Investment Innovation Institute - Investment Strategy Forum
5 May 2017
Dr Raphael Arndt, Chief Investment Officer
Check against delivery
Good afternoon, and thank you for the opportunity to speak to you today.
In a moment I will explain the role Listed Equities play in the Future Fund’s portfolio, and the multi-year journey we are on in recalibrating our approach to Listed Equities.
Before that I will provide some insight into the Future Fund’s thinking on the current investment environment – which informs the approach we take to Listed Equities.
My organisation manages five funds on behalf of you – the people of Australia. In total we currently manage around A$148 billion on behalf of future generations of Australians.
This is in the form of five separate mandates from Government. Two of those funds include Listed Equities – the Future Fund and the Medical Research Future Fund.
The Future Fund currently stands at around A$130 billion – and is Australia’s Sovereign Wealth Fund. This has grown from an initial contribution by the Commonwealth of $60.5 billion starting just over a decade ago.
The Future Fund has a long term objective to maximise returns without taking excessive risk.
Our mandate from Government is to achieve a return of at least inflation plus 4.5% per annum over the long term.
As a long term investor, we manage our portfolio dynamically based on our view of expected forward looking returns from different asset classes – which means we vary the portfolio’s risk exposure based on expected future risk adjusted returns. Listed Equities is our main lever to effect this.
Before I talk in detail about the role Listed Equities play in the Future Fund’s portfolio, let me turn to the current economic and investment environment.
In almost every speech I have delivered over the last year or two I have begun by saying that it is a particularly difficult time to be a long term investor.
This remains the case today.
The world – particularly outside Australia – continues to feel the effects of Global Financial Crisis (‘GFC’). It is a hangover that has lasted a decade.
Like any hangover after a period of over-exuberance, it takes time to recover to a normal level of output – and the global economy has taken time to grow out of the effects of the GFC. A long time!
Interest rates remain at or around record lows – although in the last six months, there are signs that we may finally be entering a period of rising rates, albeit from extraordinarily low levels.
In addition, the outlook for the global economy remains challenged by factors including demographics and debt levels.
Unconventional monetary policy has pulled future returns forward to the present – and in doing so has increased returns for asset owners by inflating asset values.
This asset price inflation has further exacerbated tensions between owners of capital and workers – with wages in much of developed world largely flat in real terms over the last decade.
In this environment, it isn’t surprising that voters have expressed their frustrations at the ballot box. This has led to a rise in protectionist sentiment and, potentially, the adoption of economic policies which will reduce growth.
Inflated asset values have depressed forward looking returns, requiring asset owners to either take on more risk or moderate their return expectations – with both options being unappealing.
In the case of developed markets Listed Equities, returns over the last five years have been strong – around 11% per annum for Australian equities and 12% for Developed Markets – helped by the tailwinds of expansionary monetary policy.
This provides important context as I now discuss the role of Listed Equities in the Future Fund’s portfolio.
Listed Equities in the Future Fund portfolio
The Future Fund’s Listed Equities program commenced in 2007.
And since its establishment in 2015, we have also had a Listed Equities program in the Medical Research Future Fund.
Since inception, the primary purpose of the Future Fund’s program was to provide a diversified global equities exposure to:
- Harvest the equity market risk premium;
- Help meet whole of Future Fund objectives; and
- Provide a source of liquidity as needed.
We believe a material Listed Equities exposure is a good way of reliably harvesting a risk premium over the long term. Indeed, the equity risk premium is amongst the most reliable and accessible sources of return for a long term investor. The Future Fund is no exception.
As I touched on – we manage our portfolio dynamically, which means our Listed Equities exposure can flex up and down depending on our risk appetite at a point in time.
Furthermore, we take a ‘one-team, one-portfolio’ approach to managing the Future Fund’s portfolio – and in this context the Listed Equities program also has a total-portfolio role in allowing the Fund to access desired exposures.
