Not since the STA and ARF merged to form AustralianSuper have the eyes of our industry been so firmly focused as they were on the Future Fund this year. And funnily enough, it was a former boss of STA, Paul Costello, in the hot seat.
The general manager of the Future Fund and his chief investment officer, David Neal, had been leaving it to their chairman, David Murray, to make most of the public comments on investment philosophy. That is, until they sat down with MICHAEL BAILEY to tell the story behind their world-beating return of -0.2 per cent for the first fifteen months of operation.
In the following pages, Costello and Neal talk about the Future Fund’s unusual way of defining investment categories, its prioritisation of asset classes and the external advisers it’s using to research managers, and their opinions of everything from alpha/beta separation to securities lending. They also had a sobering message for hedge funds awaiting the November 20 expiry of the escrow on their two billion Telstra shares.
The Future Fund doesn’t want size and complexity to go hand-in-hand. It’s why the largest fiduciary fund in Australia recognises just four non-cash asset classes. “The breadth of each category is really about wanting competition for capital in our portfolios,” says chief investment officer David Neal, in a statement which won’t be news to managers vying for an appointment at 120 Collins St, Melbourne.
Neal agrees that the anointment of ‘infrastructure’, ‘hedge funds’ and so on as asset classes with prescribed target allocations has helped push up prices to investors, and just as importantly has lead to some opportunities falling between the cracks. “There’s a whole range of what we’ve called ‘tangible assets’, where the return basically comes from the yield on a physical asset and is linked to inflation to some degree – it might be a building, infrastructure, utilities. We wanted those things to compete with each other, it doesn’t make sense to have infrastructure in the portfolio if it’s expensive and property’s cheaper,” Neal says.
The chief investment officer also argues that the more delineations there are in the portfolio, the more chance there is something will fall between the cracks. “You’d say something like agriculture probably hasn’t been looked at much in the past, because it wasn’t called something you could fit in real estate and then it didn’t fit in infrastructure – I’m not saying we’re out there buying a lot of farms – but certainly in my career there have been lots of interesting investment ideas which have popped up but it doesn’t really fit in anybody’s bucket, and all of a sudden it doesn’t get addressed by anybody.”
Not that agriculture should be assessed for the sake of it. “Almost by definition, if nobody else is looking for it, it means you’ll probably get it cheaper,” Neal says. Apart from the aforementioned ‘tangible assets’ category, the Future Fund opted for an equally broad ‘equities’ category, covering “exposure to corporate enterprise at various stages of development” and including Australian equities, global developed and developing markets equities, and – most interestingly – pulling in private equity, away from the ‘alternatives’ bucket in which its placed by many other institutions.
The Future Fund’s ‘debt’ category is more conventional, covering “exposure to interest bearing securities” including government and non-government bonds, and extending down the risk curve to mortgage-backed securities, high yield credit and corporate debt . The alternative assets bucket, meanwhile, may not include the expected components like infrastructure but does cover “a range of risk premia” – such as commodities futures and insurance-based strategies like those ultimate anti-correlators, catastrophe bonds – which are simply aimed at “providing diversifying exposure relative to the other categories”, according to the Fund’s Annual Report.
The broadness of the investment categories will in turn broaden the skills of those teams constituted to oversee each one, Neal believes. “Particularly in the tangible assets area, we think the skill sets for the people actually going and doing this stuff are quite complementary. We wanted to build a single team for our private markets capability so that they could leverage off each other – if you think about going and buying an airport, it’s typically got some retail shopping, it’s got a car park, it’s obviously got its landing fees, and lots of them have lots of land to develop – so is it infrastructure or is it real estate? It’s both,” Neal says.
So it is that within Gary Gabriel’s private markets team, the head of infrastructure Raphael Arndt will often as not do work on the same deal as head of property, Barry Brakey. The investment process has been deliberately designed as “flexible, fluid and interactive”, in the words of general manager Paul Costello, with the question asked of any prospective investment boiling down to “how will that, when considered alongside all the alternatives, help us achieve our target return [which as most readers will know by now is 4.5-5.5 per cent over CPI over rolling ten year periods] and help ensure the overall level of risk is acceptable?”
The quest for simplicity is one reason why the Future Fund has not followed institutional investors of comparable size, such as Queensland Investment Corporation or Victorian Funds Management Corporation, into an explicit separation of alpha-seeking and beta-generating investment teams. Asked whether he’d considered structuring his investment team that way, Neal accepts that alpha and beta characteristics are “one of multiple inputs” into any investment decision, but believes “the onus of proof is still on the separators…we really like the idea of keeping it straightforward, relatively small, unfussy. It might sound a bit prehistoric and unexciting, and it doesn’t mean we’re not sophisticated – there’s an awful lot of sophisticated analysis and investing that goes on – but we wanted to keep our structure understandable, and the environment we’re in at the moment gives us some support for that.
