i3 Investment Strategy Forum
11 May 2018
Dr Raphael Arndt, Chief Investment Officer
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Good morning, and thank you for the opportunity to speak to you today.
The Future Fund is Australia’s sovereign wealth fund. We manage five funds on behalf of you – the people of Australia. In total we currently manage around A$166 billion on behalf of future generations of Australians.
The largest of these funds, the Future Fund, currently stands at around A$141 billion. The Fund was established in 2006 to strengthen the Australian Government’s long-term financial position.
The Future Fund’s mandate is to achieve a return of at least inflation plus 4 per cent per annum over the long term, without taking excessive risk.
Today I will talk to you about the role hedge funds play in the Future Fund’s portfolio to help meet this mandate.
I recognise that hedge funds have historically had a public relations problem – being associated with high fees, a lack of transparency and perceptions of poor ethics and customer focus. In many cases they were also just an expensive access point to buy equity market beta. They failed to deliver on their protection promise – generally delivering the same low or negative returns as equities during the GFC.
I would call this dated stereotype ‘hedge funds 1.0’. A lot has changed. Today I will talk to you about the move from ‘hedge funds 1.0’ to ‘hedge funds 2.0’.
I will discuss the very important role that this new generation of hedge funds play in delivering uncorrelated returns and reducing risk in the Future Fund’s portfolio.
Let me begin by speaking at a high level about the Future Fund’s current thinking and positioning.
We continue to think that over the longer term the global real economy faces headwinds from ageing demographics and a significant debt burden.
However in the short term there is reason to be optimistic. In particular the global economy is exhibiting synchronised growth, and the US has been able to absorb a series of interest rate rises without impacting the economy significantly. At the same time, the threat of populism and protectionism is also increasing.
Asset prices remain expensive by historic standards. Current pricing is based on interest rates being at unprecedented lows, and assumes they will remain close to these levels.
And the world is changing – the successful investments of the last five decades won’t necessarily be the successful investments of the next five decades.
Technology is changing how people interact and how people work – and in doing so is creating threats and opportunities. I will return to this later.
So, in the current environment, we are particularly attracted to:
- Flexibility – it is very hard to predict what will happen;
- Investment strategies that are uncorrelated to equity returns; and
- Investment strategies that are focused on genuine innovation and adding value to businesses – not just financial engineering or strategies that involve leverage.
Role of Hedge Funds
It is always prudent to have a diversified portfolio.
A diversified portfolio is even more important in an environment where both equity and bond market returns may be challenged going forward.
In this environment, investors will have to be more dependent on alpha to deliver acceptable returns.
Hedge funds have an important portfolio role to play in generating returns that are uncorrelated to equity markets.
In the case of the Future Fund, we seek hedge funds and alternative return sources that can add value with the expectation of a low to zero correlation to equity beta over time.
For the Future Fund, hedge funds have a very specific purpose in our portfolio. This is to reduce risk – and in particular to provide returns during market environments involving prolonged periods of losses in equity markets.
Avoiding significant losses is particularly important because, unlike most superannuation funds, the Future Fund isn’t receiving inflows – and therefore doesn’t have the ‘luxury’ of being able to invest into a down market.
So we include hedge funds as part of our portfolio to provide diversifying returns and maintain portfolio flexibility in the event of a significant equity market drawdown.
And we size this exposure to be meaningful enough to make a difference if this type of situation eventuates.
Depending on the strategy and manager, our hedge fund mandates should provide some combination of diversification, downside protection, and alpha generation.
The Future Fund’s hedge fund portfolio consists of three types of strategies:
- Macro-Directional – this can include directional trading, generally through the use of derivatives, which is either systematic and model based, or discretionary with a portfolio manager making decisions;
- Alternative Risk Premia – accessing return streams largely unrelated to financial market assets, such as reinsurance risk; and
- Multi-Strategy Relative Value – a collection of strategies designed to identify and capture temporary deviations in prices between liquid assets such as equities and bonds.
These strategies are designed to provide diversifying returns, so that in other parts of the portfolio we can invest into riskier assets like equities and illiquid assets such as infrastructure, private equity and property, while maintaining an appropriate total portfolio construction.
In implementing these strategies we use a mixture of:
- Direct investments into funds and managed accounts;
- Fund of Funds – tailored partnerships with a small number of fund-of-fund managers to access opportunities that are inefficient or difficult for us to otherwise access – including the best managers on better terms than we can access directly; and
- Seeding new managers – we are increasingly prepared to seed new managers and strategies to get capacity and attractive terms with new hedge funds.
Following the Government’s decision to defer drawdowns from the Future Fund until at least 2026/27, we expect the Future Fund will continue to grow in the decade ahead to over
A$250 billion. We have therefore increased our focus on reserving capacity with sought after managers.
Recognising the role we want hedge funds to play in providing diversifying returns, the Future Fund currently has an exposure of A$22 billion – more than 15% of the portfolio.
And the Medical Research Future Fund also has around
A$1.5 billion exposed to hedge funds – around 20% of its portfolio.
