Infrastructure and Long-Term Investing

July 2013

Peng Chen, PhD, CFA, Chief Executive Officer & Portfolio Manager, Asia ex Japan,

Chairman, Dimensional SmartNest

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Agenda 1. Who is Dimensional

2. Defining Infrastructure

3. Historical Risk and Returns

4. Infrastructure and Long Term Portfolio

5. Return and Cost of Capital of Regulated

Infrastructure

6. Methods and Inputs for Calculating

Cost of capital

7. Summary

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Who is Dimensional

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Global Investment Team, One Dynamic Process

3

Vancouver

Santa Monica Austin

London Amsterdam

Berlin

Singapore

Sydney

Tokyo

Portfolio Management

Client Service

Dimensional Fund Advisors LP founded in 1981. Global AUM and number of employees as of March 31, 2013.

Locations with offices operated by Dimensional. “Dimensional” refers to the Dimensional entities generally, rather than to one particular entity. These entities are Dimensional Fund Advisors LP, Dimensional Fund Advisors Ltd., DFA

Australia Limited, Dimensional Fund Advisors Canada ULC, Dimensional Fund Advisors Pte. Ltd., and Dimensional Japan Ltd.

Fully integrated portfolio management

715 employees globally

$283B in global AUM

Founded in 1981

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Closely Affiliated with Leading Academics Deep working relationships benefit Dimensional’s solutions and investors

4

Academic Members of the

Investment Policy Committee

US Mutual Fund

Board of Directors

Kenneth R. French, Chairman

Tuck School of Business

Dartmouth College

Eugene F. Fama

Booth School of Business

University of Chicago

Robert C. Merton, Nobel Laureate

Sloan School of Management

Massachusetts Institute of Technology

George M. Constantinides

Booth School of Business

University of Chicago

John P. Gould

Booth School of Business

University of Chicago

Roger G. Ibbotson

Yale School of Management

Yale University

Edward P. Lazear

Graduate School of Business

Stanford University

Myron S. Scholes, Nobel Laureate

Graduate School of Business

Stanford University

Abbie J. Smith

Booth School of Business

University of Chicago

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“Dimensional” refers to the Dimensional entities generally, rather than to one particular entity. These companies are Dimensional Fund Advisors LP, Dimensional Fund Advisors Ltd., DFA Australia Limited, and Dimensional Fund

Advisors Canada ULC.

1. Global asset allocation assets are for information only; these assets are primarily an aggregate of underlying funds and are not counted in totals.

All assets in US dollars. Numbers may not total 100% due to rounding.

Dimensional Global Investment Solutions $283 billion in global AUM as of March 31, 2013

5

US $83.0 Non-US Developed $70.0 Emerging Markets $56.8

All Cap Core $24.7 All Cap Core $16.8 All Cap Core $15.6

All Cap Value $3.8 All Cap Value $5.6 Value $29.9

Large Cap Value $13.4 Large Cap Value $18.8 Large Cap $7.4

Large Cap $4.8 Large Cap $5.4 Small Cap $3.9

SMID Cap Value $7.9 SMID Cap Value $0.9

Small Cap Value $13.1 Small Cap Value $11.3

Small Cap $10.6 Small Cap $11.3

Micro Cap $4.6

Fixed Income $59.3

US Taxable $31.9

US Tax-Exempt $2.3

Non-US & Global $22.2

Inflation-Protected $2.9

Global Equity $5.9

All Cap $5.9

Other $7.9

Real Estate $7.0

Commodities $0.6

Global Asset Allocation1 $6.2

Non-US

Developed

Equities

25%

US

Equities

29%

Fixed

Income

21%

Emerging

Markets

20%

Other

3%

Global

Equity

2%

(in billions)

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Defining Infrastructure

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Infrastructure Essential physical assets, facilities, and systems that enable society to function.

