Secrets from the Future Fund

PORTFOLIO POINT: The Future Fund has taken a different approach to asset allocation than the big retail super funds, and its strategy has paid off. There are lessons for every investor.

The Australian Future Fund has a lot to teach us about investment strategies. The federal government’s Future Fund has performed much better than the big commercial funds like MLC, BT and Colonial but not as well as many self-managed funds.

So today I want to compare what the Future Fund is doing with ‘normal’ big public superannuation funds and self-managed funds. I think we can all learn a lot from what is taking place – especially the big funds, which have a lot to learn.

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Equities

The Future Fund invests about one-third of its money in listed equities. This is approximately what most self-managed funds do. But your typical industry or commercial fund invests between 50% and 60% of their money in equities and then adds to that private equity and property to reach a 70%-plus equity exposure.

Given what has happened to equity and property markets in the last few years it’s no wonder they have performed so badly. They desperately hope the current rally continues. But the Future Fund has a twist to its equity investment strategy that is different to other funds and certainly different to what I have been suggesting.

It invests only one-third of its equity money in local Australian shares and two-thirds internationally. To some extent this was a historic decision, because when it began investing the Australian sharemarket had not fallen as far as American and European shares so it found better value abroad. But it has not changed that strategy, and clearly it is unhappy with too much exposure to Australian banks and resource companies that is inherent in the Australian equity market. Overseas it is able to get a much wider exposure and is finding value there that it is not finding in Australia. The Future Fund hedges back most of its currency risk.

There is no doubt that with the Australian dollar being inflated by a series of forces including overseas central bank buying, money flowing into resource projects and the sloshing of hot money around the world, it is possible to get good value offshore. But unless you hedge you take the currency risk, and there is a real currency risk because longer-term the Australian dollar in my view is overvalued.

So the Future Fund uses a series of managers to determine its equity investments and it has a large staff to monitor them. For self-managed funds, listed investment companies like Australian Foundation Investment Co and Argo Investments (I have a holding) can do that job and do that job well in the Australian market. It’s harder to get exposure overseas unless you go to the institutions who charge large fees, but the index funds like Vanguard (with a currency hedge) provide exposure as do listed companies like Templeton. Templeton is an overseas version of Australian Foundation and Argo, although Templeton is very value orientated in its stock selection.

So our first lesson from the Future Fund is that, on an overall basis, one-third of your portfolio in listed equities is good policy and that it’s worth having a worthwhile overseas content in that equity selection. Of course, as I have mentioned many times, a large number self-managed fund beneficiaries do not want to have one-third of their money in equities. Nothing the Future Fund does should change that. The best policy is to have an equity exposure with which you are comfortable and that, of course, can be as high or as low as you want. In general the younger you are the better equity risk looks, but these are merely guide posts.

Private Equity

The next sector that the Future Fund invests in is private equity. And its exposure is about twice that of a ‘normal’ big superannuation fund. I am loath to recommend private equity to self-managed superannuation funds. If you do go that way you need to select very good managers and know what you are doing. Maybe its conservatism that comes with age, but I have seen some brilliant private equity operations and I have seen some horrible ones. The latest Nine Network debacle looked stupid when the private equity people went into it. And it looks even more stupid now. Yet these were so-called ‘top operators’ with good track records. One of the problems with private equity managers is that if they succeed they have a huge hubris problem, which can lead them into even greater risk taking. So private equity is only for those that can monitor it closely or who are happy with that degree of risk.

Infrastructure Assets

The next segment of the Future Fund portfolio is infrastructure assets. Here they have allocated 5.9% of their fund, which is actually less than the 12% that you normally see in a typical superannuation fund. But the Future Fund itself is looking to double its infrastructure exposure. The difficulty the Future Fund has had in infrastructure assets is finding good ones. Of course, the single best infrastructure asset in Australia was the ConnectEast toll road, which we sold for a fraction of its worth. Somebody in the Future Fund was totally asleep at the time and let the Canadians make a fortune.

The problem with infrastructure is that Australian governments don’t understand the rules. We are seeing that in power companies, where governments for political reasons are looking to change the charging rules. This is very disruptive to markets and causes considerable loss of faith in government infrastructure issues. We also see that investment banks, seeking high commissions, meddle in too many infrastructure assets leaving them with large amounts of borrowings. A good infrastructure play has some debt, but the debt is limited and long term. Unfortunately there are not many such assets in Australia, and the Future Fund has been forced to go overseas.

In my view there is a good chance that governments will learn from their past mistakes and start to give us proper infrastructure assets that have stable income and where people know what they are buying. Probably the best infrastructure asset in Australia is Transurban. I have a small holding in Transurban in my super fund. Another excellent one is the QR Group, but I am a bear on steaming coal and I am nervous about coking coal so I am not as enthusiastic about QR as many others. But, having said that, QR is a very good infrastructure asset. Hopefully we are going to see more power and transport infrastructure assets come forward in coming years. State and federal governments are reluctant to sell assets because it is politically incorrect. But they need the money to build roads, hospitals and schools, so eventually they are going to have to do it. And my guess is that when that happens they will involve self-managed funds.

Debt Securities

The Future Fund has 18.7% of its money in debt securities. This is three times the level of the ‘normal’ big superannuation fund. Longer term the Future Fund plans to reduce the debt securities to about 10%, still well above those in industry funds. My guess is that most self-managed super funds have an even higher percentage of their portfolio in debt than the Future Fund, and it has been an excellent investment. One of the reasons why the industry and particularly the commercial funds have performed so badly is that they didn’t understand the attraction of commercial debt. But the self-managed funds did understand, and in particular longer-term bank deposits have been excellent avenues for self-managed fund investment. As interest rates fall they are getting less attractive, but they still have attraction and given the Commonwealth government guarantee on investments of $250,000 in any bank, they are far better than bonds.

Alternatives

The Future Fund has a large investment in what it calls ‘alternatives’. These are very exotic securities and the Future Fund has a large staff managing the risks and the rewards. It is simply not possible to do that in a self-managed fund. Again you can allocate the job to somebody else but you have to be very confident in who they are and their skills because these sort of securities, if badly managed, can cause some hideous losses.

Cash

And finally we get to cash. A ‘normal’ big superannuation fund has just under 20% in cash, which is far too high. The Future Fund has about 11%, but longer-term looks to make it 5%. For self-managed funds the level of cash depends on just what the outgoings are. If your fund is in pension mode then it needs to pay a pension every year, therefore it must have the cash available. If your fund is not in pension mode there is less need for large amounts of cash unless a big distribution is planned.

Remember that in self-managed fund land there is only a gradual difference between the final years of working life and retirement. The investment policy does not have to change dramatically if it has been managed correctly. The only change comes when you go into pension mode, therefore you need to pay pensions. But portfolio income may well cover a good portion of the outgoings. Down the track our big funds will learn how to manage superannuation better for their customers but for those involved in them it has been both a painful experience.