Melbourne, 17 June 2015
Australian British Chamber of Commerce lunch
David Neal, Managing Director Future Fund.
Check against delivery
Long-term investing in a volatile world
Well it’s a particular pleasure to be here today to speak to the Australian British Chamber of Commerce given that I am myself Australian-British.
Or, depending on the results of the Ashes and the Rugby World Cup, perhaps British-Australian.
Today I’d like to provide you with an overview of the Future Fund and its purpose and in doing so share with you our progress in the nine or so years since it was established.
It has been a remarkable period in which to invest, encompassing:
- the stock market highs of 2006 and 2007;
- the trauma of the Global Financial Crisis;
- the enormous and unconventional responses of policy makers; and
- the rebound in markets driven by the flood of liquidity pumped into the global system.
But of course our focus now is on the future investment environment and I will talk a little later about how we see that and the challenges and opportunities it presents.
So let me start by explaining a little about the Fund and its purpose.
Investing for the benefit of future generations of Australians
The Future Fund was set up by an Act of Parliament in 2006 to help Australia prepare for the ageing of the population and to promote intergenerational equity for future Australians. More specifically, the Fund was designed to save and grow capital to help the Commonwealth meet its unfunded public sector superannuation liabilities.
These liabilities are currently met from the Commonwealth’s annual Budget. Setting aside the Future Fund to help meet these costs from 2020 will reduce the demands on the Budget which is under increasing pressure from the needs of an ageing population.
Put simply, the success of the investments we make today will reduce pressure on tax payers in the future. It is partly for this reason that we describe the Future Fund as investing for the benefit of future generations of Australians.
In addition, the organisation has also been given responsibility for investing a number of other public asset funds in the form of three Nation-building Funds and the DisabilityCare Australia Fund.
Subject to the passage of legislation, the Nation-building Funds will be replaced with the Asset Recycling Fund and the Medical Research Future Fund.
So, again, the success with which we manage the investment of these funds will flow through to support funding for infrastructure investment, services to disabled Australians and their carers, and medical research.
To be clear, our role is to invest the various funds in line with the risk and return objectives of government and to grow them as best we can. We have no role in determining the projects and initiatives that are supported or in allocating funding to specific areas. But nonetheless we are proud of our role in investing funds to the ultimate benefit of Australia and Australians in the years ahead.
An important point to take from this is that the Future Fund is not a superannuation fund. The Fund has no members and no individual has a call on its assets.
Rather it is a Sovereign Wealth Fund, created to invest assets owned by the government to achieve a financial objective. We were founding members of the International Forum of Sovereign Wealth Funds and Chaired the Forum as it was established and developed its operations.
Today the Forum, with a Secretariat based in the City of London, works to improve understanding of Sovereign Wealth Funds and provides an opportunity for the 29 members from America, Europe, Asia, Africa, and the Middle East to exchange views on a range of governance, investment and operational matters.
This is a valuable opportunity for the Future Fund to represent Australia in the global investment community and to collaborate with leading peer organisations.
This has included sharing perspectives with well-established funds from countries such as Norway, Singapore, China and New Zealand. We have also offered our experience and expertise to new and nascent funds in places such as Timor-Leste and Papua New Guinea, where the effective management of wealth from oil and gas resources is vital to the development of those countries.
So having set out the various investment vehicles we are responsible for and described our role as a Sovereign Wealth Fund, I’d like to turn more specifically to how we invest and how we view the current environment.
Future Fund characteristics
The Nation-building Funds and DisabilityCare Australia Fund are valued together at just under $11 billion and have short-term, conservative objectives to grow by 0.3% above the cash rate. We invest those funds in short and medium term debt instruments.
The Future Fund meanwhile is valued at $117 billion and is tasked with generating meaningful long-term real returns. Given the size of the Fund and the more challenging nature of the investment objective, I will focus my comments on the Future Fund portfolio.
We had the great benefit when we were set up of having a blank sheet of paper with which to start. We had no existing portfolio to work from and the opportunity to think carefully and deliberately about our task and how to approach it.
Of course there were some parameters within which to work.
- The Government’s Investment Directions set a target return of at least Australian inflation plus 4.5% to 5.5% per annum over the long-term. The Directions told us to take acceptable but not excessive risk.
- We knew that it was unlikely that funds would be drawn from the Future Fund before 2020. We also had no certainty of additional contributions from government, and indeed no contributions have been received since 2008.
- The legislation set us up to make investment decisions completely independently of Government. I should say that this independence has been scrupulously maintained by all the governments under which we have worked – there has never been any suggestion or hint from a standing government about where or how we should invest.
- The legislation also requires us to focus on maximising returns. Some sovereign wealth funds can have other objectives such as supporting particular sectors or trying to manage the currency. We have none of these objectives.