For instance, we have used Listed Equities as an access point for Emerging Markets exposure.
We size the desired exposure on the basis of the Future Fund’s total portfolio rather than sizing relative to the Listed Equities program.
Build out of the program
Before moving on to where we are taking the Listed Equities program from here, let me look back at our historic approach to Listed Equities.
Following the GFC, forward looking equity market returns – or equity beta – were attractive.
The Future Fund’s Listed Equities program was built out through external investment managers – with a mix of active and passive management pursuing a predominantly long-only approach, although a modestly sized long-short portfolio was added in 2010.
Passive managers were complemented with active managers where we had conviction that active managers could deliver alpha, or outperformance net of fees on a sustainable basis.
Since inception, the Listed Equities program achieved this aim, outperforming its benchmark net of fees.
However, I make the point that – as I said earlier – the program plays a role in accessing exposures we desire at a total portfolio level.
Consequently, we don’t manage the program to a Sector benchmark.
Refining our approach
As I have explained, today’s forward looking returns have now compressed significantly relative to seven or eight years ago.
Lower forward looking returns means fee drag becomes a much more significant issue than in times of healthy returns. Fees are a greater proportion of gross expected returns than they were in the past. And while expected returns are uncertain, fees are certain.
Looking back, I make the following observations about lessons we have learned from the implementation of our Listed Equities program over the last decade.
The last eight years of declining interest rates have meant that macro factors – whether falling interest rates or commodity prices – have dominated individual stock-picking.
Listed Equity managers in general aren’t particularly good at making macro calls.
Likewise, when we analyse positions in our portfolio, we are increasingly discovering managers are knowingly, or unknowingly, taking significant factor positions.
For example, an active manager with a strong value style may have a process which effectively hugs a value index and does not add much by way of true stock selection risk.
Alternatively, a manager may adopt a combination of styles but still fail to deliver idiosyncratic stock selection and instead rely on a mechanical style based process which can be cheaply replicated.
The concern here is whether we are paying managers for their stock picking skill.
If we want factor exposures, we can access factor indices much more cheaply without paying active management fees.
Likewise if we want managers to make macro calls, we can hire macro hedge fund managers with a track record of making macro calls who are incentivised and aligned appropriately, and who have access to much better macro research to inform their decision making.
In addition, too often active positions by different managers offset each other once they are aggregated up to our portfolio level. This is of no value to us, but results in us paying active fees for close to beta returns.
Today, relative to a decade ago, we have technology available that means we can better analyse positions in our portfolio – to better understand underlying factor exposures, macro calls, style tilts or offsetting positions.
In short, the advances in technology enabling better understanding of underlying exposures, combined with lower forward looking returns means the world has fundamentally changed, requiring a new approach to active equities investing.
It is into this environment that our new Head of Equities,
Björn Kvarnskog, joined the Future Fund in February last year from Swedish pension fund AP4.
While our previous approach served us well, the changing world means we too have had to change.
Frankly, we need to get more bang for our Listed Equities buck.
Björn, and his team of seven, have undertaken a review of the Future Fund’s approach to Listed Equities over the last year – and are now beginning to implement the new strategy, which remains benchmark agnostic.
Our current Listed Equities priorities
As a result of this review, our Board agreed to redefine the objectives of the Future Fund’s $38 billion Listed Equities program last year. These objectives are:
1. Capturing equity market risk premium over the long term (beta) and being a tool to adjust total fund risk;
2. Harvesting long term equity factor premias (alternative beta), which may vary through time;
3. Delivering good risk-adjusted, skill-based returns with low correlation to market returns over the long term (alpha); and
4. Allowing us to access desired exposures from a whole of Future Fund perspective.
These objectives are to be implemented in a manner that continues to provide a source of liquidity to the Future Fund as needed.
These objectives have resulted in the following sub-strategies being developed:
• Global Beta;
• Global Alternative Beta;
• Australian Equities;
• Emerging Markets Equities; and
• Global Alpha.
