Future-proofing the Future Fund

In delivering the Future Fund's best two-year return since its inception seven years ago, managing director David Neal took great pains to point out that recent returns are not sustainable.

The Future Fund, set up by then treasurer Peter Costello in 2006, generated a return of 14.3 per cent for the fiscal year to June, taking the total value of its assets to $104.5 billion and ensuring a comfortable retirement for the nation's civil servants when the fund starts paying out from 2020.

Following on from a similarly strong 15.4 per cent return in the prior year, that means the Fund has well and truly beaten its targeted return of CPI plus 4.5 per cent over all investment periods, and indeed doubled its target in the latest year.

But prospective returns are “low”, Neal stressed. “I don't think anybody would expect those types of returns to be sustainable,” he told a briefing.

That is because returns, like returns across most asset classes in the past few years, have been front-end loaded.

Thanks to the super-stimulatory policies of the Federal Reserve and central banks around the world, investors have been pushed to look for higher yields and take greater risks in a low or zero-interest rate environment.

Asset prices have gone up faster than can be sustained, so they will need to realign.

“There has been a tailwind to returns,” Neal said after the fund released its annual performance figures. “We have brought forward some of those future returns.”

As forecasters continue to downgrade global growth forecasts, and growth slows in both profits and yields, prospective returns are mechanically lower as a result.  The Future Fund says it expects future economic growth to be “somewhat subdued”.

But does the nation's sovereign wealth fund share the grim outlook that the Reserve Bank's Guy Debelle laid out in a stark and candid speech (Is Guy Debelle right?, October 15)

Debelle, in comments that rang alarm bells far more clearly than former Fed chairman Alan Greenspan's “irrational exuberance” speech in 1996 (which only seeped slowly into markets), warned of the risk of a violent correction partly because some fixed income positions might blow up as the Fed normalises rates and partly because liquidity is currently lower than most investors assume.

Neal agreed there is always the potential for a whiplash market reaction as the Fed changes policy gears, but he did play down those risks.

“We would agree with the range of views that Guy had and the risks he identified. The risk really comes down to whether they (the Fed) make a mistake or whether investors perceive they are making a mistake,” Neal said.

So while the Fed's intentions have been fairly clearly telegraphed and markets are unanimously pricing in a gradual increase in interest rates starting in 2015, any deviation from expectations could trigger a violent market reaction.

Neal didn't seem to think that markets had begun that correction already, despite the local market coming within 10 points of a 10 per cent correction from recent highs earlier this week.

“For there to be a violent move, there needs to be a significant change in investor view,” he said.

The Future Fund dismissed a question that a near doubling in its cash position to $10.2bn reflected a more cautious market positioning. There was no investment view embedded in the increase in cash levels, which mainly reflected the sale of a co-investment in US shale gas pipelines that paid off handsomely.

Certainly, the Future Fund's asset allocation is spread more broadly than a typical balanced super fund. It holds 9 per cent in Australian equities and 34.1 per cent in global equities.

Compared with a typical super fund allocation, the Future Fund holds less in listed equities; more private equity; more debt and alternatives; and less cash.

If a violent correction lies ahead, the nation's single largest investor has prepared for that day and hopes to withstand a market meltdown.