How to prepare for a less certain Future

Despite tough conditions, the Future Fund has managed to meet its target return each year since its inception, but navigating choppy markets requires caution.

When the then treasurer Peter Costello set up the foundations of the Future Fund in 2006, it was in a vastly different investment environment.

A decade into an equities bull market, the target return of the nation’s sovereign wealth fund was pinned at CPI plus 4.5-5.5 per cent. Assuming inflation ran at the central bank’s target rate of 2-3 per cent, this implied a target of 6.5 per cent to 8.5 per cent.

All easily achievable in a benign world of positive interest rates (cash rate around 6 per cent) and equity returns that doubled between 2003 and 2007. Transfers were made from the government’s budget surplus, and the outlook of the fund -- set up to finance public service retirement benefits -- appeared secure.

Then the financial crisis hit. Seven years later, interest rates in 19 economies are still barely above zero, trillions have been added to central bank balance sheets to avoid a depression, and Australian stocks have yet to regain the 2007 peak of 6,828.

So it’s a testament to the astute management of the Future Fund that it has beaten its benchmark over every timeframe: one, three, five, seven years and since inception.

Translated into dollar terms, the fund has added to the original contributions from government of $60.5 billion with investment returns of $48.7bn. The fund is now worth over $109bn, according to figures released yesterday, ensuring a comfortable nest egg for the country’s retiring public servants when it starts paying out from 2020.  

For the calendar year to December 31, the nation’s largest investor returned 13.2 per cent, against a target of 6.5 percent, an outperformance that few portfolio managers can match. Super funds returned an average 8.5 per cent last year.

“It’s not a bad result,” citizen Costello says drily, now chairman of the fund itself.

But the overriding message from the Future Fund’s management team is one of caution.

“These are difficult investment markets and it will be a difficult challenge to continue to meet targets in every time period,” Costello adds.

The fund has made such returns possible by bringing its specialists in-house and thinking in real-time about anticipated macro changes, making dynamic portfolio shifts as conditions alter.

When it looks at the big picture, such as the end of the Fed’s quantitative easing program or the ECB’s promise to launch its own QE, the fund takes positions in liquid securities to benefit from the fundamental macro shifts, adopting the types of strategies used by hedge funds.

Betting on a rising US dollar paid off last year, boosting the fund’s overall return.

Another big contributor to the fund’s performance is the diversification across public and private markets, with the private markets significantly outperforming listed ones. It has also increased co-investments in direct assets and private market lending activities that are not available to smaller players.

Over 2014, the fund boosted its allocation to cash, private equity and property and slightly trimmed alternative assets (including distressed debt), while sharply cutting equities exposure.

Local equities were cut to 8.8 per cent or $9.6bn from 10.1 per cent, while developed market global equities were cut to 20.9 per cent from 24.5 per cent, with all of the reduction in exposure coming in the fourth quarter.

Interestingly, for a player that found many of the domestic infrastructure assets that came to market in the past couple of years too pricey, it has not been put off the sector.

“We’re not willing to buy those assets at any price, but we are looking at a range of the opportunities coming up,” says the Future Fund’s chief investment officer Raphael Arndt. He was previously the head of infrastructure at the fund, managing $7bln in assets.

Some of the assets that the fund shied away from were Port Botany and Port Kembla, which sold at very high multiples of 27 times earnings. On the calendar for this year are privatisations including the Port of Melbourne and New South Wales’ poles and wires; the sell-down of Queensland’s electricity assets is probably on hold.

As all investors should have done by now, the Future Fund has taken some risk off the table.

Returns were front-loaded over recent years thanks to unsustainable central bank largesse. Asset price inflation cannot continue indefinitely -- and Arndt and his prudent colleagues don’t expect it to.