Future Fund takes unfettered approach

David Neal, chief investment officer of Australia's A$97.6 billion (US$90.6 billion) Future Fund, says his fund's absolute-return focus, not bound by fixed strategic asset allocations or benchmark constraints, could help it clear a challenging return hurdle over the coming decade.

It won't be easy.

In a recent interview, Mr. Neal said his Melbourne-based team's working thesis for the economic outlook is that policymakers will succeed in engineering a soft landing — avoiding major shocks but leaving the global economy facing a slow healing process that will offer up “pretty uninspiring returns” for investors along the way.

The 2006 legislation establishing the Future Fund — to help cover future unfunded superannuation liabilities — set an annualized long-term return target for its investment portfolio of between 4.5 percentage points and 5.5 percentage points above Australia's consumer price index.

At the moment, Mr. Neal said, there's still “enough from markets, and from (idiosyncratic) pockets of opportunity, for us to have a reasonable chance — not a strong chance — of achieving our mandated return objective.” If the fund's 45-person investment team manages to do so, a good deal of the credit, he believes, will be due to decisions made in 2007 by Future Fund's board on how to structure the fund's investment program and governance.

“We sort of said, "Let's see if we can do this thing without a benchmark, without a fixed strategic asset allocation and how we would go about it,'” with a focus on absolute return predicated on a strong alignment of the management and the board, Mr. Neal said.

Mr. Neal, who moved to the Future Fund CIO role from his prior post as head of consulting with Watson Wyatt Australia, said the board acted on his “one-team, one-portfolio” proposal, aimed at breaking down the asset-specific silos separating team members in favor of rewarding everyone on the strength of the overall portfolio's returns.

At the Future Fund, every investment idea competes with every other for space in the portfolio and everyone is rewarded on the total portfolio's results. Asset class specialists “don't need to worry if they have an unbalanced sector portfolio” because that would carry no implications in terms of how they're rewarded, Mr. Neal said.

That goal of having the entire investment team keep the broader portfolio in view has left Future Fund's sector teams focused on property, infrastructure and real estate spending less time on direct investment deals than their peers at a number of other big asset owners.

The time and effort needed to make a direct $500 million infrastructure investment is enormous, but that would be “only half a percent of our portfolio. If being involved in that for two months ... means that we didn't do the research on (a) subsector that turns out to have a 2% better premium than this transaction, then we got it wrong,” Mr. Neal said. “For us, the ability to keep our heads up and understand what's going on in the world” is key.

Mr. Neal said that over its eight-year history, Future Fund's board and investment team have made three big strategic decisions regarding effective equity exposure:

nan initial low-risk phase adopted in the runup to the global financial crisis, with targeted equity exposure of between 25% and 30%;

na move starting in mid-2009 to the lower half of a more normal 45% to 60% equity range, amid strong central bank policy steps but lingering economic uncertainties; and

na move to the top half of that normal range at the start of 2013, amid gradual healing of the U.S. economy and evidence of stronger support from European policymakers.

Today, said Mr. Neal, that third “strategic regime” of equity exposure toward the high end of normal might be getting long in the tooth, because “risk premiums are starting to look skinny.”

As of March 31, the Future Fund's allocations were: developed markets global equities, 23.7%; Australian equities, 10.2%; emerging market equities, 8.7%; private equity, 8%; property, 5.3%; infrastructure and timber, 7.9%; debt securities, 11.8%; alternative (hedge fund) assets, 13.6%; and cash, 10.8%.

Looking out 10 years, the expected returns from broad market beta are likely to be “quite low” — an inevitable consequence of moving to a more normal environment from a period of extraordinary monetary policy support, Mr. Neal said.

Still, “we don't think we need to be rushing to man the lifeboats just yet,” he said. Even if the risk premiums available are likely to be somewhat lower than in recent years, with continued central bank support they should be OK for the next two to three years, he said. “We're reasonably happy to be at normal risk levels and to accumulate that risk premia,” he said.

In a low-return environment, Future Fund will not chase returns. “As risk premia come down, we don't, we haven't and we wouldn't step out on the risk curve to maintain returns,” Mr. Neal said. And if targeted returns can't be had without taking excessive risk, the investment team would simply have to explain that to the fund's board, he said.

But Mr. Neal said focusing on “idiosyncratic” sources of returns is one option to fill the gap.

“Are we smart enough, are our managers smart enough, to find niche sectors, where capital perhaps hasn't gone for whatever reason, and top the returns up,” Mr. Neal asked.

If so, he contends, Future Fund's ability to make investment decisions outside of the constraints of a fixed strategic asset allocation, and its willingness to hire external managers unconstrained by benchmarks should prove to be an advantage.

Identifying and acting on medium-term opportunities created by major changes in the economy is a source of potential returns, said Mr. Neal.

For example, the post-financial-crisis raft of regulations on financial institutions has left banks less willing or able to extend loans, creating an opportunity that Future Fund has jumped on. “We have significantly over A$3 billion in private lending ... and if we could have gotten significantly more than that, we would have done it,” Mr. Neal said.

Just as Future Fund's investment team has no constraints on its allocations, it tries to give its lineup of more than 80 external managers maximum latitude as well.

Mr. Neal said it's hard to understand why an asset owner would hire a manager for its expertise and then force that manager to operate within strict guidelines and controls. “There's just as big a chance that by constraining them, you're increasing the risk rather than decreasing it,” he said.

Asked if he has any concerns that its unconstrained managers might all zig or zag at the same time, Mr. Neal said that prospect doesn't make him lose sleep.

“Our job is to take risk. Most funds, I think, are dramatically overdiversified. It's much harder for us to get sufficient concentration of good ideas in the portfolio than it is to ensure that we have sufficient diversification,” he said. n