Speech by David Neal, Managing Director, Future Fund, to the Stockbrokers of Association of Australia Annual Conference, Melbourne.
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I’m delighted to join you today.
I am conscious that I may well come at things from quite a different perspective than many in this room.
My organisation works for a single client, the Australian Government, rather than meeting the needs of multiple clients but I hope that my comments on how we operate and think about the world will illuminate some of the issues you face.
Today I will take a few minutes to provide some context about the Future Fund. I’ll then talk about how we see the investment environment. I will also make some comments about culture and how important that is to us in managing this environment and pursuing our objective as a long-term investor.
Future Fund purpose
TheFuture 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 perhaps from commodity price volatility.
Other funds focus on turning a depleting asset, such as oil, into perpetual financial assets.
Sovereign development funds hold and allocate resources to priority areas for national development. The Future Fund doesn’t do these things. It falls into a fourth category. The Future Fund is an intergenerational fund. It is simply designed to save and invest surplus money from one period in time to help meet higher expected costs in another.
In particular 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.
Importantly, there are no individual members of the Future Fund. No individual makes contributions to the Future Fund and no individual has a claim on its assets. The only entity with a claim on the assets is the commonwealth government on behalf of all taxpayers. In that sense, we all own the Future Fund.
From 2020 the assets we manage can be used by the Australian Government to meet its superannuation liabilities. These are currently met from general revenue, so using the Future Fund to offset these liabilities will ease pressure on the Commonwealth’s budget and ultimately on taxpayers. In providing a mandate to the Board, the government has stated that it will benchmark it against long term real returns of 4.5-5.5%pa.
We also manage two Nation-building Funds, the DisabilityCare Australia Fund and the Medical Research Future Fund.
In their various ways these funds
- provide funding for investment in infrastructure;
- support Australians with a disability and their carers; and
- fund world-leading Australian initiatives in the fields of medical research and innovation.
So through these portfolios 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.
And it inspires our people to do the very best job they can.
But this purpose also exerts a great deal of pressure on us to be prudent in investing these assets. Every dollar contributed to the Fund came from the Australian taxpayer, and I’m sure they could think of some things they would very much like to do with that dollar.
And 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. It is a dollar that has to come from the earnings of hard-working Australians.
This perspective 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.
With that context, let me talk some more about the investment environment.
Since the Global Financial Crisis of 2008, central banks have applied policy measures first to stabilise the situation and then to stimulate growth.
Despite their efforts, growth has remained subdued and as further shocks hit economies these measures have become increasingly unconventional.
Central banks started by lowering interest rates and 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. In recent months 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. They have staved off the crisis and stimulated economic growth, albeit that the growth the globe has had has been generally patchy and fragile. Global growth remains subdued, as are global trade volumes.
But the world is a risky place.
We see geopolitical risk in the Middle East that threatens instability in an important region.
China is embarking on a crucial transition from an investment and export driven economy towards one focused more on domestic consumption and services. This transition necessarily involves accepting a lower rate of growth, albeit that this growth will be of higher quality and more sustainable.
Whilst we believe China’s policy makers understand the challenges, have a plan to address them, and are skilled and focused, this is an immensely complex and unprecedented task. The potential for missteps is high and as a minimum we can expect there to be bumps and twists as they move along their reform path. Not least of the challenges is to manage the rapid credit growth that has taken hold over the last few years.
In Europe, there is tension between the economic and political strands of the European Union and the enduring economic imbalances between northern and southern Europe.
Whether the UK decides to Stay or to Leave the Union, it serves to highlight the potential for other countries to reconsider the nature of their membership and commitment to it. This comes at a time when Europe, and indeed many parts of the world, is facing an uprising of fringe political parties as rising inequality translates into angry and dissatisfied voters.
The US has made more progress along the path of economic recovery than most, and has at least managed to get to the point where it has made a first, very tentative step to increase rates from zero. But this beginning of a so-called normalisation feels extremely fragile, and geopolitical shocks, natural disasters or policy miscalculation could send it in reverse.
In many ways this is not new. The risk of these kinds of shocks is always present.
What is different today is that the global policy environment seems ill-equipped to cope with a shock. 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 limited capacity for monetary policy to respond should things go wrong.
For investors this presents a challenging environment. It creates a dilemma for how much risk to take, and I have a chart here to help illustrate this dilemma. (See Figure 1).
The blue line here represents a normal trade-off between risk and return.
In our view, given all the structural economic and market issues that we believe are in play today, this normal line has shifted down and out from the light blue line to the dark blue line.
So if an investor originally had a return target, and associated risk tolerance, up here [Point 1 – CLICK] it has been shifted to here [Point 2 - CLICK].
Here’s where the dilemma comes in. The investor might elect to reach for the same return, and move out to Point A [CLICK], pushing far out along the risk curve. If you are concerned about the sustainability of current conditions, and believe we are in a world of heightened risk, this feels like a brave call. If the curve subsequently shifts back up, most likely through markets selling off, this investor would take some heavy losses.
