With its 10th birthday approaching, the Future Fund is entering its next incarnation complete with a new investment team structure. Investment Magazine spoke to Raphael Arndt, Stephen Gilmore and David Neal.
When David Neal, the inaugural chief investment officer of the Future Fund, became its managing director on August 4 last year, his previous role was split in two. Long-time head of timberland and infrastructure Raphael Arndt became the chief investment officer responsible for leading the investment team in developing the research, due diligence and selection and monitoring processes for assets and investment managers.
Stephen Gilmore, previously the Future Fund’s head of investment strategy, became the chief investment strategy and risk officer. In doing so he took on additional responsibility for managing and monitoring total portfolio risk settings and continuing to focus on portfolio design, and understanding the macroeconomic and market environment. Both report to Neal.
The new investment team structure is indicative of the Future Fund 2.0. It reflects the need for more resources and communication due to the increased complexity and competitiveness of the investment environment, as well as the increased complexity of the fund’s investment portfolio – particularly compared to 2006, when the fund was created.
Something is clearly working. For the year to the end of June 2015, the fund returned 15.4 per cent – 9.4 per cent above its benchmark – and the fund’s best one-year performance. Since its inception in May 2006 it has returned 8 per cent, against a target return of 7.1 per cent (CPI plus 4.5 per cent).
At $117 billion, it is Australia’s largest investor. It is not set apart by size alone, as it has one of the most flexible and adaptive portfolio construction processes among its global peers. One of the fund’s investment strategy beliefs is that “portfolios are most efficiently managed as a whole, rather than as a collection of individual sub-portfolios”.
What this means in practice is a multifaceted approach to portfolio construction. Strategic themes and a “view of the world” are fed into scenario analysis. Sector risk and opportunity analysis is conducted, including top-down and bottom-up analysis; and the manager review committee and asset review committee also feed ideas to the investment committee. The investment committee – which includes the sector heads, the chief investment officer, chief investment strategy and risk officer, and the managing director – is responsible for the investment decisions.
This team approach makes the fund unique. Ideas are debated by the investment committee, and staff are rewarded for supporting ideas that are not their own. Whether or not an investment is “good for the portfolio” is always front-of-mind.
In this way, Arndt says, nothing much has changed with the new team structure. The decision-making process is the same as it has always been. “The portfolio was built under the ‘one portfolio’ approach. So irrespective of who you are and what you do, no one person controls the decisions.”
It is as if they share thoughts and philosophies, and to add emphasis to the point, Gilmore finishes Arndt’s sentence.
“It is very collaborative along the way; you always want team buy-in. It can be a challenge when people come from different work backgrounds and bring their experiences. We all have biases. A person with a top-down background will look at things differently to the way we do things. A while ago we asked people, ‘What portfolio would you have if you could choose?’ Everyone had more of what they did in it.”
But the Future Fund isn’t big on individuals. No individual is mentioned in its culture, value statements or behaviour. The ‘one portfolio’ approach is central; and regardless of job function, remuneration for all employees is partly based on the entire portfolio performance.
For the investment team, this is more significant, with remuneration based on contribution to the total portfolio. This can be demonstrated in a number of ways, Arndt says.
“For example, if you said your sector is overpriced, or if you lent staff to a project or were challenging views, that is regarded well,” he says.
So the new investment team structure hasn’t changed decision-making. But what has changed since the fund was created, according to Arndt, is “the external world”. During the financial crisis the most important decisions were beta, or asset allocation decisions. The fund had money it had to invest, having received $60 billion from the government.
“We had a lot of cash, and our conversations were debates about whether to buy this or that risk, and then have the sector heads implement and choose managers,” he says. “Looking back to then it seemed easy. The world has evolved and assets are expensive; there is more competition for assets.”
Now that the portfolio is fully invested, holding cash is a choice. The investment programs are also more complicated and more nuanced in assets such as private debt.
According to Gilmore, the increased complexity and competition for assets means it is more important to have one portfolio. “The portfolio is fully invested, so anything new needs a sale. The new structure makes that easier. For example, I’ll look at the portfolio risk level then go to Arndt to implement. The new structure just reflects the fact the jobs are more complicated.”
Gilmore says the fund is continually adapting its risk-assessment tools.
“At the beginning it was a focus on CVAR or tail losses; now we look at market exposure, liquidity, and refined metrics and factor exposures,” he says. “At the beginning it was easier, and a good environment for risk assessments. As time has gone by it is less clear, and growth is muted. The dispersion of scenarios has grown, there is more uncertainty and at the same time returns are lower.”
This environment of competition and complexity means investors are left with the choice to take more risk, or accept lower returns; the Future Fund is okay with this choice. One of its investment beliefs is that reward for risk varies through time. Being flexible allows for ideas to be implemented quickly and negative environments to have less impact on the portfolio, or to be turned into opportunistic investments.
Gilmore and his team are responsible for the macroeconomic view, and Arndt then looks at the portfolio in total and how to best implement that view. The main constraints for the fund are the volatility in the Australian dollar, some illiquid investments, and the risk tolerance.
