Raphael Arndt, CIO Future Fund on Talks About Diversification and Risk (Part 2)

May 11, 2015 by Loch Adamson

#Australia sovereign fund CIO talks diversification & asset allocation #portfoliomanagment
#Australia Future Fund uses its cash position to balance #investmentrisk across its portfolio
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Founded in 2006, Australia’s A$117 billion ($93.4 billion) Future Fund is designed to bolster government finances by offsetting future public-sector superannuation liabilities from 2020. The fund takes a so-called total portfolio approach, which encourages sector experts to share their investment ideas, which often derive from broad-based themes such as demographic shifts or changes in resource availability.

Founded in 2006, Australia’s A$117 billion ($93.4 billion) Future Fund is designed to bolster government finances by offsetting future public-sector superannuation liabilities from 2020. The fund takes a so-called total portfolio approach, which encourages sector experts to share their investment ideas, which often derive from broad-based themes such as demographic shifts or changes in resource availability. 

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

How important is diversification to the Future Fund?

That’s an interesting question. We worry a lot about diversification at the fund portfolio level and that is quite important and we go to great lengths to ensure we have it. The reason we have quite big exposures to hedge fund strategies is to ensure that we want to diversify from equity risk. However, we don’t think about diversification within the equities portfolio or the hedge fund portfolio or the property portfolio. So we’re quite happy to have quite concentrated bets on investment ideas at the sector level provided that they’re not unduly concentrated at the overall fund level.

What’s your view on tactical asset allocation?

We don’t follow the asset allocation approach that’s typical in the industry and the best way I can use to describe what we do is that we do strategic asset allocation very frequently. So we don’t have a concept of a tactical asset allocation away from a benchmark — because we don’t use a benchmark. So we don’t really have a concept of tilting. 

What we do is we look at the world and the risks and the range of scenarios that we see, and we look at the portfolio and the exposures and the relative risk-adjusted price of various assets and we decide what is the best portfolio to construct today based on those themes and then in six months we do it again. If the world changes materially within that six-month period then we will do it whenever we need to do it.

What are the advantages of this approach?

If one particular asset class is especially attractive you have access to it. You’re not constrained by some rules around how far you can depart from some benchmark. For example in 2009 we saw that debt was incredibly attractively priced given where the asset markets had got to after the financial crisis, and we increased the debt exposure from something quite low to 20 percent of the fund. And when the value of debt securities got bid up to the point where we thought that was no longer attractive we reduced the exposure down to something around 10 percent of the fund. 

Is moving such large positions a challenge?

Yes, its challenging to have conviction in your view, and of course you can and will be wrong from time to time. To move the physical asset portfolios you develop over time incurs quite high friction costs from trading positions in and out, not just in terms of buying the securities but also in terms of the impact on institutional culture. If you’ve got a big property team and they’ve bought some really exciting shopping centre in the middle of some big town and they think it’s a great asset then they won’t want to sell it typically.

So that’s why we focus on having a small team that’s connected to the whole portfolio and we use managers because it becomes much easier to make those kinds of decisions. If you manage things internally, it can become very hard to sell assets.

You seem to have a close relationship with the team across asset classes.

We have mugs that carry the moniker "one team, one portfolio" and the investment committee is made up of all the heads of all the sector teams plus the strategy guys, the person responsible for overlays, the person responsible for emerging markets, the managing director and myself. 

We meet at least every two weeks, if not more often and talk about every asset class, every sub-strategy within those asset classes and the macro picture across the whole portfolio. And then every six months we review every asset class in the portfolio, every detail with the entire senior investment team, which is a bit over 20 people sitting down to do that. 

This means that we can debate things sensibly. We can talk about what might add value and where we see challenges and opportunities for the portfolio.

Do you think you will be changing your large cash position this year?

The way to think about the cash exposure is not to think about it as a cash allocation, but to think about it in the context of the overall portfolio. So we have quite risky sector portfolios, so to some extent holding cash against those balances the risk at the portfolio level. So we certainly don’t feel under-risked, the portfolio is exactly where we would like it right now. It would be roughly neutral, it’s not low- or high-risk.But the exposures that we’re actually holding are higher risk within their sectors. 

The second thing is that we’re expecting quite a lot of volatility and being nimble is important. So we’ve decided to implement a bit of our exposure through futures and options and so some of the cash is held against those types of strategies. 

Thirdly we are concerned that we plan for potential events that could be demanding on fund liquidity, and when your home currency is Australian dollars, which is quite a volatile currency, you need to have plans for that. Typically the Australian dollar is correlated with risk, so when we’re at a point where we want to buy assets we’ll have some liquidity drain on the fund, so we’ll have some currency hedges, so we want to make sure that we’re in a position to buy assets when they’re available, so all those things come together. 

Are you making preparations to protect the portfolio?

One of the things we’re thinking quite a lot about at the moment is protecting the downside and buying the upside through various options strategies. So we’ve been doing quite a bit of that because we think that at this point in the cycle it makes much more sense than putting on more traditional risk exposure.

What are your thoughts on securities’ lending?

We don’t do securities’ lending, although we’ve looked at it a couple of times. We think of ourselves as a universal owner of assets and lending your securities to someone who’s going to short them and push the price down doesn’t seem to make a whole lot of sense to us. So we haven’t done that.

Are you engaged in any collateral management or collateral transformation efforts?

In terms of collateral management, we do have quite an extensive collateral program because of the various overlays that we run, but we haven’t tried to get too cute with how we manage that. That’s something that needs to perform in extreme market events so it doesn’t make sense to get too cute with it. 

What role does corporate governance play in your investment decisions?

We always think of ourselves as a long-term investor focusing on the big picture and improving the long-term value of the assets that we buy. Campaigning for corporate governance improvements is part of the role we play. This is something we’ve done since the inception of the equities program and that we’ve chosen to resource internally because we think it’s important. 

We believe we have a role to play and that our peer funds have a role to play in improving the market for everyone, whether that’s corporate governance in listed or unlisted companies or structuring the arrangement of fees and terms with managers or whether it’s increasing transparency in how we go about doing things.

Thanks for taking the time to talk to us, Raphael. It’s been a pleasure.

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