This meaningful sizing is because, just like house and contents insurance, there is nothing worse than being underinsured when you most need insurance protection.
I recognise there are other ways of insuring the portfolio against losses – such as holding cash, foreign currency or buying equity puts.
However, these strategies all deliver lower expected returns, under a range of scenarios, than a well implemented hedge fund program.
Hedge funds are the only option to get returns that are uncorrelated to equities and also provide a reasonable return in most scenarios.
What we are looking for
Let me then turn to how we are building such a program and what the Future Fund is looking for.
Let me start by saying what we aren’t looking for.
We aren’t looking for an expensive way to purchase equity market or credit exposure – or any other exposure we can easily identify and cheaply obtain.
Instead we are looking for diversifying returns, from managers with a demonstrated ability to make money under different market conditions – preferably including proprietary ability that cannot be easily replicated.
We want the most efficient use of the Future Fund’s capital – namely an appropriate match between a fund’s assets and our liquidity rights, and ideally denomination of our holdings in Australian dollars.
Because hedge fund managers should be good at hedging and because, at least in our program, they invest into liquid assets, it makes sense for them to be able to provide an Australian dollar asset class and to provide liquid terms.
We are therefore extremely reluctant to invest in structures that involve locking up our capital with limited redemption rights where the underlying assets in the vehicle are relatively liquid.
While we have some less liquid hedge funds in our program, the bar is high.
We also want to play an active role in improving standards across the sector for all investors. David George, the Future Fund’s Deputy CIO, Public Markets, is a Trustee of the Standards Board for Alternative Investment, the body responsible for setting standards for the hedge fund industry globally. We work with the SBAI to increase governance standards across the hedge fund industry as a whole.
When undertaking due diligence, the Future Fund’s investment team examines a hedge fund manager’s performance through several lenses to better understand the composition of returns – and our statistical analysis helps us understand what has driven that performance.
We want to see a manager demonstrating real skill over time, not just generating returns from exposures to market beta or factors such as value or momentum.
When assessing performance and fees paid, we want to be paying for alpha, not beta. We look at how the alpha generated is split between investors and the fund manager. We expect to keep the majority of the skill based return, and not pay it away in fees.
Finally, we look for the right level of transparency. A list of all of a fund’s assets once a month or quarter may be interesting but is often of limited utility.
Real transparency comes from having exposure data that matters, and from an open and genuine dialogue with a manager.
We seek to partner with our managers, and draw from their insights to help inform our portfolio thinking, and hopefully we help shape their thinking too.
Fees can often be the focus of discussion when the topic of hedge funds is raised.
In discussing fees, it is important to look at what an institutional pool of money is buying in return for the fees being paid.
For instance, I am not interested in paying hedge fund fees to buy equity market beta that I can buy for one or two basis points through a passive Listed Equities mandate.
However, if a manager genuinely delivers uncorrelated returns through the application of skill, we will pay an appropriate fee for this.
This means we seek fees that appropriately align our managers, including paying for performance where alpha is delivered from true skill.
As I mentioned, we look to see how any alpha generated is split between the investor and the manager – and in general we believe that an investor should keep at least 50% of the alpha generated.
Where we invest with managers in different strategies, we seek netting of performance fees across our total relationship. This means we won’t pay performance fees on one strategy, while at the same time another strategy with the same manager has underperformed. This is one driver towards the smaller number of large relationships that is evident in our portfolio.
Hedge Funds 2.0 at the Future Fund
Alongside the establishment and evolution of the Future Fund over the last decade, the hedge fund industry has evolved.
The ‘have a hunch, bet a bunch’ hedge fund manager is a relic of a bygone era, largely cleaned out by the GFC which exposed strategies which use high leverage and poor risk controls. These have been replaced by institutional quality investment processes.
High-speed data analysis and multi-faceted risk systems have more value in modern markets than stock tips on the golf course.
In our experience, the hedge funds depicted in the TV show Billions are no longer relevant for institutional investors, having been replaced by managers making huge investments in data and technology.
To help put context around this, we have hedge fund managers who:
- have some of the world’s largest supercomputers;
- have invested 3,000 person years in R&D;
- collect over 10,000 independent and proprietary data sources;
- employ over 1,000 computer programmers or ‘quant’ investment staff; and
- invest around A$1 billion per annum into their business.
At the same time we have seen some brand name hedge funds get too big to be able to move their portfolios around, and too fat and comfortable from their base fees to want to take any significant risk.
With no risk taking, there can be no real, skill based return – just market returns. So we have seen these large managers take more and more equity risk – under the guise of ‘long-short’ strategies.
These business models are exposed by our analytical approach – with regression analysis highlighting a structural equity exposure at very high fees for what it is.
The rest of the industry has seen this too, and these managers are going out of business at an increasing rate, replaced by managers you have likely never heard of who are happy to stay below the radar.
Like the industry as a whole, the Future Fund’s hedge fund program has evolved.
Our Debt and Alternatives Team of ten people has worked incredibly hard over the last four years refining our hedge fund strategy to:
- Maximise our expectations of diversification;
- Increase the impact of that diversification on the fund; and
- Deliver the most efficient portfolio possible in terms of capital, fees and risk.