It includes

• Transportation (roads, bridges, tunnels, airports, railroads, ports, etc.),

• Energy and utilities (power generation, fuels, water systems, etc.),

• Communication (line-based networks, air-based networks),

• Social (schools, hospitals, prisons, other public buildings) assets of society.

These are long-lived, real assets that are costly and time-consuming to replace, often

without immediate substitutes, that typically generate relatively stable cash flows that

increase with inflation.

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Is Infrastructure an Asset Class?

Criterion for An Asset Class

• Logical grouping of assets that share similar characteristics

• Collectively have an inherent, non-skill-based return (Beta, not Alpha)

• Unique risk and return characteristics and non-overlapping with other asset classes

• Investable

Infrastructure

• Stable cash flows: usage does not materially decline with price increases or during

periods of economic weakness

• Long-term returns: governments allow private owners to earn fair returns in order to

incentivize them to keep facilities in good working order

• Inflation protection: the ability to increase rates linked to inflation over time

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34453_072013 Source: EIA, J.P. Morgan

Is Infrastructure an Asset Class

10

34453_072013 Source: EIA, J.P. Morgan

Is Infrastructure an Asset Class

11

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Ways of Investing in Infrastructure

12

• Direct ownership – control, but concentrated risks

• Private Equity Funds/Partnerships – more diversified

• Listed Infrastructure Vehicles

– Traded on an exchange,

– Liquid, and have extensive financial reporting requirements regulated by the various stock exchanges

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Historical Risk and Return

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Source: Dow Jones, FTSE, MSCI, S&P, UBS

*Estimate

Various Index that Tracks Infrastructure Industry Breakdowns

14

34453_072013 Source: Ibbotson Associates.

Various Index that Tracks Infrastructure Geographical Exposures

15

Source: Dow Jones, FTSE, S&P, UBS

34453_072013 Source: Ibbotson Associates.

Historical Performance Benchmark Historical Risk and Return Characteristics (June 30, 2013)

16

S&P Global

Infrastructure - Total

Return Index

MSCI AC World

Infrastructure Sector

Capped - Total Return

Index

UBS Global

Infrastructure &

Utilities 50-50 -

Total Return Index

UBS World

Infrastructure &

Utilities - Total

Return Index S&P 500

Inception Nov-01 Jan-99 Jan-95 Jan-06 Jan-26

Return (%)

1 Year 11.69 12.91 14.67 8.64 20.60

3 Year 10.39 12.64 12.28 9.10 18.45

5 Year 1.84 4.09 1.20 -0.77 7.01

7 Year 4.12 5.96 4.87 4.56 5.66

10 Year 9.67 9.17 10.79 NA 7.30

Inception 8.72 5.18 7.56 5.20 9.95

Risk (STD %)

1 Year 8.24 8.97 12.12 11.38 6.74

3 Year 10.07 9.28 13.94 12.98 13.56

5 Year 14.86 12.45 18.58 16.54 18.42

7 Year 14.45 12.61 17.67 16.19 16.71

10 Year 13.57 11.45 16.56 NA 14.58

Inception 13.51 11.62 14.89 15.91 19.02

34453_072013 Source: Ibbotson Associates.

Infrastructure and Other Asset Classes

17

Returns-Based Style Analysis of Infrastructure

Source: Morningstar EnCorr

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Risk Return Trade Off

18 Source: Author’s own estimate and Ibbotson Associates.

CAPM Expected Returns

Asset Class Risk-Free

Risk Free

Rate

Beta Relative

to US Stocks

US Stocks

Risk Premium

CAPM Return

Estimate

Risk Estimate

(Standard

Deviation)