We are at a different stage of implementation for each – and the implementation of our new approach has, and is, requiring an investment in technology to give us better insight into underlying exposures in our portfolio. This development is ongoing.
The implementation of our new approach has meant we have interrogated and reviewed our positioning across the Listed Equities portfolio and made some changes where that has been warranted.
Role of our sub-strategies
Let me now explain what we are looking for in the different components of our Listed Equities program.
The Global Beta strategy is being implemented – and is an extension of our historic Beta portfolio.
We intend that this will be the most significant part of our Listed Equities program going forward. It will efficiently deliver equity market risk premia in a cost-effective way.
While the programme will certainly be passive, it will not necessarily be entirely market cap. What it will be is liquid, scalable, and aimed at delivering the equity risk premia sustainably over time. As I said, this is still a work in progress.
Global Alternative Beta
We have had an Alternative Beta strategy focussed on Quality and Value factors since inception. This has served us well.
We continue to believe that sustainable factor based returns can be harvested – either passively or actively.
We will build on the existing program. Greater investment in technology and our systems will underpin further development of our Global Alternative Beta strategy – which we are still developing.
Technology and new tools enable factors to be harvested more cheaply now than at any time previously.
Over time we intend to build out an alternative beta approach that will enable us to capture desired factor exposures – which could include exposures such as value, quality, momentum, small-caps and other factors.
We anticipate that this program will include both passive and active approaches. But the hurdle for an active manager will always be the value added net of fees compared with a passive implementation.
We are also reviewing our approach to Australian Equities.
We are an Australian fund, with an Australian return mandate. The Australian equity market has and will always remain an important avenue for us to obtain exposure to our domestic economy.
However, the Australian market is challenged by concentration and lack of diversity – 40% of the ASX200 is banks and miners.
Large funds quickly confront liquidity constraints in the Australian market.
These things lead me to conclude that there are many challenges for long only active managers in the Australian market which are operating at a scale that the Future Fund needs.
When assessing our desired weighting to Australian Equities we need to weigh up the benefits of a domestic exposure linked to our mandate which we do not need to currency hedge with the necessity to be properly diversified and, in an equities context, liquid.
As at 31 March 2017, the Future Fund’s exposure to Australian equities was $8 billion, or 6.5% of the Future Fund’s portfolio and 22% of the Future Fund’s Listed Equities portfolio.
This exposure, is materially higher – by almost a factor of ten – than the 2.5% Australia comprises in the MSCI All Country World Index.
Emerging Markets Equities
Emerging Markets remains a key sub-strategy in the Listed Equities portfolio.
We fundamentally believe in Emerging Markets – and we are attracted to the positive demographics and expected future growth from those geographies.
Emerging Market economies now make up more than half of global GDP (PPP) and contribute around almost the same proportion to global economic growth. It is our view that true long term investors cannot ignore these markets, especially with the headwinds facing developed markets due to demographics and deleveraging.
Listed Equities is an attractive access point to Emerging Markets. Emerging Markets can be hard to access through other sectors. For instance, Emerging Market Private Equity is in its infancy and there can often be sovereign risk issues and limitations on foreign investment associated with property and infrastructure access points to Emerging Markets countries.
As at 30 June 2016, we had approximately 13% of the Future Fund invested into Emerging Markets, with around 7% in Emerging Markets Equities. Today this is about 25% of our Listed Equities exposure – versus 10% that Emerging Markets make up in the MSCI All Country World Index. This sizing and our exposure is to meet whole of Future Fund appetite for Emerging Markets.
We also have a longstanding ‘Emerging Wealth’ strategy implemented through Listed Equities.
The first investment in this strategy was in 2011. We designed the strategy internally and worked with our managers to access listed companies exposed to the growing Emerging Markets middle class, no matter where they are listed. Apple is a good example of a company fitting this description. We expect ‘Emerging Wealth’ to remain an important strategy going forward.
