Speech by David Neal, Managing Director, Future Fund, to the Australian British Chamber of Commerce, Sydney.
Check against delivery.
When I first thought about the title of today’s session - “long-term investing in a volatile world” – it occurred to me that:
a) the Future Fund has always been a long-term investor; and
b) since the Future Fund was created the investment world has always been volatile.
So that might suggest that what I say today ought not to differ from what Future Fund representatives said last year, three years ago, five years ago and seven or eight years ago.
But in fact,
- the investment environment is constantly changing;
- the organisational issues faced by investors are changing; and
- how investors respond is changing.
So I will take some time today to offer you a perspective on how we see things today and in the future.
I will also talk about the importance of culture and how we are developing that at the Future Fund and offer some thoughts on how our approach might be relevant to the broader investment and financial services community.
Future Fund purpose
The Future Fund is Australia’s sovereign wealth fund. We invest around $133bn through five different public asset funds on behalf of the Commonwealth.
The largest portfolio, at a little over $117bn, is the Future Fund itself and my comments today will be primarily about this portfolio.
Sovereign wealth funds come in many different forms.
Some are designed as stabilisation funds reducing the impact of external shocks on a country’s economy and its budget. This can be important for countries with a high level exposure to commodity price volatility.
Other funds focus on turning a depleting asset, such as oil, into perpetual financial assets. The Norwegian sovereign wealth fund and a number of Middle Eastern funds fall into this group, turning oil assets into financial assets.
Sovereign development funds seek to provide support for development objectives by holding and allocating resources to priority areas for national development.
The Future Fund falls into a fourth category. The Future Fund is an intergenerational fund. It is designed to save money today to meet the costs of tomorrow.
In the Future Fund’s case, it was set up to help ease the pressure of an ageing population on Commonwealth finances by helping to meet the Commonwealth’s unfunded superannuation liabilities.
Now that might sound a little dry.
But when you think about it – and certainly for us who work at the Future Fund - it is far from dry.
Back in 2006 we were set up and entrusted with a very large amount of money - around $60.5bn.
We were asked to invest this to maximise returns with an acceptable level of risk.
So far, so dry.
But think about it in these terms:
- Growing the Future Fund helps ease the pressure on the budget and ultimately on taxpayers.
- Growing the Nation-building Funds helps provide funding for investment in infrastructure
- Growing the DisabilityCare Australia Fund helps finance support for Australians with a disability and their carers.
- Growing the Medical Research Future Fund helps fund world-leading Australian initiatives in the fields of medical research and innovation.
Every dollar that we make is a dollar that adds to Australia’s wealth and contributes to its future.
That is why we talk about our task as investing for the benefit of future generations of Australians.
This gives a real sense of purpose to what we do.
It is about a long-term benefit to Australians.
It inspires our people to do the very best job they can.
This purpose also exerts a great deal of pressure on us to be prudent in investing these assets.
While every dollar we make benefits Australia, every dollar we lose is a dollar taken away.
It is a dollar that is either not available or has to be found from somewhere else in the Commonwealth budget.
This has had a very real impact on how we build and manage the portfolio. It means that not only do we seek to generate strong long-term returns, but that we try to protect the portfolio when markets turn sour.
We talk about this in terms of dynamically managing the portfolio. When we see the potential for good risk-adjusted returns we are prepared to increase our risk levels.
When we believe that the risks we are being invited to take in the markets are not likely to be rewarded sufficiently, we reduce the overall risk level.
That is one of the reasons why our portfolio currently has a relatively high allocation to cash – we see risk being insufficiently rewarded. Our emphasis on avoiding excessive risk leads us to protect the portfolio by reducing our risk exposures.
With that context, let me dive a little deeper into how we see the investment environment.
Following the Global Financial Crisis of 2008, central banks did what they needed to do and applied policy measures first to stabilise the situation and then to stimulate growth. As growth remained subdued and as further shocks hit economies these measures became increasingly unconventional.
Central banks started by lowering interest rates.
They progressed to zero-interest rate policy, then quantitative easing, credit easing, forward guidance and now negative interest rates.
The flood of liquidity drove investors back towards investing in risk assets. Investment markets picked up and investment returns surged.
So the fundamental building block of long-term investment returns, government bond yields, are at historic lows.
The last estimate I saw suggested that over USD$6 trillion of bonds globally are trading at negative yields.
Just pause and think on that for a second on that. USD$6 trillion of money that investors are lending to someone and being prepared to pay for the privilege of doing so.
One market adage is that when times get tough investors are more concerned about the return of their money than the return on it. For this USD$6trillion, investors are taking it a step further, to being more prepared to simply accept the return of most of their money.