Cash 3.38% + -0.01 x 5.95% = 3.30% 0.89%

U.S. Bonds 3.38% + 0.03 x 5.95% = 3.54% 4.36%

Non-U.S. Bonds 3.38% + 0.24 x 5.95% = 4.81% 10.47%

Global High Yield 3.38% + 0.46 x 5.95% = 6.11% 12.77%

U.S. Stocks 3.38% + 1 x 5.95% = 9.33% 20.18%

Non-U.S. Developed Stocks 3.38% + 1.26 x 5.95% = 10.88% 22.05%

Emerging Stocks 3.38% + 1.46 x 5.95% = 12.06% 35.93%

Global Real Estate 3.38% + 1.16 x 5.95% = 10.27% 23.04%

Commodity Futures 3.38% + -0.03 x 5.95% = 3.18% 18.48%

Global Private Equity 3.38% + 1.5 x 5.95% = 12.31% 39.89%

Infrastructure 3.38% + 0.84 x 5.95% = 8.35% 18.70%

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Efficient Frontier Asset Allocation

Source: Ibbotson Associates.

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Return and Cost of Capital of Regulated

Infrastructure

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Return and Cost of Capital

• Regulated Utility’s return is closely tied to the target cost capital set by regulators

• Long-term forecasts

5 Methods of Estimating Cost of Capital

1) The build-up method

2) Discounted Cash Flow Model (single stage and multi stage model)

3) Capital Asset Pricing Model (CAPM)

4) Modified CAPM model

5) Fama French 3 Factor Model

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Build-up Method

Treasury

Bills

LT

Treasury

Bonds

LT

Corporate

Bonds

Default

Premium

Large

Cap

Stocks

Small

Cap

Stocks

Small Cap

Premium

U.S.

Equity Risk

Premium

Horizon

Premium

Real

Risk-Free

Rate

Expected

Inflation

Real

Risk-Free

Rate

Expected

Inflation

Real

Risk-Free

Rate

Expected

Inflation

U.S.

Equity Risk

Premium

Horizon

Premium

Real

Risk-Free

Rate

Expected

Inflation

Horizon

Premium

Real

Risk-Free

Rate

Expected

Inflation

Horizon

Premium

Risk-Free Rate + Market Risk Premium

+Firm Size Premium + Industry Premium

+potentially other factors

Cost of Equity =

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Estimating Cost of Capital

• Discounted Cash Flow Model (single stage)

• CAPM

• Fama and French

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34453_072013 Pastor and Stambaugh (1997), Costs of Equity from Factor Based Models. NBER Working paper.

Cost of Capital Estimation Models

• Incomplete, Not Incorrect

• Two sources of estimation errors

– Error introduced by the specific model used: e.g., CAPM vs. DCF

– Error Introduced by the specific inputs used: e.g., the equity risk premium

• Drawing on multiple sources of information may help reduce such errors.

• Pastor and Stambaugh (1997) found that uncertainty about inputs are as big source

of overall cost capital estimation uncertainty as model misspecification.

24

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ERP Estimation Methods

• Historical RPs measure over various markets and time periods (Ibbotson & Sinquefield)

• Consensus forecasts:

– Individual investors (USA today)

– Economists / Professors: e.g., Welch (2001), (2004);

– CFOs, e.g., Graham and Harvey (2013)

• Demand: degree of investor risk aversion, e.g., Mehra & Prescott (1985), Mehra (2003),

Constantinides (2003)

• Real economy (supply): stock market is constrained to be part of the economy, e.g.,

Diermeier, Ibbotson & Siegel (1984), Shiller (2000), Fama & French (2002), Ibbotson and

Chen (2003)

25

34453_072013 Source: Ibbotson Associates (2013)

Summary Statistics (1926–2012)

26

DISTRIBUTION OF ANNUAL RETURNS

Large

Company

Stocks

Compound annual

return

Arithmetic annual

return

Risk (standard

deviation)

9.8% 11.8% 20.2%

Government

bonds

Compound annual

return

Arithmetic annual

return

Risk (standard

deviation)

5.7% 6.1% 9.7%

Inflation

Compound annual

return

Arithmetic annual

return

Risk (standard

deviation)

3.0% 3.1% 4.1%

Treasury

Bills

Compound annual

return

Arithmetic annual

return

Risk (standard

deviation)

3.5% 3.6% 3.1%

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Historical RP approach

• ERP is stock returns minus average bond income return (5.1%)

