The investment team at Australia’s $154 billion Future Fund is more optimistic about the outlook for markets now that some geopolitical risks have settled and returns for the first quarter of 2019 have been boosted by three months of strong equity markets.

The sovereign wealth fund has delivered a 5 per cent return for the March quarter, according to a portfolio update released on April 29, 2019.

The solid quarterly result contributes to the fund posting a return of 10.4 per cent annualised over 10 years, tracking well ahead of its benchmark target return of 6.5 per cent. A much more meaningful number for a long term investor such as Australia’s sovereign wealth fund, which doesn’t have to pay out any money for a decade after Canberra last year extended the fund’s accumulation phase timeline.

Future Fund chair Peter Costello puts the solid quarterly result down to the US Federal Reserve’s decision to hold interest rates steady and easing US-China tensions. US-China trade talks have since stalled.

Not surprisingly, the Fed’s decision in March to keep interest rates on hold following a market rout sparked a dramatic rise in share prices.

While a good first quarter suggests some reason for optimism, Costello warns that longer term, the global economy will face structural challenges, including demographic shifts and high levels of debt.

“Long-term real yields remain very low, indeed negative in a number of major economies, which implies that long-term prospective returns will be lower relative to history,” he says.

Still, at a senate estimates committee hearing in Parliament a couple of weeks back, chief executive David Neal indicates that the environment, at the moment, has starting to look a little stronger.

“The actions of the Federal Reserve and other sorts of risks in the market have tempered a little, and, if anything, we’re a little more positive on the markets,” he tells the committee. Significantly, for the first time in some time, the fund has been slightly increasing its level of risk. “We are about neutrally risked, if you like.”

Clearly, the changes articulated by the US Fed on interest rate and balance sheet policy are significant to the fund’s deputy CIOs – Wendy Norris and David George – who are tasked with making investment decisions.

“While the long term implications are difficult to assess, in the short to medium term the Fed guidance, when combined with Chinese growth more generally, have lowered some of the near-term risks to the global growth environment,” says George. “The recent rally in bond yields would be consistent in direction with the changed guidance from the Fed, although the extent to which the market is pricing low inflation for the long term continues to surprise many in the market,” he adds.

Taking on more risk

As a consequence, the deputy CIOs confirm the fund has taken on a “little bit of increased risk” but argue it is “at the margin”. This is revealed in the fund’s portfolio update which shows that the fund’s exposure to listed equities, which stands at 33 per cent at the end of March, increased by $7.5 billion for the quarter as global equity markets took off.

Importantly, the fund’s allocation to illiquid assets such as infrastructure, property, private equity and alternatives has dropped to 44.6 per cent, from 46.1 per cent, although asset values rose by $1.2 billion to $68.9 billion.

The public/private mix and the total portfolio approach is key to how the fund constructs portfolios. And right now, the fund is looking to lower its holdings in illiquid investments to build flexibility in the portfolio, Neal tells the committee.

“That gives us some optionality to change strategy in the future. It’s at the margin of the portfolio, but I think it’s an important move.”

This view jibes with research from the International Forum of Sovereign Wealth Funds, which reckons opportunities in private assets are diminishing as valuations are high, competition intense and sovereign wealth funds have reached their target allocations.

Yet while the Fed’s response to market swings at the end of last year may extend the current cycle in the near to medium term, Norris says there is no change in the Fund’s long-term view of the attractiveness of private markets.

“We don’t make big wholesale changes in what we’re doing in private markets as we get closer to the end of the cycle, but we focus more and more as we see the risks build in the environment,” she explains.

“The temperature is slightly going up in the markets as we get closer to boiling point.”

Running the portfolio’s private market assets takes enormous discipline – about what you can sell, what you should sell and what to buy, adds Norris.

“You want to think through the cycle and harvest returns when you can but it’s a slow moving ship. “We can’t really pull on the hand brake and dive in quickly when the market turns, so there’s an element of making sure we’re comfortable with the overall risk/return of market cycles.”

Adding alpha

Despite the stronger performance of public markets, George says there are important warning signs ahead.

For instance, a dwindling number of stock markets are doing well and within each market “fewer and fewer” companies are driving performance.

“We spend a lot of time right now thinking about how the public markets are changing,” he says. In some cases the market cap of equity indices are shrinking as more assets become private, some companies become bigger and there is less number of overall companies.”

It’s against this backdrop that he is grappling with the “active manager versus passive index” debate.

Is this a time for active management?

“That’s a very tough question to answer,” he says. “I think there are more opportunities for active management but it depends upon where you look for them.”

The deputy CIO still believes active management strategies can add alpha to the fund’s portfolio. However, with stocks at least at fair value many will view them as expensive which he argues is one more reason to expect further volatility.