The Board considered these parameters and developed an investment model, process and strategy that remains essentially unchanged.
There are a couple of characteristics of our approach that I thought I would highlight.
The first is that we place our long-term real return objective at the forefront of everything we do. Now that might sound like a statement of the obvious, but it’s actually rather less common in institutional investment than you might think. The problem with a long-term real return objective is that, because of the inherent volatility of investment markets, measures over short to medium term periods don’t tell you very much about how well you are going. The usual response of the industry to this is to interpose a benchmark of some sort – a notional portfolio of asset classes that would be expected to achieve the long-term objective using long-term return assumptions. Now the investor has something it can compare its return to, and monitoring is straight forward. The weakness is that the danger is the entire focus of the investment team is now on beating this benchmark. Under this model, very little energy ends up being spent on whether the benchmark or the portfolio continues to be well positioned to achieve the objective given an ever-changing investment landscape.
We have sought to avoid this, and every decision we make is assessed against whether it improves our chance of achieving the long-term real return objective or not. This places much greater demands on the investment process, but also on the monitoring of our progress and on the overall governance of the Fund. We are fortunate however to have a very strong Board that puts considerable effort into understanding the economic and market context, and the characteristics of the portfolio we are building. They monitor and govern by assessing and understanding, having the confidence not to micro-measure using short term numbers.
This strong, capable governance in turn supports another feature, which is that our portfolio is managed dynamically to respond to the changing landscape and set of opportunities. The Board’s detailed understanding gives us, the management team, the confidence to construct quite a different portfolio comprised of the best opportunities we can find, irrespective of asset class or geography. We seek to integrate the bottom up opportunities we find with our top-down view of the state of the investment world. If we believe risk is being well rewarded, we will increase our risk exposure and target higher returns. Conversely, if risk is not being well rewarded, we will tend to reduce risk and wait for better times.
A final characteristic I wanted to touch on is that we leverage off external partnerships for the execution of our investment ideas. It is quite in vogue these days to internalise the management of assets, building teams to select Australian and global stocks and to source, underwrite and execute direct investments in private markets. This is an understandable trend. The margins extracted by the investment management industry are, in general, too high, and the alignment with the clients is, in general, too low. If investment managers don’t address these twin issues, they will find that they are increasingly replaced by their clients. This is a long-term and powerful trend.
For our part however, we focus on leveraging strong partnerships with managers under arrangements that are as cost effective and well aligned as possible. For us, given our approach, there are considerable hidden costs to building large internal management teams. Most importantly, we worry that a substantial expansion of the team by adding a large number of specialists will have a profound impact on our culture and decision-making. We place a very high value on our ability to join-up our team, ensuring that the senior decision-makers across all asset classes understand the range of available opportunities in other asset classes so we can have a strong debate about the best portfolio to build. This “one team, one portfolio” approach relies on a strong culture and gets progressively harder to achieve successfully as the organisation grows. We believe our focus on building the best total portfolio trumps any potential cost-saving from internal management.
These characteristics have shaped quite a distinctive investment portfolio.
Today it comprises around:
- 8% Australian listed equities
- 30% in offshore listed equities, with around two thirds in developed markets and a third in emerging markets
- 10% in private equity
- 13% roughly equally split across property and infrastructure
- 10% in our debt portfolio
- 14% in alternatives such as hedge funds, and
- 15% held in cash.
Around 70% of the portfolio is invested offshore. This reflects where we have found the best opportunities but I should note that with a mandate tied to Australian inflation, we are strongly attracted to Australian investments all others being equal. Incidentally, we have $9bn invested into Britain, across equities, infrastructure, property and a $1.7bn portfolio of loans.
Our asset allocation is somewhat different to that of many other investors, including many superannuation funds. We generally have a lower allocation to listed equities and a larger allocation to other sectors in an effort to enhance the portfolio’s diversification. In particular, at around $16 billion our alternatives program, largely hedge funds, is, I believe, the largest such program in Australia.
But even within these broad investment categories there are often a number of important differences.
In property and infrastructure for example, many investors favour well established, core assets. Increasingly investors are seeing the reliable income streams such assets throw off as being a higher yielding replacement for bonds, given the very low bond yields at the moment. As a result, these assets are now changing hands at relatively high prices, and relatively low prospective returns.
The Future Fund has some exposure to core assets like these, but to quite a large extent we have been seeking out ‘non-core’ assets with stronger return profiles. In property for example, a number of years ago we invested in a vacant office building in New York that needed work to refurbish and reposition the building so that it could then be leased.
Our flexibility, together with the fact that we had no need to generate immediate income and the fact that the building was less attractive to those interested in ‘core’ property, meant we could buy it at a discount to intrinsic value, have the refurbishment and letting work done, with a view to selling it as a core property at the higher prices such properties can demand.
