Future Fund: Benign conditions mask structural risks
Despite near term plans to maintain a neutral exposure to markets that are fully priced, the $150 billion Future Fund says that underlying structural risks to the global economy make valuations less compelling over the long term.
The sovereign wealth fund’s short-term view is that the investment environment is relatively benign but those conditions are masking a number of structural risks that could result in something like a financial crisis, said Nigel Wilkin-Smith, director, portfolio strategy at the Fund.
“The benign environment – reset by the US Federal Reserve to potentially lengthen this current cycle – actually creates more risk over a secular horizon,” he added. “Consequently, we have to be careful about how we manage our risk profile.”
These comments were made at the Fiduciary Investors Symposium where panellists discussed the challenges of managing risk in fragile times, diversification strategies and investing in illiquid alternatives.
Speaking of the growing risk of complexity, Wilkin-Smith said managing risk is tougher now as the Fund aims to generate a real return of 4 or 5 per cent which might require it to take a significant amount of risk, even though the Fund’s mandate demands acceptable, but not excessive, risk.
Also, he added, the Fund invests in taxpayer dollars and it is critical that taxpayers are not exposed to undue drawdown risk.
Allison Hill, director of investments at QIC, reinforces diversifying the portfolio as the best approach in a fragile environment, incorporating as many defensive elements as she can.
“We are still holding bonds despite their low yields. Moreover, we still maintain an exposure to foreign exchange in some countries to hopefully protect us in the event of a crisis,” she said.
To the investment specialist, the best defensive play is broad diversification going across all asset classes to smooth returns as much as possible.
“Our approach is to diversify sources of return and get equal risk from both bonds and equities,” she said.
The discussion turned to the robustness of illiquid alternative strategies given the current policy settings.
In terms of funding illiquid, or otherwise complex investments, Wilkin-Smith said he thinks about the required excess returns above appropriately chosen liquid proxies.
Importantly, he said, an analysis of the cost of capital is to some extent a function of the current portfolio’s structure.
“The more complex your portfolio structure, the higher the excess returns you should demand from illiquid or complex investments. Otherwise, they can be a cost to the portfolio in the limit,” he argued.
The portfolio strategist urged investors to be circumspect about the diversification benefits provided by absolute return strategies like hedge funds.
Over the last ten years, he added, these strategies probably haven’t delivered the outcomes expected by many investors.
“The past success of hedge fund strategies, whether discretionary or systematic, has, to some extent, hinged on the secular compression of interest rates, and broad hedge fund returns since the financial crisis have demonstrated that many of these strategies will struggle in an environment of low but stable interest rates.”
John-Pierre Couture, chief economist and portfolio manger of emerging markets at Hexavest, highlighted the refinancing tsunami that will hit the capital markets when companies rollover US$4 trillion of bonds within three years. This is roughly two-thirds of their outstanding debt.
“This is huge,” Couture said, adding that indications are that the economy will slow down at the same time the rollovers escalate.
The economist said deteriorating credit quality will lead to fallen angels and more corporate credit rating downgrades.
“The problem is half of the investment grade companies are rated triple-B just above high yield status.”
The share of bonds rated triple-B stood at nearly 54 per cent, the highest in records going back to 1980, according to OECD analysis
On the other hand, central banks are well aware of this situation and will do whatever it takes to makes sure those assets are refinanced,” Couture argued.
“To that end, I think the central banks will keep the flat yield curve as long as possible.”