I have talked a lot about the benefits of passive and low cost strategies and how they are playing an increasing part in our Listed Equities program.
However we continue to believe there is a role for active management and that it will continue to play an important part in our Listed Equities strategy. We call this our Global Alpha program.
Though this program we are seeking out managers who can add value through genuine stock picking skill that is uncorrelated to market returns, or beta.
We have reshaped our Alpha program – with the intention that we have a small number of managers delivering attractive risk-adjusted returns.
We are looking for true stock picking skill executed in a way where we are not paying for beta or for style or factor bets.
We also don’t want active positions across different managers that offset each other at our portfolio level.
We envisage that pure stock-picking skill has the best opportunity to thrive when given the broadest canvas possible.
In our view, this is most likely to be found in relatively small capacity managers looking at global stocks with long-short market neutral mandates. In this type of strategy we are paying for pure stock picking alpha and the results are highly transparent.
Ensuring alignment with our managers in the Global Alpha program will be a priority.
Importantly we won’t pay active management fees for the delivery of market beta or factor exposures, which we can purchase for a few basis points.
Many Australian and global equity fund managers have been given a free kick over recent years due to the rise in asset values, and hence their funds under management. They can thank central banks for the effects of quantitative easing which have allowed them to grow.
This era is ending.
As I touched on earlier, low forward looking returns mean that fee drag is front and centre in the minds of all institutional investors.
Responding to the new era
I am conscious that many institutional investors are giving serious consideration to the issues I have raised today.
And I am equally conscious that there are different ways of responding to the current environment.
There are three principal approaches that can be taken to improve returns from equities in a low return environment:
- Reducing fee leakage by moving from active management to passive management (from alpha to beta); and
- Paying only for genuine manager skill which adds value at the whole of portfolio level (including ensuring that positions don’t cancel).
In reviewing our Listed Equities program, we have been particularly conscious to ensure that going forward we maximise risk adjusted returns, and deliver the program as efficiently and cost-effectively as possible.
In examining the options above we have chosen not to go down the insourcing model.
It is a legitimate model, and one being adopted increasingly – but a model that doesn’t align well with the Future Fund’s ‘one team, one portfolio’ approach.
As I mentioned, our Listed Equities team is seven people, and our broader investment team is approximately sixty people. We are based in Melbourne, and are able to come together and share bottom-up and top-down insights across sectors as we seek to maximise returns.
Internalising functions that can be implemented efficiently externally risks losing the Future Fund’s unique culture that encourages cross-team collaboration. We aim to make the best investment decisions regardless of sector while avoiding sector silos.
We believe external managers can efficiently implement both alpha and beta strategies – and consequently we have consciously chosen not to go down the internalisation path.
We also believe that there is a place for active managers with genuine and reasonably priced stock-picking skill. You will not see the Future Fund adopting a fully passive portfolio any time soon.
Let me conclude by thanking you once again for the opportunity to be here.
As I have articulated, the world has changed.
Listed Equities remain an important part of the Future Fund’s portfolio.
In the current environment, the use of technology allows institutional pools of money to better understand exposures in their portfolios – and to leverage off this knowledge to control portfolio exposures and scrutinise fees.
Technology also mean Listed Equities exposures can be accessed more cheaply and efficiently than before, which is appropriately challenging fund manager business models.
We are in an environment where sophisticated investors are no longer willing to pay active management fees for beta returns, or even for sensible positions from the managers’ point of view but which cancel other positions at the portfolio level. Nor will investors pay for stock picking skill but receive only style factors or managers taking macro bets.
What does all of this mean for a long only active equities manager?
It means fund managers need to consider their value proposition.
They need to take a good, hard look at themselves and their client’s needs and understand how they are creating value and how much of that they are seeking to retain though fees.
In short – they have to confront the new reality.