Why the Future Fund is so cashed up

Summary: The so-called Board of Guardians of Australia's Future Fund are cautious, for good reason. They point to the potential for market shocks and to prospective lower returns in a challenging investment environment.

Key take-out: The eye of the financial storm that sparked many nations to implement massive quantitative easing programs and record low interest rates has passed. That means higher rates are definitely on the way.

The Chairman of Australia's Future Fund, the former Federal Treasurer Peter Costello, says the biggest economic and investment challenge ahead will be the “normalisation” of interest rates and a consequent downward adjustment in asset prices.

Which is the key reason why Australia's $133 billion sovereign wealth fund now has more than $28 billion, equal to 21 per cent of its total investment capital, sitting in cash.

Indeed cash ranks above all other asset classes in the Future Fund's portfolio, except for international equities, which collectively totalled just over $29 billion at 30 June. The fund's lowest allocation is to Australian shares, which accounted for 6 per cent ($8 billion) of assets.

With the primary mandate of managing the Commonwealth's unfunded superannuation liabilities, Costello points to an extremely uncertain investment climate ahead as global central bankers grapple with the timing of official rate rises and as international political tensions escalate.

He told Eureka Report that higher interest rates have been flagged for a long time, and when they do begin to rise “that will affect asset prices quite significantly”.

“In this environment the board is maintaining its patient long-term approach to investment.”

It's a strategy that is definitely paying off. Over the past decade the Future Fund has achieved an annualised return of 7.9 per cent, adding $73 billion in total earnings to its initial $60 billion in seed capital from the Federal Government. In the last financial year its return was 8.7 per cent against a target return of 6.4 per cent.

With the Federal Government having announced it will not be drawing any money out of the fund until 2026, Costello says that will give the fund ample time to grow its investment capital base to more than $200 billion – which will be enough to keep the Future Fund going for the rest of this century.

Chief Executive David Neal says a major focus of the Future Fund investment team has been to reduce risk and increase liquidity, hence the high amount of funds invested into cash.

“A fundamental part of our approach is to only take risk where we believe it will be adequately rewarded. With low yields on offer, investors globally are being driven up the risk curve to strive for their target returns. This tends to drive prices up and further reduce expected returns. Given the risks we see and the rewards on offer, we believe this is a time to maintain our discipline.

“If markets looked very attractive, if prospective returns were high and risks were normal or lower than normal, then you should expect to see the portfolio have quite a lot more risk in it.

“We move the portfolio risk level according to the outlook that we see, and we think that's sensible, pragmatic and prudent.”

Neal says that while there was little change in the Future Fund's top level portfolio allocations over the last 12 months, there was significant activity behind the scenes as the fund was positioned into the best assets.

“There has been a fair amount of sales activity where particular assets have achieved their business plans, and we've reinvested that. One of the highlights obviously for the year was the fund's investment into the Port of Melbourne.

“The overall portfolio construction is fairly consistent and that suggests our view has remained fairly consistent throughout the year.”

With an increased focus on private equity investments, infrastructure and alternative assets, Neal says the Future Fund's objective is to continue to identify and pursue investment opportunities that offer strong risk-adjusted returns.

But there are no sovereign bonds in the fund's $14 billion debt securities portfolio.

Neal says government bonds are too expensive, with interest rates at record lows, and he doesn't see that changing in a hurry.

“The traditional defensive assets, bonds, remain expensive which reduces their defensive characteristics.

“We strive to add additional returns, or reduce risk, by searching for idiosyncratic opportunities. Strategies that have low correlation with traditional risk assets are particularly attractive (such as our venture/growth portfolio).”