At the moment, the Future Fund has nearly 20 per cent of its portfolio in cash. But the cash level is misleading as a mark of the portfolio risk, Gilmore says. Instead he describes the risk level as mildly below neutral.
In fact, the fund sees better value investments further up the risk curve with the cash holding being used to adjust for total portfolio risk.
Last year was a very active year for the portfolio, with a slow turnover up the risk level. The cash holding is used to adjust for total portfolio risk.
“At the higher risk end there is a better payoff and plenty of good things to buy,”
Arndt says. “We had a big year last year with more than 50 transactions, and a net sale of $14.5 billion of assets. It was a very active year,” Arndt says. “Most assets are expensive. But we think higher risk assets are more attractive on a risk adjusted basis.”
Arndt is excited about the “innovation cycle”. In particular, he talks about the energy space – fuel cells and solar – as areas of interest.
“There are lots of good ideas out there trying to disrupt the business model. We are always thinking about how we can be disrupted.”
A principle enshrined very early in the development of the investment program was the value of maintaining flexibility in order to capture opportunities presented by evolving market conditions.
How the fund continues to maintain that flexibility but have more processes, technology and staff in a more complex and integrated world is a constant conflict. For example, the fund now has more overlays and is more active in currency hedging and exposures.
“We are responding to market conditions. What we do now is more complex. Both Steve and I lead highly skilled teams, and we guide and oversee them. We talk together about the process, and implementation of ideas,” Arndt says. “The systems and approaches weren’t formed in the early stages. We are enhancing those to reflect a more complex world.
“We want to develop better processes and systems but guard against process driven investments. We don’t want to get stuck on mandate definitions or risk budgets for the team.”
Gilmore says when the portfolio is fully invested, like it is now, and new opportunities arise, they need to be compared to each other, and the quant framework needs to support qualitative decisions.
“For example, in unlisted assets we need to look at listed or unlisted proxies, and the expected outperformance,” he says.
Instead, the team will remain small and nimble enough to always be able to focus on the question of “Does it make sense to the portfolio?”
The investment team now numbers around 50 to 55 and Arndt expects it to grow in response to the more complex environment Ideas are screened early by the sector teams and strategy and risk team, and those ideas then go to the investment committee to debate. The team, under Arndt’s watchful eye, is very wary of becoming too complex, and is guarded on the point of being so complex that the portfolio is not fully understood. Keeping a sense of simplicity is guiding their decisions.
Working with managers
The Future Fund is already known for its relationships with fund managers, and it remains an area of focus for the next iteration of the way the internal team works.
“We want to enhance the way we work with managers,” Arndt says. “We use managers because we think prioritising our time for asset allocation is a better use of time than managing assets.”
The fund does not manage money directly (it can’t by law) but it is increasingly investing alongside its partners. “As the world is more competitive, capital providers need to get better and more nimble at reliably bringing capital to the best opportunities. We are now doing quite a lot of co-investments.”
For example the fund now has around a dozen private equity co-investments, as well as co-investments in the debt portfolio.
“We have done a lot of regression analysis on our hedge fund managers to see their positions and exposures, and whether it is beta or skill. We have terminated managers where we don’t think they have been adding value; others have great conviction,” Arndt says. “The best managers like being challenged on ideas.”
The fund has an internal team of around 50 but employs 100 managers that employ tens of thousands of people, and the investment team considers those employees and their ideas to be an extension of the fund.
Neal says that focusing close attention on managers has added greatly to the fund, much of which is hard to quantify.
“The edge in the mandate is not selecting managers, but getting the best out of managers, the broader intellectual property out of them,” he says.
The benefit of such close relationships shows up in other ways, such as the ability to have flexible and evolving mandates with managers the team trusts. The credit exposures and some private market exposures are examples of this.
“Most of our private markets’ portfolio is unusual and is made of ideas in response to the market. Look at things in our portfolio that are really different; they’re not mandates we’ve tried to structure, like the joint venture with Dexus on industrial property,” Neal says.
He also sees this almost free and inventive approach to investments as intellectually stimulating to his staff. “For senior people this is important; we don’t box them in.”
What Neal is now interested in developing is knowledge management systems, to help process that. “How do we measure the additional knowledge we get and where does it pop up?” he says.
Neal says 10 years ago the focus was on the investment challenge, and building the business was a simultaneous activity. There was no opportunity to grow slowly.
“We were given $60 billion to manage and get on with it, it needed to be up and running, so we were trying to do both at the same time. We woke up one day and saw the systems and support structures creaking as we’d been so focused on investments.”
The risks that the Future Fund focuses on are investment, organisational and structural. The new investment structure allows Neal to spend time and resources on the latter two.
The fund has developed a data management platform – designed to be nimble and flexible – with analytics and external integration. At times, Neal says, it is a challenge to get the investment team to tap into that. “They need to think what they want and how it is delivered, and that takes time to think about. But the investment team is focused on, and motivated by, investment opportunities.”
So Neal has now hired someone with finance programing skills to take on that responsibility. Knowledge management is another example of the new processes Neal is working on.
“We need to do it, because the investment world is getting harder and more competitive and the less competitive investments are often smaller and more complex. Whichever way you look at it, it is more labour intensive.”