, that's a bit of jargon, which means that it wiggles less than the market. So beta is a measure of how a given stock moves relative to the market. And so the market, by definition, has a beta of one. And so a less volatile asset would have a number less than one, meaning so typical infrastructure asset might be like 0.6.7 maybe, which means that if the market goes up by 10% or down by 10%, you would expect your infrastructure asset to move by 7%, which dampens your overall volatility, and that creates a benefit to your overall portfolio.

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Phil: So would that include a transurban, for example?

Vince: Absolutely. I haven't looked at what Transurban's beta is, but it would certainly be less than one. Telstra's will be less than one.

Phil: AGL doesn't go very up very much, has it?

Vince: AGL, remember, volatility cuts both ways. It saves you on the downside, but penalizes you on the upside. But when you look at your portfolio theory, you go back to the pharma french five factor model. Beta is the biggest of those factors. So when you look at your return, you would expect, because you've got a lower beta, you would expect your return to be lower. And that's partly the price you pay for lowering your volatility. But when it comes to infrastructure and real estate, to a certain extent, the fact that your revenue is linked to GDP and inflation and is relatively stable, and your, uh, profitability is generally determined by the cost of capital, you can actually generate excess returns in an academic sense. So that trade off is not linear.

Phil: Is that to do with the income aspect?

Vince: Yeah, capital growth, it's accomplished, but. So, if you look at how infrastructure assets are valued, which is really. Well, in fact, how all assets are valued is you look at the future cash flows and you discount it by the cost of capital. And so the more certain those future, uh, revenue streams can be, the lower the discount rate. And lower discount rates reflect in two things. They reflect in lower cost of debt and they reflect in lower returns to shareholders, because shareholders demand a lower return for less risky assets. But you usually find that the upside from higher gearing offsets that, because the more certain your future revenue, the more debt the vehicle can support. And so you need less equity than its similar active business. And so that allows you to effectively buy more revenue for the same price. That's the upside. The downside is that when interest rates go up, the cost of capital goes up, and so more of your cash flow is used to pay to pay the debt. There's less cash flow for equity, and because the risk free rate has gone up, investors demand more returns. So the value of your stocks fall. So they are interest rate sensitive stocks. But importantly, it's real interest rates that effective because the revenue goes up with inflation. So it's really where interest rates move up, but inflation doesn't. So increases in real rates are bad for infrastructure, whereas decreases in real interest rates are, uh, good for infrastructure. And that's really what we've seen over the last 20 od years. That as 30 years, probably, as inflation has come down, the spread between nominal interest rates and inflation has also come down, which means the real interest rates come down. And that's very attractive for infrastructure investors. So what all of that means is that by adding infrastructure into your portfolio, you will lower your overall volatility by less than you'll give up in your returns. So your risk adjusted return goes up, and when you look at the impact on the returns, it's very low. So what that means is your sharp ratio, that is the return per unit risk you're taking, goes up, and that's generally a good thing for long term investing. So infrastructure is an important part of anyone's portfolio. And whilst Australia's got a reasonable weighting in its index, it's still small. So we would generally suggest a specific allocation to infrastructure via an ETF. Yes, we generally use etfs.

Phil: That'll be an ETF, presumably that will include infrastructure from around the globe.

Vince: Yeah, that's right. So we would use a global infrastructure fund, which does include a material weighting to transurban.

How do I choose an infrastructure investment if I'm a retail investor

Which sort of brings me on to the point about, well, how do I choose an infrastructure investment if I'm a retail investor? Institutional investors, like your superfund, for example, obviously get access to buying either when the government does the deal in the first place, or buying from other institutional investors. And they obviously have an informational advantage over you which isn't shared with you. So when you invest in one of the big super funds, which has a material allocation to unlisted, uh, assets, of which a big chunk will be infrastructure, uh, they don't disclose how they got to the valuation. They don't disclose much of the accounts of the vehicle, although you can usually get those from the relevant regulator if you prepared to put in the effort and pay the money. And they don't disclose a lot of the restrictions on the sale. So most infrastructure assets held by institutional investors will have, uh, restrictions on who can sell. They'll obviously often have preemptive rights for other shareholders. So if you want to sell your share of Brisbane airport or Darwin airport, you've got to offer it to the other shareholders first, usually. And these transactions don't happen very often. So the only time you really know the price is when a parcel of it change hands. And you don't usually know the full terms and conditions of that sale. So it may or may not represent a true length transaction.