And ultra low yields isn’t a short term phenomenon. Last month the Irish Government sold a 100 year bond at a yield of 2.35%. Just imagine all the things that can happen over 100 years. And this isn’t even a government that is able to print its own currency.
Even more incredible is that this is a country that just a few years ago was financially on its knees and locked out of debt markets! And now it can borrow for 100 years at 2.35%.
To an extent, the aggressive monetary policy measures have worked, in that they have staved off the crisis and stimulated economic growth, albeit that the growth the globe has had has been generally patchy and fragile.
On the fiscal side, generally high debt levels and political pressures have meant that governments have, for the most part, been unable to provide much support. Politics in many countries has also generally hindered meaningful reforms that might help support sustainable recovery and growth.
Not only that but we also have a world that is risky.
We see geopolitical risk in the Middle East that threatens instability in an important region.
China is transitioning from an investment-led economy towards one focused more on consumption. It has a plan for opening up and reforming its economy, but the potential for missteps are high.To be clear, China’s policy makers are skilled and focused, but we can expect there to be bumps and twists and turns as they move along their path.
In Europe, there is tension between the economic and political strands of the European Union, including the enduring economic imbalances between northern and southern Europe and the economic, political and social pressures - and the human tragedy - of the refugee crisis.
In addition, Brexit is one thing, but whether the decision is to Stay or to Go, it serves to highlight the potential for other countries in the Union to reconsider the nature of their membership and commitment to it.
Similarly growth in the US remains modest. Geopolitical shocks, natural disasters and policy miscalculation can jeopardise recovery.
In many ways this is not new. The risk of these kinds of shocks is always present.
What is different today is that the policy environment seems ill-equipped to cope with a shock. I noted earlier that debt and politics are constraining fiscal policy. On the monetary side, central banks have fired many of their policy bullets – both conventional and unconventional – and with less ammunition they have less scope to respond to new shocks.
So we see a low growth environment, with low prospective returns, elevated risks and fiscal and monetary policy with limited capacity to respond should things go wrong.
For investors this presents a challenging environment.
And in this environment we believe it is prudent to take less risk than we might under more normal circumstances.
This is a direct consequence of how we think about our purpose, as I mentioned earlier. As well as being focused on generating strong returns we are very conscious of the risk of losing money for the taxpayer.
As a long-term investor we see it as prudent to take risk off the table and wait until we see a better balance between risk and reward.
This dynamic management approach is a hallmark of the Future Fund.
To be clear, this is not about trading the portfolio on a daily basis and trying to ‘pick the bottom’. Instead it is about making sure that we protect capital from long-term swings. It is about preserving our capital and ability to take advantage of periods when returns are expected to be better.
So how are we currently positioned?
Well the Future Fund has returned 11.3% pa over the last three years and 9.5% pa over the last five. Last financial year the Fund grew by 15.4% adding $15.6bn to the portfolio.
By contrast in the financial year to the end of March, the Australian listed equity market had fallen over 3%, as had the global developed market index. Emerging markets had fared even worse, falling over 12%. Our own portfolio is flat for that period. This is a clear illustration of the lower return environment that we have been highlighting for some time.
We have brought down the level of risk in the portfolio during 2015 and 2016. We now have just over 20% in cash, and our listed equity holdings have fallen below 30% from just under 40% a year earlier.
To be clear though our approach is not to leave markets and hide under the blankets.
There are still areas of opportunity and there are different scenarios that can yet play out in terms of when risk levels may normalise and prospective returns improve. But our current stance is undoubtedly cautious. We are prudently managing the nation’s wealth in an uncertain and challenging environment.
Change in the institutional investment industry
Let me change direction at this stage and make a few broader comments about the institutional investment industry.
Institutional investors – sovereign wealth funds like the Future Fund, superannuation funds and insurance companies – rely on a series of relationships that form an investing value chain.
The chain runs from investee companies, through their management and Boards up to fund managers with their own layers of management, up through to institutional investors – again with their asset class teams, management teams and Boards or trustees.
At the top of the chain is the ultimate beneficiary – the superannuation fund member, or in our case the Government on behalf of taxpayers.
The way these Principal-Agent relationships all down the chain are managed is critical to the outcomes for that ultimate beneficiary. In almost every case along this chain, the objective of the Principal is distorted in setting the incentive structure of the Agent.
The Board of a superannuation fund, on behalf of its members, might be interested in generating a real return over 5-10 years.
