Could you match the Future Fund?

Last month Eureka Report ran a fascinating piece by my colleague Bruce Brammall headlined Did you beat the super benchmark. The article allowed readers to review their portfolio performance against the average performance of index fund managers.

Reading the results of the Future Fund this week it struck me that many readers might actually be well served taking a hard look at how the Future Fund works, especially the fund’s stated aim of returning around 7% per annum – or inflation plus 4.5%, to be precise.

The Future Fund, now chaired by former Treasurer Peter Costello, is Australia’s closest thing to a national sovereign fund. The fund manages the liability of public servants – it is now emerging as one of the world’s biggest funds with assets topping $100 billion. Though it must be said the fund has a long way to go before seriously rivalling the giants of the sector such as the Norwegian Sovereign Fund ($US942 billion) or Saudi Arabia’s national fund ($US738 billion).

Earlier this week it was widely reported that Costello aims to drive better returns from the fund’s allocation to private equity, infrastructure and alternative assets.

However, on closer inspection a remarkable aspect of the Future Fund is how relevant it is to Australian retail investors. For example, did you know it has half its total assets in shares?

It’s also worth noting that while many argue the Future Fund “invests in areas most people can’t go” the truth is that the fund has the majority – roughly 62% of its assets – in three allocations pots that are easily accessible to the retail investors: Shares, fixed interest investments and cash.

What’s more, over the five years to the end of June 2014 the fund has returned, on average, a very satisfactory 10.9% per annum. The return of the Future Fund since inception (May 2006) has averaged 7.1% per annum.

Among the key lessons any investor can take away from the Future Fund are:

• The way that the Future Fund has formulated a long-term target return;
• The asset classes that the Future Fund uses;
• The respect that the Future Fund has for market returns.

Let’s have a look at these three separate areas and see what the Future Fund has to offer.

Measuring Long-Term Returns

The Future Fund target is clear and, I think, makes a lot of sense for individual investors as well. The target return for the fund is 4.5% to 5.5% above CPI (inflation) per year over “the long term”. This is restated in the fund’s 2012 Statement of Investment Policies as being 4.5% above CPI over 10-year periods.

A target like this makes a great deal of sense for those of us managing individual investment portfolios for a number of reasons.

The first is that it makes sense to link any target return to inflation. Just picking a target return, say 8% a year, is effectively meaningless. If you meet that return of 8% per year, over a time of unusually high inflation of 7% per year, you have really only just increased the purchasing power of your money. If, on the other hand, inflation is 2% per annum then your 8% return is very strong – it means you have increased the purchasing power of your assets by 6% per year. In other words, if you link your goal to inflation, say a target of returning 4.5% per year above inflation, suddenly your goal is linked to the purchasing power of your investments.

Calculating this return over long periods, say 10 years, also makes a great deal of sense. There are many studies, for example the DALBAR Analysis of Investment Behaviour (http://www.qaib.com/public/default.aspx) that show investors often significantly reduce returns by moving into and out of asset classes at the wrong times – buying when markets are higher and selling when they fall – effectively decreasing their returns.

A longer-term investment horizon, such as a decade, should reduce the amount of wealth destroying short-term asset allocation adjustment.

And, of course, it makes sense to measure returns: After all, the aim of an investment portfolio is to make a return, and unless you are carefully calculating this return it is hard to know just how well (or badly) the portfolio has performed. I am often surprised at the number of people who have not actually measured the performance of their investment portfolio.

As an example of what this means, the Super Ratings Median Balanced Pension Fund (growth assets of between 60% and 76% in the fund) return over 10 years (to the end of June 2014) was 7.3% per annum (super funds returned 6.8% per annum over the same period). This means that $100,000 invested in a balanced pension fund that matched the average return would have grown to just over $202,000. Unless you are measuring returns, you don’t know whether the returns in your own portfolio are superior or inferior to these sort of benchmarks.

Asset Classes – For the Future Fund

The graph below shows the asset allocation for the fund at the end of June, 2013. A number of interesting observations flow from looking at the data. The first is that even in a sophisticated investment vehicle like the Future Fund, the majority of assets are equally available to individual investors including listed equities (40.6% of the fund’s value), fixed interest investments (15.6% of the fund’s value) and cash (5.8% of the fund’s value).

The second is that the Future Fund is prepared to invest significantly in overseas markets, with 23.8% of the assets in developed markets and 7.1% in emerging markets, with only 9.7% in Australian markets. While I am not sure that individual investors, who are well served by franking credits and the relatively attractive dividends paid by Australian companies, will rush out to be overweight international shares in their portfolios, it is a reminder that some exposure overseas makes sense.

The third is that nearly 50% of the fund’s investments are held in shares – a vote of confidence in shares as a long-term investment vehicle by the Future Fund managers.

Click to enlarge

The Respect for Market Returns

For all the skills and talent available to the Future Fund, it has a very strong degree of respect for the market: That is, the fund allows for the fact that old-fashion allocation of funds is a more important driver of investment returns than the particular skills of the investment desk.

The Fund’s 2012 Statement of Investment Policies includes an interesting statement as its first investment strategy:

“The focus should be on the effective management of beta (market related risk) because it is a stronger driver of long-term returns than alpha (skills related risk)”.’

If, as a retail investor, you see the logic in this comment then the next logical step is to assume that considerable returns can be underpinned through something as a simple a low-cost and well-diversified investment option such as an index fund or low-cost listed investment company, rather than chasing ‘alpha’, the skill related returns.

It is easy for investors to fall into the trap of trying to chase the ‘alpha’ of market timing or stock picking, and this is an important reminder not to forget the role of the markets in long-term investment returns.

According to the ASX Russell Long-Term Investing Report, the average return from investing in Australian shares taxed at the super fund rate over the past 20 years has been 9.1% p.a (to the end of December, 2013). A simple market-matching return would have turned $100,000 into $571,000 over this period of time. Market return – the beta return – does a great job of creating wealth over time.

Having acknowledged the importance of the market return, the Future Fund does of course allow for the idea that skilful managers can add value after fees.

Conclusion

The Future Fund acts as an interesting case study for investors – and is supported by a website that provides information that is well worth a read. (http://www.futurefund.gov.au/

The key document is the Statement of Investment Policies, which models something that an individual investor should consider – having a written investment strategy (something self-managed super fund investors have a legal obligation to create).

Within the investment strategy are many ideas that are worth considering for those of us managing much smaller portfolios, starting with a well thought out investment goal framed relative to inflation, a thoughtful approach to asset allocation and a focus on market returns, or ‘beta’, in driving the long-term returns of the investment portfolio.

Scott Francis is a personal finance commentator, and previously worked as an independent financial adviser. The comments published are not financial product recommendations and may not represent the views of Eureka Report. To the extent that it contains general advice it has been prepared without taking into account your objectives, financial situation or needs. Before acting on it you should consider its appropriateness, having regard to your objectives, financial situation and needs.