Phil: Yeah, it's not something that you can value like a stock. That's the price. You can see every.

Vince: That's right.

Phil: Um, because it's hidden behind the ownership structure as well. And they've got to have, presumably, auditors who will say what that is.

Vince: So between actual sales, you rely on a financial model which is often entrusted to the most junior analysts in the team because it's someone you can really trust. That's right.

Phil: You can count on.

Vince: And so that model is made up of a whole bunch of forecasts and assumptions. So your assumptions on inflation going forward, your assumptions on real interest rates going forward, your assumptions on what the regulator is going to do at the next price, reset your assumptions on number of flights landing at your airport, your assumptions on how much each passenger landing at the airport is going to spend. All of those will have material impacts on the overall valuation. So it's very hard to get a handle on what the, uh, value actually is until its trade actually happens. And they don't happen very often.

Phil: So we're talking here in the super system or in the.

Vince: Well, no, no, in unlisted infrastructure generally, or unlisted assets generally, wherever you're finding.

Phil: Them, in whichever vehicle.

Vince: And of course, many of the big super funds have big holdings in unlisted infrastructure, listed infrastructure or listed assets generally. On the other hand, as you pointed out, Phil, are priced every day. There are thousands, tens of thousands, even millions of transactions that go to incorporate all the known information into that price. They're also subject to regulation. So when Sydney Airport was listed, it published its accounts in its annual review. Shareholders could go along to the annual general meeting and question management. You knew that every share being traded was at arm's length, so the price was the price. And so that's why we like listed infrastructure. And of course, being listed, investors will pay more for a listed asset because they're prepared to accept a lower return for transparency. So the advantage of an institutional investor is they can earn a higher return because they're not paying this so called liquidity premium, which is fine if you are the actual institutional investor where you do know the information. But a retail investor is one step removed from that, and that information is not shared, whereas a retail investor can access that information directly from the company, in the case of a list infrastructure. And that's, I think, the key point here, that one's not inherently better than the other. It depends on the circumstances, but more importantly, access to the information. As a retail investor, you don't get access to the unlisted information.

Phil: So hopefully, as a retail investor, you can have a lot of unlisted in your super account, and then presumably or possibly you would like to have more of your listed assets in your own personal investment account.

Vince: I mean, that's the truth for most Australians who have their super, in large super funds, because by choosing one of the large super funds, you are, uh, by definition choosing to invest 40% or more of your money in unlisted assets. Whether that's wise or not is a much bigger question. And I think the asymmetry of information makes that an unwise choice for most people. Australia is at the bottom of world standards in terms of its disclosure by super funds. And I think that's a reason why, unless you're being rewarded for it, is a risk that you shouldn't be taking. And there is no evidence that retail investors are being rewarded for that additional risk, that it's being absorbed into the price that these institutional investors are paying for the asset. So if you go back to the principle that listed assets should trade at a higher price, that an investor in a listed asset should be prepared to pay more for the same set of cash flows as an unlisted investor would because of that liquidity premium, then how can an unlisted investor pay more for the same asset than the market values at it? That's a mathematical nonsense. So how it happens is that, uh, the unlisted investor puts more debt into it, so the investment becomes inherently riskier. So more debt, less equity, makes the price you pay go up, but increases the risk of your investment. The other angle is that the unlisted investor may have a better view, or a different view of the future. So, in the case of Sydney airport, the consortium of super funds that bought it would say, we think the markets overreacted to Covid and we know better. Now, sometimes that works, but more often it ends in tears. And so, as a general guide, unless you're actually sharing in the upside of the unlisted risk, I don't think a retail investor should be taking that risk. And so we would generally recommend a listed approach where possible. It's not always possible. Private equity is a good example. Private credit, I mean, by definition, they can't be listed. But for things like infrastructure and real estate, we think that transparency of listed is something that should be valued by a retail investor, and we would generally avoid unlisted. If you're the future fund and you've got analysts doing this all day long, and you can do the digging, then absolutely, that's a choice. But that's not the choice that's being faced by the average retail investor who isn't being provided with the information and doesn't have the time to look at it and doesn't have an army, uh, of analysts to analyze it. And therefore, that's not a risk that I believe that you should be taking.