Complexity breeds problems and distractions for organisations.” Costello accepts that “complexity tends to find its way into every organisation”, but the Future Fund is yet to create too many hard-and-fast investment rules for itself – for instance, indexation and fundamental indexation have been a major feature of the equities portfolio in its early months, but Neal refuses to name any sector where he suspects beta-tracking will be there to stay. “It’s not really an explicit ‘oh is there alpha here or not?’ decision, it’s ‘is this package of risk interesting to us?’ The reason we started off with lots of indexation is simply that we didn’t have a team. We didn’t have a way of analysing complex packages of risk.
Fundamental indexation is in there for a chunk of the international equities because implementation is easy, there’s a small licence fee in there but essentially it’s cheap and governance-light, and it adds diversification within the portfolio.” The Future Fund has made progress towards a more active configuration for international equities, with Peter Sartori’s regionally-focussed Treasury Asia Asset Management among the beneficiaries.
However Australian equities managers – probably the majority of buy-side players reading this – will have to wait a bit longer to discover if their overtures have been in vain. A passive mandate with Vanguard remains the only foray for now. Even at 30 per cent of the Future Fund’s ‘equities’ allocation – or 10 per cent of the entire portfolio – the minutiae of how the target ex-Telstra Australian equities portfolio will be implemented is not a major priority for Neal at this stage. He does not yet have a firm idea of how many active Australian equities managers will be employed, or whether the size of the program will allow a series of sector-focussed specialists to be used. “Until we find a good active idea, we will be passive. Remember for us there is no rush.
"We’re still doing the research – we only want managers we have a very high conviction in, and I think we might find it difficult to get lots of those in a small market like Australia…I know it’s of interest but it’s a part of a part of our portfolio, so frankly we haven’t gotten as far as thinking about small caps in Australian equities yet.” Once Australian equities mandates do start getting awarded, they will be complicated by a rule not well known until the appearance of the 2007/08 Annual Report – they will be prevented from buying Telstra shares on-market. We know this rule exists because during the year, one of Future Fund’s global equities managers liked Sol Trujilllo’s story enough to buy up nearly half a million of the telco’s share.
In what was no doubt a surprise to the (undisclosed) manager in question, the Federal Ministers responsible for the Future Fund had to be informed, and the shares promptly disposed of off-market. Paul Costello knows that a prohibition on the Australian sharemarket’s third-largest stock has the potential to impair the ability to add value for Australian equities managers. He revealed that the fund would consider providing a facility to its Australian equities managers, which will allow them to hold Telstra shares to the desired weight in their portfolio – as long as they buy them off-market from the Future Fund.
“Government can change its rules at any time but to the extent that this [prohibition on new Telstra shares] remains, managers who are attracted to Telstra will be able to hold it on their own accounts but it will be internally transferred to them by us.” The Fund might not be able to buy more Telstra shares but as this issue went to press, the November 20 milestone was reached after which it can certainly sell them. However David Neal has a message for any hedge fund eagerly awaiting the expiry of the escrow (coincidentally also the day after ASIC’s ban on short-selling of non-financial stocks was lifted). “There’s actually no reason for us to sell Telstra shares at any price…to date there’s been a nice little yield on them.
If a hedge fund wants to hang around waiting for four years for us to sell it, good luck to them.” Costello reiterates that there is no pressure on the Future Fund Guardians to dispose of the stake, and says that hedge funds – “whether they really are there or not” – will get “awfully bored waiting and watching”. The general manager admits to being a little tired of the “endless rumour” surrounding the Fund’s intentions re Telstra, although whether all this chatter has in fact been started by hedge funds is anybody’s guess.
The Future Fund’s ad visors
Another common topic of Future Fund speculation is its relationship with asset consultant Watson Wyatt, a subject spiced up by the fact David Neal ran the firm’s Australian operations before taking the big CIO role. Paul Costello clarifies that the relationship with Watson Wyatt was always intended to change over time. “When I arrived here, I had to think immediately about what role external advisors would have with the Fund, because it was a clear expectation that we would invest in an internal capacity to a material extent. Watson Wyatt was extraordinarily useful in those very early days and months, helping to put in place the broader structure of the portfolio, strategic asset allocation and capital markets research and so on, assisting the board and then myself.
That role has changed a great deal over the last year – this process is now led by the internal team and always will be, but we continue to see great value in having a contest of ideas, people against whom the internal team can contest a perspective.” Neal reveals that during 2007/08, the Future Fund in fact reached out to new external advisors. Among them are Wilshire Associates for private equity manager research, and Albourne, the UK-based creator of the online ‘Albourne Village’ of 50,000 hedge fund and private equity market participants, for hedge fund manager research.
“We’ve got an internal investment team which is relatively small given what we have to cover, somewhere just above 20, and it’s pretty top-heavy too if you look at it – it’s certainly not a pyramid, if anything it’s the other way around,” Neal says. “The reason for that is we wanted a highly informed, highly talented team internally covering all of the different disciplines, so we could have a really strong focus on strategic portfolio construction. How do you decide whether you want to go and buy more infrastructure or more corporate debt, if you don’t have a broader team working closely together?”