• Historical (1926–2012) ERP equals 4.47% geometrically

• But, extrapolating stock market ERP would outrun earnings and GDP growth

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Possible Biases in the Historical ERP

Survivorship Bias:

• In 1900, an informed investor may have chosen the U.S., Germany, Russia, the U.K., Japan, or Argentina

• 100 years later, only U.S. and U.K. investments still have value

• The return on U.S. stocks was much higher than investors expected

Changes in Investors’ Attitudes and Market Conditions

• Investors are more comfortable with equity investing

• Stock volatility has fallen since 1946

• Bond volatility has risen since the 1970s

• These changes suggest that the ERP is lower today than it was over much of the historical period

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34453_072013 Source: Ibbotson Associates SBBI Yearbook (2013) 29

Growth of Stocks, GDP per Capita, Earnings, and

Dividends (1926–2012)

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The Supply Of Stock Market Returns

• Stock market participates with earnings and real economy growth

• Supply factors include inflation, earnings, PE ratios, dividends and payout ratios,

and GDP per capita

• Retained corporate cash can be used for dividend payouts, share repurchases,

acquisitions, etc

• Assumes Miller & Modigliani, constant ERP, inflation pass-thru, and current fair-

priced PE ratio

30

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Decomposing Stock Market Returns Results add geometrically, not arithmetically

31

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

11%

1—Building blocks 2—Income and

capital gain

Inflation

3.00%

Real risk free

2.08%

ERP

4.47%

Real capital gain

2.52%

Income

4.10%

Inflation

3.00%

Source: Author own estimate based on data from Ibbotson Associates SBBI Yearbook (2013)

Total

9.8%

34453_072013 Source: Author own estimate based on data from Ibbotson Associates SBBI Yearbook (2013)

More Decompositions Of Historical Equity Returns

32

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

11%

2—Income and

capital gain

Real capital gain

2.52%

Income

4.10%

Inflation

3.00%

3—Earnings

Earnings growth

1.97%

Income

4.10%

Inflation

3.00%

4—GDP/POP

Growth GDP per

capita 1.86%

Income

4.10%

Inflation

3.00%

Growth of factor share 0.65% PE growth 0.54%

Total

9.8%

34453_072013 Source: Ibbotson Associates SBBI Yearbook (2013)

PE Ratio The PE ratio has gone from 10x to 30x in 2000, to 16X currently

33

10.92

16.37 As of Dec 31, 2012

0.00

5.00

10.00

15.00

20.00

25.00

30.00

35.00

40.00

45.00

1926 1931 1936 1941 1946 1951 1956 1961 1966 1971 1976 1981 1986 1991 1996 2001 2006

34453_072013 Source: Author own estimate based on data from Ibbotson Associates SBBI Yearbook (2013)

Forecasting Stocks From Earnings Growth PE Growth of 0.50% per year is not forecast to continue

34

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

11%

3-Historical

Inflation

3.00%

Earnings growth 1.97%

PE growth 0.54%

Income

4.10%

3F ERP

Real risk free

2.08%

ERP

3.91%

Inflation

3.00%

3-Historical ERP

Inflation

3.00%

Real risk free

2.08%

ERP

4.47%

3F-Earnings Forecast

Inflation

3.00%

Income

4.10%

Earnings growth 1.97%

Total

9.8% Total

9.21%

34453_072013 *Arnott & Asness (2003) disagree, claiming that corporations waste retained earnings.