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When you're considering adding infrastructure to your portfolio, what are the considerations

M that's sharesight.com sharesfor beginners. So when m you're considering adding infrastructure to your portfolio, what are the considerations? What are the factors? Is it to do with your age or.

Vince: Um, no, I mean, I think that I would start with an overall growth defensive split and then I would manage the volatility within my growth portion by allocating some of that growth portion to infrastructure and real estate. And there is a very marginal trade off on return. So when you replace some of your bonds with gold, you replace some of your equity with real estate and infrastructure, you end up with a, uh, diversified portfolio with much, much lower volatility.

Phil: And it's diversified across asset classes, not just in sectors on the market available. Yeah, I, uh, think it's an important decision. It is an important asset classes.

Vince: So when I say diverse, in that case, you start with your growth defensive split. And growth traditionally meant equities or businesses. I would add bricks to that analysis, which is really infrastructure and real estate. And so those three components form the core of our growth allocations. And then within each of those, within your equities, you've got large cap, small caps, you've got australian, you've got global, you've got emerging markets, you've got value, you've got growth, you've got small cap.

Phil: Mid cap, large cap.

Vince: And so that then when you then look at the infrastructure component, you want to be making sure that what you're getting is actual infrastructure. So when you look at the indices or indexes, there are usually core index and broader indexes. So you look at the FTSE index or the S& P index, they have a core index and uh, a broad index, the broad index includes things like service providers, engineers, designers, operators, labor, hire people. So they are much closer to ordinary businesses than infrastructure. So we like to look at the core infrastructure indexes. And then both of the big providers of indexes also run a capped index. So you often see the FTSE 50 50 core index, which is a fairly popular one, that's tracked by a number of etfs, and that imposes caps on the individual sectors. So it poses a cap between electricity, transport, water. And that's a bit of an artificial cap. It's designed to make sure that you have broader diversification, but it means you're less market cap weighted, which sort of, by definition, means it must be less efficient. And so we focus on the core indexes, which is generally either the FTSE or the SPDR. And then the other big decision you need to make is to hedge or unhedge. And many of the global infrastructure etfs, uh, are hedged. That is, they invest in overseas assets, but hedge the currency back to australian dollars. And that sort of harks back to the days when people treated infrastructure like a bond. And I'm going to put my hand up and plead guilty to this here, that that was one of the marketing tools we used to convince institution investors to invest in infrastructure in the 90s, that we went, don't you worry about that? It's just like a bond, or it's just like real estate. And so people got into the habit of, oh, I hedge bonds, therefore I should hedge hedge infrastructure. And that sort of, I think, fundamentally misunderstands the purpose of infrastructure in a portfolio. So, for both real estate and infrastructure globally, we would take a unhedged position, just as we do with equities, we generally take a view that hedge bonds, uh, unhedge equities and infrastructure is really just a low beta equity.

Life Sherpa uses four factors to identify where your returns come from

Phil: So, tell us about the portfolios available in invest at life. Yeah.

Vince: So at, uh, life Sherpa, we take an evidence based approach to investing. So we have constructed a range of portfolios.

Phil: Four of them, aren't they?