“I think in equities markets it’s getting perhaps tougher and some of that I think is exacerbated by more data availability and more technology to work with that data. It’s changing how much mis-valuation is out there for active managers to find,” he explains.

In public markets, this means George is paying very close attention to how the skill set to deliver active management value add is evolving.

This applies particularly in equities but also to other asset classes.

“Markets will always tend toward more efficiency. So, if the driver of that is more data availability and better technology, then what characteristics are calling out those investment partners harnessing new data sources and technologies best?

“We are seeing some trends that would say that this wave of data availability may actually be rewarding those with more scale, versus less, in harnessing it.

To him, this will likely result in fewer successful managers which have comparatively more success. “These kinds of things are influencing how we evaluate our managers.”

Team revamp

More than 12 months have passed since the fund overhauled its investment team and already there are tangible signs that the sovereign wealth fund’s move to restructure, to tackle its ever-increasing size, is paying off.

Both Norris and George are convinced the restructure has started to yield results thanks to strengthening the team’s collaborative approach to investing.

It was last March when Norris took up the new role of deputy CIO for private markets, and former head of debt and alternatives George became deputy CIO for public markets.

The sovereign wealth fund revamped its investment team in a bid to turbocharge its “joined up” investment process which brings together top-down macro views and bottom-up sector opportunities to construct the overall portfolio.

Together with Raphael Arndt as CIO, Norris and George lead the bottom-up investment strategy, looking across the world for great assets. Since the dual deputy CIO structure was instigated, the fund has bumped the number of deputy CIOs up to three.

Former New Zealand Super operative, Sue Brake will lead the top-down elements looking at the global economy, financial markets and political risk, how this will impact the portfolio, and the level of risk the fund can accept.

Hiring a third deputy CIO underlines the fund’s move to drive more collaboration between the investment teams in line with its one team, one purpose philosophy.

The new appointment further underlines how even the nation’s biggest fund is trying to figure out the best way forward in a much more complex operating environment.

A better rhythm

One year into the new structure, both George and Norris have had time to find an operating rhythm. What’s changed for both of them is the increased focus on the strength of the team.

“We are starting to build a greater sense of collaboration rather than each of us contributing the best thing we can individually – the restructure is making those connections a bit more tangible,” Norris says.

“We are also trying to help the sector heads feel they have some cross accountability for actually delivering the overall portfolio outcome and that’s I think what has really changed.”

While it is far too early to tie the fund’s result to the restructure of the investment team specifically to the fund’s latest result, Norris reckons she can link the fund’s more collaborative approach directly to returns.

She cites an instance where the private markets portfolio had an opportunity to buy listed property shares and it was the instant communication with the public markets team that made that happen.

“If we were thinking in terms of just private markets, we wouldn’t have known how to react quickly enough to seize the opportunity,” she says.

“So, David and I were able to quickly pull together the right people from the public and the private market side to make a quick decision that wouldn’t have happened if it hadn’t have been for the restructure.” George is convinced when teams grow they naturally become more insular and siloed.

“We try and avoid that as much as possible but it is a natural dynamic. We need to try and get ahead of that dynamic and make sure we build a place where we get the total portfolio conversation, and the cross-sector conversation, really working.”

The higher level of communication is critical with a total portfolio approach which does not operate with a fixed strategic asset allocation and avoids silos across asset classes.

This whole of portfolio approach also empowers people to make decisions. While the approach is better, George says, it is not always easier.

As he points out, just because the fund itself is a lower risk fund at a total portfolio level, the portfolios themselves are not necessarily constructed with just low risk assets. In his view, it can be very hard to appreciate the whole portfolio strategy if, for example, people want to create good returns when markets are volatile.

For instance, he argues, across public markets some of these contributors to the 2018 annual result were diversifying strategies that were not necessarily expected to create high returns all the time.

“I think it’s a hard thing to learn because if you are a really specialised person in property say, it’s difficult to look across the portfolio and appreciate that listed equity markets are seen as more attractive and have a slightly higher utility to the portfolio.

Does this create tension?

As he sees it, they wouldn’t be doing their jobs properly if there wasn’t some tension. But as he points out, the one team, one portfolio approach has been Neal’s objective from the start. He has developed and pushed the culture and people know that when they join.

“The new structure is creating a forum where we get the balance right between giving people the opportunity to have a voice and be challenged in a way that fosters good decision making. I think that is one of the biggest cultural challenges we have to address in each committee meeting and we are all on a journey to do that.”

Elizabeth Fry has been a financial journalist for more than 25 years and has written for a number of publications, including CFO, The Financial Times and The Australian Financial Review.
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