In delegating responsibilities to their Agent, the fund’s management team, they will typically incentivise them to beat a strategic asset allocation, or perhaps the peer median, over 3 years.
In turn the management team will hire an investment manager and monitor their performance monthly, and likely sack them if they underperform an index for 2 years in a row – setting a clear incentive structure.
In response to this, the manager will make it very clear to the CEO of their investee companies that they can’t tolerate volatile share prices, and the CEO will respond by managing the next quarter’s earnings. The value creating project that might have impaired short-term earnings gets shelved.
So how can we better manage these Principal Agent relationships?
A key challenge in the investment industry is that we have data and measurement everywhere, but there is very much more noise than signal in these measurements. This is exacerbated by the natural human preference to place greater weight on immediately available information. Investors can track performance to the minute. Markets punish companies that don’t meet expectations in a quarter.
This means that delegations from a Principal to an Agent that rely on this data create incentives for the Agent to manage their own career risks, with little room left over to put the client first.
Relative risk is being managed, and all notion of managing what really matters, absolute risk to generate strong long-term returns, has dissipated.
One response to this is to design smart incentive systems that aim to better align each Agent.
But it is hard to build incentive systems that link rewards to the 10 year plus horizons of most relevance to institutions.
Another approach taken by some institutional investors is to cut out the middle man and build their own in-house teams to do the investing. But in-house investment teams are also Agents and can be drawn to short-term benchmarks and consensus.
While both approaches have some merit a more fundamental approach, one that we take at the Future Fund, is to work harder on the way the Principal Agent relationship is managed, by changing the traditional model of delegation, monitoring and control.
We start by engaging closely and regularly with our partners to provide them with a rich understanding of what we are trying to achieve and why. We then place great emphasis on a more qualitative, subjective approach to assessing the relationship, seeking to understand what the manager is doing and why. This helps us check alignment with our goals, and provides a much deeper appreciation of the quality of what’s being done than any metric will do on its own.
Essentially our monitoring process places greater weight on understanding and subjective judgement than objective, clear, but ultimately ill-fitting and misaligning measurement.
This is how we manage our manager relationships, but it’s also how we manage ourselves.
Our Board gets deeply involved in understanding our investment thinking, understanding not just what we are building but why we are building it that way. This much closer engagement means the Board does not need to rely on a strategic asset allocation benchmark to measure us against, and we can all focus on the long-term real return target that ultimately matters.
Within the management team we operate in a similar way. We prioritise debate and discussion across our asset class teams. Our people’s performance is rewarded on the basis of the whole portfolio, not the particular asset class on which they work.
This is a cultural shift away from behaviour being framed by narrow incentive structures and benchmarks to broader concern for the whole fund - a concern for doing the right thing in the context of the objectives of the Fund and the needs and expectations of the ultimate beneficiary.
In fact this question of culture lies at the centre or our organisation.
Across the financial services landscape, culture, quite rightly, has had an enormous focus in recent months.
The focus has often been on ‘conduct risk’ – the risk that individuals or teams do the wrong thing and damage the interests of customers and clients not to mention the reputation and performance of their company.
Conduct risk is critically important. It certainly forms a key part of the Future Fund’s risk management framework.
But I also like to think about culture as having the capacity to create additional value, not only about managing the downside.
For the Future Fund a strong client-centric culture enables us to stay more sharply focused on pursuing our purpose. It helps us have the kinds of conversations within our organisation that allow us to move away from benchmarks and deliberately decide not to chase returns by increasing risk.
Culture allows us to inquire, to challenge and test ideas, which in turn allows us to innovate.
This is the kind of culture that we seek to develop in our own organisation, but it is also the kind of culture that we hope to find in our partners.
Now this is hard work, particularly in an industry used to hard data and generally populated by people who are strong on logic and quantitative skills.
We have had the advantage of building our organisation from the ground up. This has helped us recruit people who engage in and add to our culture. It has allowed us to design our systems, processes and governance arrangements to support that culture.
But even with these benefits maintaining our culture requires constant effort. Without that effort it is all too easy for behaviours and values to soften and to shrink back to something less powerful. And so this remains a major focus for us.
So to draw this together, I have talked about the investment environment, the limited firepower available to central bankers to deal with further shocks to the system and the generally low return environment that we see ahead.
I have talked about the potential for economic and political shocks globally that have increased the level of risk to which investors are exposed.
I have talked about how we dynamically manage the portfolio and work with investment managers to secure better alignment in the investment value chain.
But my key point, something that is critically important to the Future Fund, is that culture underpins how well we deal with this environment, how well we manage risk and how well we deliver strong investment returns for future generations of Australians.
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