Vince: There's four of them, ranging from a, uh, 90 ten portfolio, which we call our Everest portfolio, down to a 50 50 portfolio. That's the split between growth and defensive assets. Within our defensive assets, we use a combination of cash, bonds and gold. And within our growth portfolios, we have allocations to equities, sort of global and domestic, and infrastructure and real estate. And then we have an allocation to what we call small cap value. So they are small companies that score highly on the value metrics. So we did talk very briefly 20 minutes ago about the pharma french five factor models, which is a way of identifying where your returns come from. The biggest one we talked about was beta, which is the market, effectively, the next one is, uh, size. So generally, over time, small companies outperform big companies, largely because they're riskier. And it's much easier to double the size of a 100 million dollar company than a $10 billion company. And so generally you want to have an allocation to small caps, which is quite hard in Australia, because once you get outside, uh, the ASX, ah, 300, there is no tradable index. And the 300 is not actually that small and the small half of it. So the 200 to 300. So if you look at the difference between IOZ, which tracks the ASX 200, and Vas, which tracks the, uh, ASX 300, there's bug roll difference. The ASX 200 makes up 97 point something percent of the ASX 300. So you've got to look outside the 300, and there is no tradable index. So you really need to look at an active manager. And there's certainly a lot of evidence that in that small end of the market, active management adds value. The third factor then is the value factor, which is broadly defined as the ratio of the price to the underlying cash flows. So a high pe, that is price to earnings ratio, like Facebook, Google, all trading on your 30 plus whatever the number is today, will, by over time, underperform value stocks, which are trading on a lower p, which trade on a lower PE, and therefore, if you pay less for the same cash flows.

Phil: But then you always get that thing where you get a good company. Okay, maybe not, um, in the 30s, but maybe in the low 20s, which is still a good company, which is still making great.

Vince: That's right.

Phil: You can never buy it at a value price.

Vince: Well, that's right. And, ah, that's that challenge in value investing that it's historically been more expensive to employ.

Phil: I know there's a couple of fund managers that I've interviewed over the last few years, and they're value fund managers and they've underperformed for years.

Vince: And of course, Warren Buffett is, uh, the archetypal value investor. And over time, and that's the thing about these factors, it's over time. You cannot say that in any given period, the factor will deliver. So it's really the academic evidence backed up by 100 years of market data and countless, well, uh, not countless, but probably five Nobel prizes, says that I can explain almost 100% of the returns within an asset class by looking at those five factors and beta being the biggest one. But what you can't do, uh, is say today, this value stock will outperform that growth stock. That's just a nonsense, and that's not what the research is based on. But over time and over time can be a very long time. And that's the challenge with non market cap weighting investing, that in order to get a different result, you have to do something different. And sometimes different is different bad, and sometimes it's different good. But over time, if you stay the course, small cap will outperform large cap, and value will outperform growth. But when and for how long? And that's the challenge with running a value fund, is, uh, when the tides are running against you, there's a temptation to go, oh, well, let's have a little bit of growth. And that's why we saw the growth of growth at a reasonable price. Investing in the 90s style creep is a big problem with active managers, and you've got to really keep an eye on them. But there's no doubt that at the small cap and at the value end of the market, active management adds value.

Phil: How can listeners find out more about the life Sherpa, uh, investment portfolios?

Vince: Well, you can find out everything about lifesherpa and our investment portfolios at lifesherpa.com. au, au or if you want to cut out the middleman and go straight to the portfolios, you can go to invest lifesherpa au.

Phil: Vince Scully, thanks for coming on again.

Vince: I've been Vince Scully that's great.

Chloe: Thanks for listening to shares for beginners. You can find more at sharesforbeginners.com. If you enjoy listening, please take a moment to rate or review in your podcast player or tell a friend who might want to learn more about investing for their future.

Any advice in this blog post is general financial advice only and does not take into account your objectives, financial situation or needs. Because of that, you should consider if the advice is appropriate to you and your needs before acting on the information. If you do choose to buy a financial product read the PDS and TMD and obtain appropriate financial advice tailored to your needs. Finpods Pty Ltd & Philip Muscatello are authorised representatives of MoneySherpa Pty Ltd which holds financial services licence 451289. Here's a link to our Financial Services Guide.