An alternative path would be to nudge risk down to towards Point B [CLICK]. If the line does then subsequently move back up, this investor will have moderated its losses, and be in a position to rerisk to increase returns from that point back to around where they used to be.
For our part, in this environment we believe it is prudent to take less risk than we might under more normal circumstances. We are more in the camp of moving towards Point B in the chart. This dynamic management of risk 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.
We can use our position as a long-term investor to be patient, to not feel we need to chase returns at all times, but rather to take risk off the table when we believe it is prudent to do so and wait until we see a better balance between risk and reward.
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.
More broadly it is also why our Board will discuss our risk and return objective with government in light of the expectation that long-term returns will be lower. Ensuring that we are clear on the appropriate balance between risk and return is a critical aspect of our program. It is that clarity which helps us manage the portfolio so that we do not expose capital to excessive levels of risk.
So how are we currently positioned?
Well since inception a little under 10 years ago, the Future Fund has broadly doubled its initial contributions of just over $60bn, generating a return of 7.4%pa over that time.
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 and global developed listed equity market had fallen over 3%. Emerging markets had fared even worse, falling over 12%. Our own portfolio was 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.
One of the themes we have been pursuing for some time is to look for what we call ‘opportunistic’ investments in the property and infrastructure space.
Many investors are attracted to core assets in these sectors. This has particularly been the case as investors have hunted for assets that throw off reliable income streams to replace low yielding bonds. As a result prices for these core assets are changing hands at relatively high prices and so offer relatively low prospective returns.
We have pursued opportunities to take on ‘non-core’ assets with higher return profiles.
Let me give you an example. A number of years ago we purchased a stake in a vacant office building in New York. This was less attractive to investors seeking core assets and we were able to gain exposure at a discount to intrinsic value. Through our manager, the property was refurbished and tenanted, turning it into a core asset attractive to a broader range of institutions and attracting a higher price at sale.
We also continue to see opportunities in private equity, particularly in venture capital and early stage growth. This is particularly the case where bank finance and public market funding are constrained and we see this as an opportunity to access innovation and value creation. We have been particularly attracted to co-investment opportunities which provide us with increased exposure to quality opportunities.
Of course, these kinds of strategies generally demand more resource and higher levels of skill and so they tend to be more expensive and place a higher demand on our internal team. So while we carefully consider the cost implications of these strategies we believe that the value created and the diversification benefits they can provide make them attractive.
Change in the institutional investment industry
Let me change tack at this stage and make a few broader comments about the investment industry and, more broadly, the importance of culture.
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.
Each link in the chain, institutional investors like me and my colleagues, fund managers, stockbrokers, investment banks and consultants represents an opportunity for misalignment to creep in and detract from achieving the ultimate beneficiary’s original objective.
This is exacerbated by the investment industry’s preference – perhaps obsession – with hard data and measurement and the natural human tendency to give greater weight to immediately available information.
One response to this is to design smart incentive systems that aim to better align each Agent in the chain to the objectives of the ultimate beneficiary.
This is important, but it is hard to build incentive systems that link rewards to the 10 year plus horizons of most relevance to institutions.
At the Future Fund we try to adopt a more fundamental approach. We aim to change the traditional model of delegation, monitoring and control by addressing the way the Principal-Agent relationship is managed.
We focus less on short term measurements against benchmarks and place greater emphasis on a 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.
It is an emphasis on being roughly right rather than precisely wrong.
This is a cultural shift away from decisions and behaviours being framed by narrow incentive structures and benchmarks to a broader concern for doing the right thing in the context of the objectives of the Future Fund and the needs and expectations of the ultimate beneficiary.
It is this cultural shift that facilitates a change in the risk-taking stance of the Future Fund in the interests of our beneficiaries.
I don’t know enough about your world to comment, but I see too little of this behaviour in the institutional investor world.
Might I suggest that the broader investment industry could look carefully at the true professions for some guidance?
When you go to the doctor you have a high degree of confidence that the treatment you receive will be in your best interests. You are confident that the nurses, doctors, consultants and specialists and all the supporting providers and suppliers are aligned to your interests.
This trust is critical because of the massive asymmetry of information and understanding between the doctor and patient. We are utterly reliant on them.
The complexity of the investment world is such that a similar asymmetry exists. It is therefore a similar level of trust, confidence, professionalism and client focus that the investment industry must seek to emulate.
When you visit the dentist, he or she has every financial incentive to drill a hole and fill it. But we trust that they won’t. The financial industry has failed to generate this trust. True professionalism is lacking.
Now shifting to this more qualitative approach to driving alignment in the investment chain is hard work.
At the Future Fund 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 in conclusion, I hope I have left you understanding the following:
- the Future Fund has a very simple mandate to save and invest for future generations of Australians. It seeks to maximise the long term return, subject to acceptable risk levels. There are sovereign wealth funds in the world set up to do other things, but the Future Fund is not one of them;
- the global investment environment is highly challenging, with low long term prospective returns and elevated risks. This presents a tricky dilemma to investors. For our part, we have been reducing risk levels; and
culture and alignment are essential ingredients to long term investment success. Our industry has some work to do in this regard before it can legitimately describe itself as a true profession.
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