This work is nearing completion, and has entailed substantial portfolio restructuring to reduce exposure to bulk betas and to ensure that our managers are complementary with each other.
This has involved manager turnover, and we have restructured mandates or replaced managers for more than two-thirds of the hedge fund portfolio – roughly A$14 billion.
This work has led to the hedge fund program trailing equity beta falling from an average of around 0.4 to zero between 2011 and 2016. In addition, the hedge fund portfolio now includes specific hedging strategies designed to deliver at a scale which can help the entire portfolio in stressed markets.
This work, which is ongoing, involves analysing underlying performance data and identifying the drivers of performance – namely, looking through the ‘story’. We invest on the basis of data, not stories.
Coming back to some of the things that are important to us that I discussed earlier:
- in terms of liquidity, we can access a substantial proportion, over 25% of the program, on one day’s notice if necessary; and
- we have optimised currency hedging, so the manager undertakes this on our behalf for around 70% of the program.This further reduces the drain on the Fund’s liquidity in times of stress.
This makes our portfolio much more liquid than a hedge fund portfolio of a decade ago, and it imposes a much lower opportunity cost on the fund due to the reduced need to hedge the currency exposure.
Furthermore, a year ago I established the Market Insights and Portfolio Implications function to increase our capacity to leverage insights from our manager relationships across all asset classes – and Tanya Branwhite the Director of that function is here today. We have access to some of the best investment minds in the world, and we can see how they are positioning their portfolios, often in real time.
Tanya, together with the rest of the team, has access to all of our managers and regularly conducts a survey of their positioning which helps inform our decisions in the rest of the portfolio.
Hedge Funds 2.0 at the Future Fund: Measuring success
Let me now turn to how we measure success of the hedge fund program. After running the program for 10 years, how are we doing?
We measure performance against the objectives of:
- downside protection; and
- alpha generation.
In looking at the historic performance of the Future Fund hedge fund program, there are two distinct five year periods over the decade since inception.
The first five years of the Future Fund’s history included a small hedge fund program that provided some diversification, risk reduction and overall benefits to the total portfolio – albeit with higher correlation to equity returns than was optimal.
Our historic experience during the first five years of the program was that our long/short managers turned out to be an expensive access point to get an equity market exposure.
The higher beta component was useful to the Fund as it built out its risk profile, and there was a degree of alpha generation, but it came at a fairly high cost.
While it is better to capture a rising market inefficiently than to not capture it at all, we had ample scope for improvement.
About five years ago we reviewed our approach. This led to a re-working of the hedge fund program, with greater emphasis on delivering true diversifying returns to benefit the total portfolio.
Over the last five years the hedge fund program has been significantly increased in size, both in absolute terms and as a proportion of the total Fund, as we have sought to emphasise the downside protection the program delivers.
At the same time, as I touched on earlier, I am pleased to say the program’s correlation to equity markets has fallen to nearly zero, as we obtain market beta exposure more efficiently elsewhere.
During the last five years the program has delivered significant diversification benefits and alpha generation, but an environment of strong equity beta performance has made it difficult to test the ‘downside protection’ thesis.
However, given that the Future Fund as a whole already has significant equity exposure, it is better served by strong equity markets. It is therefore a thesis I am comfortable we haven’t had to test live!
As the team nears completion of what has been a four year journey of re-structuring, I am happy with the composition of the program and the role it is playing in the portfolio.
I hope you now have a better appreciation of the role hedge funds play in the Future Fund’s portfolio.
This diversification role is particularly important given the Fund isn’t receiving inflows, which makes avoiding a significant portfolio loss in the event of an equity market drawdown even more important.
The inclusion of uncorrelated sources of return in our portfolio allows us to invest into risk assets elsewhere in the fund.
We can do this because the hedge fund industry has evolved, and can deliver returns that are genuinely uncorrelated to equity markets, and we have restructured the program to capture this.
And we have been able to access capacity at scale for the program to play a meaningful role at a total portfolio level – while structuring our relationships so they are generally liquid and Australian dollar denominated.
While a meaningful hedge fund program is rare among Australian institutional investors, I encourage industry participants to consider such a program in their portfolio to protect against the risks associated with a repeat of a GFC type event in equity markets.
The fees paid, while unquestionably high, are worth paying for skilled managers who collectively can add significant value to the portfolio overall.
I also call on consultants, who might currently rank funds according to fees paid, to properly assess the risks associated with equity market exposure. Doing so may lead to increased appreciation of the true value of diversifying strategies.
Importantly, an effective hedge funds program allows an investor to buy into a down market rather than being a forced seller if we have a repeat of a GFC like selloff.
While I hope we don’t experience a significant downturn in equity markets, I feel much more comfortable having 15% of the Future Fund in hedge funds to provide some protection against the possibility that markets turn.
It’s time to re-examine what hedge funds offer. The industry has evolved and improved, and features a new breed of managers that are different from their predecessors. They have changed their approach. I believe that it is time we all did the same.