Given this is the Australian British Chamber of Commerce let me offer another example, this time from the UK.
The Future Fund has a stake of a little less than 20% in Gatwick Airport in West Sussex. Gatwick, as some of you may know, is the UK’s second largest airport. Its first commercial terminal was developed in 1935. There was major development work in the 1950s and some might say that since then it had been left to languish.
We bought into Gatwick in 2010 through an investment manager with an ambitious program to refresh the airport and its terminals, better meet the needs of airlines and travellers, and grow capacity. This has involved detailed, hands on, operational work by the management team at Gatwick with input and funding from Gatwick’s investors.
Work has focused on process improvements as well as improvements to the buildings and facilities and faster turnaround times for the airlines.
I’m not sure how many of you have flown through Gatwick recently? For my part, it has created an ongoing sense of frustration for me. The frustration is that whenever I’m somewhere else in the world, the stop/start inefficient operation of the security screening now drives me mad. That’s because I’ve seen it done so much better! Gatwick has re-engineered the process, and it works! Next time you fly to London, check it out!
As well as improving customer satisfaction and operational scores, Gatwick has seen increasing passenger flows with 3.2 million passengers passing through in April, the busiest April ever and the 26th consecutive month of passenger growth. To help manage this increasing traffic, earlier this year plans were confirmed to transform Gatwick train station and increase the frequency of train services.
Now this demands not only capital, but it is also labour intensive work and that means our investment fees and costs will be higher. This raises a more general issue for us. In part because of our approach of leveraging off the best external managers, and in part because of our focus on generating value through the sorts of activities I’ve highlighted at Gatwick or our New York office building, our fee level is a fair bit higher than others. But if we were driven by fees, we’d be forced to join the scramble for expensive core assets that require less management, and are therefore cheaper, but also offer lower risk adjusted returns. For our part, we remain focused on the net returns. Our 11.6% pa for the 5 years to the end of March, our 8.2%pa since inception, and the $56bn of value we have added to the initial contributions, are all net of costs.
Outlook and challenges
So having given you a sense of the Fund’s purpose, approach to investing and some of the characteristics of the portfolio, let me close by offering some thoughts on the investment outlook and our positioning.
Since 2008 we have seen unprecedented action by central banks and governments to defend economic growth through quantitative easing and other policies which have had the effect of driving yields down and asset prices up.
For investors this has boosted returns over recent years, but has done so essentially by bringing forward returns from the future. Our portfolio has generated a 52% cumulative return in less than 3 years since June 2012. These levels of return are not sustainable indefinitely.
The look forward returns across the board are now much lower than they were, and much lower than normal. You only have to look at long bond yields of 2 to 3% in the US, UK and Australia to see that. I saw some data from JP Morgan this week that calculated that as at 1 June there was over 1½ trillion US dollars of bonds trading on a negative yield.
This creates a tough dilemma for all investors. Given these low returns, achieving long-term return objectives from here is going to be very difficult. Indeed I suspect that many funds may currently have portfolios that they do not believe will meet their long-term return needs. Funds could respond to this by moving out along the risk curve, taking more and more risk to stretch for higher returns. Indeed this is exactly what central banks want us to do. They believe this will help kick start animal spirits and increase economic activity. The issue for the investor of course is that if you think these long-term returns are not normal, then once the central bank music stops, you might expect that markets will reprice to restore more normal levels of return. This repricing would be painful, and especially so if you have a moved out along the risk curve.
The Federal Reserve is widely expected to begin raising rates in September this year. The Bank of England is expected to start mid next year. The question for investors then is whether the party is winding down. For those that believe it is, and that there may be a hangover afterwards, an alternative approach is to move down the risk curve, building a more defensive portfolio. Once any repricing occurs, these investors would then move back into riskier assets at higher levels of prospective return. The problem with this approach is that there is some chance this environment will persist for many years yet. These are challenging times for all investors.
For our part, we have begun taking modest amounts of risk out of the portfolio, although at this stage we are still well within what we would consider to be normal levels of risk. We are more inclined to reduce risk than to chase return, but we have to recognise the determination of global policymakers.
So in closing, as we look at the world, and the myriad pressures, uncertainties and evolving economic policy settings, we take our responsibilities of investing Australia’s sovereign wealth fund extremely seriously. We have developed a distinctive approach, which means we tend to build a portfolio that looks rather different to others.
We try to position that portfolio to be as robust as possible to the range of scenarios that may play out while being capable of achieving our risk and return objectives over the long term.
Given the somewhat unusual market conditions, we are focused on keeping our discipline to only take risk where we see adequate reward, and we are redoubling our efforts to work alongside our partners to identify those niches that we believe offer the best risk-adjusted returns.
Thank you for your time and I’d be delighted to take questions.