Raphael Arndt, CIO Future Fund on Coping with High Prices (Part 1)

May 05, 2015 by Loch Adamson

Raphael Arndt, CIO Future Fund on Coping with High Prices
What are the Future Fund's challenges in 2015? @iiSWC talks to CIO Raphael Arndt
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Founded in 2006, Australia's A$117 billion ($93.4 billion) Future Fund is designed both to bolster government finances by offsetting future public-sector superannuation liabilities from 2020. It was funded by budget surpluses and the proceeds from the privatization of Telstra, a formerly government-owned telecommunications company.

Sovereign Wealth Center's Victoria Barbary talked with CIO Raphael Arndt about what lies ahead for Future Fund. This is the first of a two part interview. The transcript has been edited for grammar space and context.

What are the Future Fund's challenges in 2015?

Assets are increasingly expensive and in places overpriced, because of the sustained impact of the policy of various central banks around the world. And that means that yields are very low by historical standards and it also means that there's a great risk, I think, of quite significant volatility from a shock event. You can identify the problem, but its harder to solve it.

Do you think this is going to continue?

Major economic blocs are starting to diverge as they wade their way through the cycle. So we've got the U.S. starting to grapple with a normalization of monetary policy and the speed of that and I think its clear enough that the economy is recovering, although its fairly lacklustre and slow compared to most recoveries from recessions and we're well progressed in that now. But then if you look at the euro zone, which is just beginning to impose its quantitative easing and there's still a significant deleveraging cycle that has to occur there and there is continued policy risk.

What about your outlook for Asia?

If you look at Japan, they're continuing to struggle with the deflationary forces that they've suffered with for decades now, and there's some quite interesting policy activity underway to try to change that, but we've yet to see the results of that to any significant extent. We have China clearly slowing and some of the traditional stimulus mechanisms, particularly on the fiscal side, being less effective than they have in the past. So there's quite a range of issues to grapple with.

Does this divergence create opportunities?

It does. It's not as simple as saying I like this geographical exposure over that one. There's still a great deal risk. There're no assets that are cheap anywhere. There are two things at our portfolio level. One is that we worry about intertemporal risk decisions. If we think risk is being well rewarded we think we should have more of it, and if risk is being less well rewarded then we should have less of it. So we have been reducing the risk exposure in the fund and building the cash exposure or other liquid asset exposure. So as risk is not being rewarded we've decided not to stretch too far into a zone where it might not be sensible to go at this point in the cycle.

Are there any pockets of opportunities?

There are still some niches that are being reasonably well rewarded, we think. And they tend to be things up the risk curve, so in almost all the asset classes we've got a somewhat risky portfolio now. So in the portfolio we have no sovereign bonds or investment-grade debt, but we have quite a lot of private debt and structured credit.

What about real estate and other asset classes?

In infrastructure and property we've been reducing our exposure to core and looking to buy more higher-activity type strategies where you have to develop something or create something to turn into a low-risk asset that fits the ‘core asset' characteristics attractive to other investors and then sell it. It may be development risk, or it maybe something that's harder to define, so it may be something that falls in the crack between infrastructure and property or between private equity and infrastructure or private equity and equities. We don't mind. We've got quite a small team that can get together and debate opportunities across asset class boundaries and assess an opportunity on its merits.

Have you got the flexibility to take advantage of these opportunities?

Yes. Our mandate from the government is an absolute return mandate over long time periods. So there's no concept of relative return, so that gives us quite a high degree of flexibility in the portfolio construction.

What are you finding your external managers most useful for at the moment?

We use managers for everything, but our approach is what I would describe as hybrid. So we would be a very informed LP and we use managers typically as an extension of our internal teams. So we don't make multiple bets into a number of core products and in effect get the beta of the sector. That would be a bad thing to do particularly when you think that the risk may not be that well rewarded.

But we do have a large number of separate account mandates with managers in which we target specific measures, and that includes where we may retain vetoes over individual decisions particularly in things like debt, or where we do quite a considerable amount of co-investing alongside private markets' managers. We're doing that now in everything from property right through to venture capital.

Have you been looking at smart beta or multi-asset strategies?

Smart beta's just one way of talking about a quant manager. It's not necessarily a new concept. It's more efficient now and there are more options now. But in terms of equities picking a different subset of equities doesn't get away from any broad concerns you might have about the overall pricing of equities in general. Style tilts within equities such as momentum is actually something we've been doing since we began the equities program, so its nothing new. One thing that's been interesting is that the rally that's occurred across risk assets has been driven by a compression in risk premia primarily due to base policy rates. That means that lower quality and small-cap stocks have risen in some cases even faster than higher quality and larger positions and our experience is that active managers have struggled to outperform to the extent that they justify their fees in the last few years.
 

Now that might not continue if the cycle changes, but I think that looking at new ways of being able to implement new ideas more efficiently is something that we are interested in and have done some work around. We do believe in active management, but we do think that it's important that the managers justify their fee structures and are accountable to the value that they actually bring after fees.

Can you tell us about how you go about selecting managers?

We have close relationships with our managers. We have quite a concentrated portfolio â€" we don't have a large number of managers. Our starting point is to assume that we take a passive exposure and move to active only if we believe a manager can add value net of fees. That may not be outperformance, it might be lower risk or a different set of exposures to the broad beta, but we do have quite detailed discussions with those managers and we do seek to take techniques and insights from those managers back into the program and share them widely across the team.

For example, some of the work we've been doing recently has been drawing some of the insights from our equities, debt, property, infrastructure and private equity managers working in emerging markets together. Are there consistent views coming out across sectors and what can we learn from that? Or are they divergent and what does that tell us and how does that inform our investing more generally?


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