The Dividend Yield Approach

• Add the current dividend yield (2.14%) to future dividend growth

• But Miller & Modigliani show that lower payouts do not affect total returns*

• Future EPS and dividend growth will be higher than past growth because of low dividend

payouts and the high current PE ratio

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34453_072013 Bloomberg and Wall Street Journal (July 10, 2013): http://online.wsj.com/mdc/public/page/2_3021-peyield.html

Historical Vs. Current Dividend Yield Forecasts

Based On Earnings And Dividend Models

36

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

11%

3F- historical earnings forecast

3F(ERP)-historical earnings forecast

4F- current dividend forecast

4F'- current dividend forecast ERP

Past dividend growth

Real

risk free

1.07%

ERP

3.91%

1.50%

Current income 2.14%

Inflation

2.20%

Inflation

2.20%

ERP

2.50%

Inflation

2.20%

Total

7.29% Total

5.87% Total

5.87%

Total

9.21%

Real risk free

2.08%

ERP

3.91%

Inflation

3.00%

34453_072013 Source: Graham and Harvey (2013)

CFO Survey Forecast— Graham & Harvey (2013)

10-year forecasted S&P 500 (mean) annual returns over and above the 10-year Treasury bond yield

• As of end of 2012, 10

year expected S&P Total

Return: 5.46%

• As of end of 2012, 10

year expected equity risk

premium 3.83%

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34453_072013 Source: Author own estimate based on data from Ibbotson Associates SBBI Yearbook (2013)

Arithmetic and Geometric Estimate

ERPA = ERPG + 0.5σ2

= 3.91% + 0.5 × 20.182

= 5.95%

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Summary

• Infrastructure should be treated as an separate asset class

• Infrastructure investments has lower risk and returns than traditional equities. Return is tied to

long-term cost of equity targets

• Long-term strategic portfolios should allocate to infrastructure, particularly for investors on the

lower to modest risk levels.

• The dedicated allocation to Infrastructure tends to be around 3-5% (in addition to existing weights

in the broad equity portfolios)

Cost of Capital

• Many potential methods. No method is incorrect; only incomplete methods

• Estimation error in inputs needs to be considered, in particularly equity risk premium

39

34453_072013 40

Ang, Andrew and Geert Bekaert. 2001. “Stock Return Predictability: Is It There?” Columbia University and NBER Working Paper.

Campbell, John Y. and Robert J. Shiller. 2001. “Valuation Ratios and the Long Run Stock Market Outlook: An Update”, NBER Working

Paper, No.8221.

Diermeier, Jeffrey J., Roger G. Ibbotson, and Laurance B. Siegel. 1984. “The Supply for Capital Market Returns,” Financial Analyst Journal,

vol. 40, no. 2 (March/April): 2-8.

Fama, Eugene F. and Kenneth R. French. 2002. “The Equity Risk Premium,” Journal of Finance, vol. 57, no. 2 (April): 637-659.

Graham, John R. and Campbell R. Harvey. 2013. “Expectations of Equity Risk Premia, Volatility and Asymmetry from a Corporate Finance

Perspective,” Working Paper, Fuqua School of Business, Duke University.

Ibbotson Associates. 2013. Stocks, Bonds, Bills, and Inflation 2001 Yearbook, Ibbotson Associates, 2013.

Ibbotson, Roger G., and Rex A. Sinquefield. 1976a. “Stocks, Bonds, Bills, and Inflation: Year-By Year Historical Returns (1926-1974),” The

Journal of Business, vol.49, no. 1 (January), 11-47.

Ibbotson, Roger G., and Rex A. Sinquefield. 1976b. “Stocks, Bonds, Bills, and Inflation: Simulations of Future (1976-2000),” The Journal of

Business, vol. 49, no. 3 (July): 313-338.

Mehra, Rajnish, and Edward Prescott. 1985. “The Equity Premium: A Puzzle,” Journal of Monetary Economics, vol. 15, no. 2, 145-161.

Miller, Merton, and Franco Modigliani. 1961. “ Dividend policy, Growth and the Valuation of Shares,” Journal of Business, vol. 34, no. 4

(October): 411-433.

Shiller, Robert J. 2000. Irrational Exuberance, Princeton University Press, Princeton, NJ.

Welch, Ivo. 2000. "Views of Financial Economists on the Equity Premium and Other Issues." The Journal of Business, vol. 73, no. 4

(October): 501-537.

References

34453_072013

Disclaimer

41

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