Debt is indeed much on Neal’s mind. He considers that active positioning in the asset class is a “bigger fish to fry” than Australian equities at the moment. “We’re particularly attracted to what’s going on in debt markets. Credit is attractively priced, you need some pretty detailed work done on the underlying credits but there’s some interesting risk-adjusted returns there, we think.” Apart from Australia’s liquidityhungry banks, PIMCO Australia has been another early beneficiary of this view, through a credit mandate. The short road from idea to implementation is one Neal attributes to the uncomplicated and collaborative decision-making structure.
“We wanted a lean team so we didn’t get bogged down in our own organisation, but that also means you’ve got to leverage a lot of external capabilities,” he says. Now pay attention, those managers which aspire to a Future Fund mandate (and that means most of you). Neal adds that he is well disposed to funds managers or investment banks which can provide “broader input” beyond the investment activity stipulated in their IMA. “Not every investment manager has to be able to provide additional input, but there really is an indirect investment value add."
"It might be that conversations with them help us frame our own strategic portfolio structure or understand the asset class better. Some will offer to do bespoke pieces of research for you – we’re interested in those types of collaborative arrangements, we commit to a relationship and get something a bit broader.” No mandate with the Future Find will be set in stone. “I like the idea of a mandate evolving, or tagging on an extra mandate with a manager in which we can co-invest. I want a manager who’ll say to us, ‘within the context of our mandate, we’ve bought enough of this, we wouldn’t want to buy any more but we think it’s a great idea’. We then have the chance to say ‘great, we’ll set up another structure somehow and buy some more of it’,” Neal says. “It’s efficient for us to have that sort of deep relationship with a relatively small number of organisations, rather than having 200 investment managers working for us that you can’t control.” It follows that Neal’s team is exploring the possibilities of multi-asset class mandates.
None have been awarded as yet (BlackRock Investment Management provided an overlay strategy but that is purely synthetics-driven and used for execution management) but Neal is looking keenly, partly because he sees multi-asset class mandates as an instructive benchmark for his own team. “We are interested in looking for organisations that can manage against our type of mandate. To go to an organisation and say – we want CPI plus 5 per cent over five years, manage to that. Not many places are equipped to think over that long-term time horizon and across multiple asset classes, most are shorter term and like the comfort of a benchmark to manage to,” Neal says. “It’s potentially a very powerful information tool for us. If we’re not doing as well as that external manager, the board and Paul are going to say to us, ‘well what are you doing?’”
The pleasures of youth
Being born in 2006 has helped the Future Fund in a number of ways. One well-documented benefit – the Fund was not fully invested in equities during the worst run for that asset class in many years. As a result, by the end of the September quarter 2008 the Fund had lost just 0.2 per cent in the fifteen months since making its first non-cash investment, and indeed more than 50 per cent remained in that least-risky asset class. The Fund had the luxury, in Q4 2007, of materially slowing its entry to equities just as many were looking for the exits. Since then it has had the equally fortuitous ability to lend to banks, just when ‘senior bank debt’ is the answer you’re most likely to get when you ask professional investors for their favourite asset class.
The timing of its birth also allowed the Fund to dodge a bullet on securities lending. “The whole regulatory discussion around securities lending coincided with the Future Fund coming on stream, so the most logical and sensible decision for us, given the many other things we had to do, was just wait for the new regulatory environment to emerge and consider our options from there,” Costello says. Given that Future Fund’s global custodian, Northern Trust, is being sued by several of its clients for investing their securities lending proceeds in credit plays that went bad, the Fund is probably glad it had the chance to sit tight.
The cashed-up Fund has also avoided the problems many funds are now experiencing in maintaining their currency hedges, particularly as they pertain to less-liquid assets, after the Australian dollar plummeted from US98c to US60c last quarter. The Fund’s policy that it will be “substantially in Australian dollars” is unaffected, according to a spokesman. (The Fund arranges the hedging itself through Northern Trust.) One policy that’s a work in progress is the stance towards environmental/ social/governance considerations in investing. “The first issue was really to confirm our position on voting. Presently, investment managers appointed by the organisation have the delegation to vote the fund’s interests, and part of the appointment process is confirming that the approach they will take is broadly consistent with a series of principals the Fund itself has established,” Costello says.
“Then later on, as a second order issue, we’ll work out how to complement that with the environmental and social perspectives.” Of course the Fund itself does get to decide how it will vote its Telstra shares. By the time you read this, the Future Fund’s opinion of Donald McGauchie’s chairmanship and Sol Trujillo’s salary package might be better known but when we spoke, the guys were giving nothing away. Prior to joining the Future Fund, Paul Costello ran The New Zealand Superannuation Fund, considered by the Peterson Institute of International Economics to be the world’s most transparent sovereign wealth fund. Costello is working towards a similar level of transparency for his new employer, but no matter how much scrutiny is placed upon the Future Fund, its success probably depends on some things remaining secret.