Australia’s Future Fund is among the fastest sovereign wealth vehicles to report its performance, which makes it a useful leading indicator of the way that these vital institutional engines are performing in changing conditions.
All funds are of course different, with variety in mandate and approach, but most face the same challenges of investing at scale for the very long term while riding out the changing conditions of the short term.
On August 31, the Future Fund reported on its year to June 30 – one that covered the end of the stock market rally around the world – the emergence of most nations from most pandemic restrictions and the reappearance of inflation and rising rates for the first time since the global financial crisis of 2008.
All things considered, the fund did well: a 1.2% decline over the year. Since global equities and global bonds both fell by more than 10% apiece over the same period of time, the fund has a right to be pleased with its efforts.
“To preserve the value of the fund in that environment is exactly what we would look to do,” says Raphael Arndt, chief executive officer.
Repositioning
The Future Fund has always had a heavy allocation to illiquid assets, and over the last 12 months it got heavier still. The weighting to equities fell from 36% to 29% through the year, while private assets grew dramatically. As of June 30, 2022, 17.2% of the fund was in private equity, 17.8% in alternatives (which at the Future Fund chiefly means hedge funds), 9.5% in infrastructure and timberland, and 6.8% in property. Just 8.1% of the fund was in debt securities.
Positions like these demonstrate how the Future Fund saw trouble coming and repositioned early. In 2021, it began a three-year programme to reposition the portfolio for a climate of higher inflation, increased volatility and lower returns. Arndt said today that A$30 billion ($20 billion) of assets were moved in order to reposition, and that the return overall was 4% better than it would have been without those changes.
The fund’s assets under management stood at A$194 billion as of June 30 – A$134 billion of it in investment gains since the May 2006 inception, and an annualized gain of 7.8% a year over that timeframe.
But moving into private assets is easier said than done. Pretty much everyone wants to do it, which makes it progressively harder to get an edge, or to find attractive opportunities.
Asked about this by Euromoney, Arndt says there are two areas to consider: where the fund is competing directly as a buyer of assets, as in property and infrastructure; or where it invests through funds, as in private equity and hedge funds.
On the fund side, “there is quite a shakeout in the industry,” he says. In private equity in particular, “it’s been pretty easy to make money for the past decade,” thanks to economic growth, robust stimulus, cheap debt and plentiful liquidity.
“That environment is changing now. Economic growth faces headwinds; it will continue to do so because of demographic effects and policy effects both monetary and fiscal; the cost of debt is rising; and liquidity is being withdrawn.”
We have seen a reasonable decline in equity markets, but it could be argued it’s nowhere near enough to be considered fair value
Raphael Arndt, Future Fund
This, Arndt says, will draw a line between “well-credentialled, highly capable managers who have demonstrated their ability to add value through skill, and managers who have been sailing with the wind at their backs.”
The job of the fund, he says, is to make sure it continues to be exposed to the best managers in the world.
As a direct buyer of assets, the Future Fund has still found attractive opportunities, notably its purchase alongside Sunsuper and the Commonwealth Superannuation Corporation of 49% of Telstra InfraCoTowers, which operates over 8,000 tower assets across Australia, and the purchase of Tilt Renewables by Powering Australia Renewables, which is a fund established by AGL Energy and QIC managing money for Future Fund, among others.
“There was certainly competition for both of those things,” says Arndt. “There are lots of investors looking for those assets. It’s important for us to understand why we are buying those assets and what they are worth to us. We’re not just interested in chasing the market.”
Both of these investments appear to have inflation-defensive characteristics, and, being in Australia, don’t bring global macroeconomic or cross-currency challenges with them. “Domestic investments are more attractive now than they have been,” he says.
Tightening cycle
So, what would need to happen for equities to be attractive once again, and for the portfolio to be rebalanced in their direction?
“We have seen a reasonable decline in equity markets, but it could be argued it’s nowhere near enough to be considered fair value,” says Arndt. “It’s very clear inflation is still rampant across the world and interest rates have some way to go to reach a long-term neutral level.”
Bonds are pricing in more aggressive tightening, he says, and given the amount of debt that is held around the world, “we would expect that tightening cycle to trigger economic slowdown and recession-type conditions in much of the developed world. It’s very clear equity markets are not pricing that in.”
The fund has reduced its holdings in cash, but not drastically so: year on year, the figure has fallen from 15% to 12.1%.
“In an inflationary environment cash is one of the worst assets to hold because you are guaranteed to lose” just from the act of holding cash, Arndt says. “The cost of holding cash has gone up quite a lot.”
But the need for liquidity across the portfolio, plus an intention to be opportunistic, limits the amount that cash can be reduced. The fund established a dedicated treasury function for liquidity and balance-sheet management that came into effect on April 1, a clear sign of how the fund’s leadership is worrying about volatility.
Around the world, sovereign funds are dealing with the same challenges as the Future Fund. As they report, we may find the themes of private capital, competition for alternative assets and a need for liquidity are illustrated time and again.
