Well-timed moves and a strong governance structure has helped Australia’s sovereign wealth fund mature. So what comes next?
At $226 billion, the Future Fund is the nation’s largest financial asset, but CEO Raphael Arndt still describes it as “a gangly teen in some respects”.
Born into a global financial crisis and maturing through a global pandemic, this “gangly teen” has serious nous as it approaches its 15th birthday. Steered by the unique combination of an involved investment-focused board and an appointed management agency, the fund is chasing ambitious growth in an uncertain world.”
“Population growth is lower, a period of deglobalisation looks likely, there’s reduced free flow of trade and geopolitical issues are becoming more prevalent,” says Arndt from the fund’s Melbourne office. “At best, there’s more uncertainty. It’s a time to question how you do things. We don’t think it’s good enough to say, ‘It’s worked in the past, it’ll work in the future’.”
The Future Fund is almost a year into a project querying its approach to investing, given the fundamental changes in the world, and Arndt says one thing is clear: returns will be lower than those expected in the past. It approaches that challenge with an enviably large cash stock — $33b, its biggest single asset — having sold $6b to $7b of illiquid assets ahead of the COVID-19 crisis, including half its share in Gatwick Airport in the United Kingdom.
The prophetic move was more about the pursuit of flexibility than the quality of the assets. “We didn’t have a crystal ball, [but] it was very clear the assets were expensive in the context of their history,” he says.
“The drag created by the financial crisis had passed and central banks had broadly kept stimulus on, the US Federal Reserve was starting to write notes, there were market jitters. Governments, by and large, were sticking to their austerity message. Corporate margins had been very high. We queried how sustainable that was.”
The writing, says Arndt, was obviously on the proverbial wall.
The Future Fund made a similarly fortuitous call ahead of the GFC. The board began to invest the portfolio into listed equities during June 2007 but, on the advice of its newly formed management agency, slowed the program due to concerns about stretched valuations.
“Something didn’t seem right in terms of market value,” says Arndt, who joined as head of Infrastructure and Timberland in 2008 “just in time for Lehman [Brothers] to go broke”.
The fund entered the GFC in the enviable position of having cash to deploy in a market where assets suddenly looked underpriced. This set the collaborative and data-driven tone of the organisation, which today has 182 staff managing six separate funds.
“Through that early investment period, we had the benefit of a small team and a high level of engagement and that became our whole approach — one of collaboration, avoiding silos, working together. It [was] the genesis of the culture to be research-led and not worry about peer risk.”
Arndt casually throws in the organisation’s work motto: “one team, one purpose”. A singular focus on that purpose — to grow the $60 billion pool of seed capital to cover future Commonwealth superannuation obligations – has seen the team add $118b in earnings to the original fund. It has also grown the five other funds added to its mandate more recently, covering medical research ($21b), disability care ($15b), droughts ($4b), emergency response and recovery ($4b) and First Nations land and water rights ($2b).
We are facing elevated risks and lower prospective returns. In this environment, the board is maintaining its patient long-term approach to investment.
Growth in a global pandemic
For a sovereign wealth fund (SWF), the Future Fund is refreshingly free of restrictions and influence despite having one powerful and informed client: the Commonwealth Government.
On paper the investment mandate is simple. Grow the asset pool at an average return of CPI +4 to 5 per cent per annum over the long term. In reality, it’s not at all simple.
“In the world we’re going into, that is a very ambitious target and it will be very hard to achieve,” says Future Fund chairman Peter Costello AC. It’s an honest admission from the man who created the fund in the final stretch of his 11-year term as federal Treasurer.
Back then, the target was even higher: 4.5 to 5.5 per cent. The rate was reduced from 1 July 2017. Should it come down again?
“Returns in the future are going to be much less than they were in the immediate past,” says Costello. “We’ll work to that target as long as we’ve got it. I would be extremely pleased if we met it, particularly in a world where interest rates are zero.”
When he launched the Future Fund on a Monday night in November 2006, Costello emphasised the critical importance of good governance. A “board of guardians”, not directors, is responsible for oversight of the fund and its management team.
“We have deliberately used the term ‘guardians’, as it is the board’s role to guard these assets against any attempt to steal them from future taxpayers and it is their role to protect the fund against future governments of any political persuasion which might try to use or appropriate them for their own purposes,” he told those gathered.
Since that time, no government has sought to intervene. “I think it’s established credibility and respect for that independence,” Costello tells Company Director.
The Treasurer of the day can set the investment mandate, but the fund can table a statement in Parliament if it believes the government is acting improperly. The current mandate, set in 2017 by then-Treasurer Scott Morrison, is brief: target the benchmark return, do not trigger takeover provisions, do not hold more than 20 per cent in a foreign publicly listed company, do not diminish the government’s reputation in financial markets and do have regard to international best practice for institutional investment.
Costello, who also chairs Nine Entertainment Co, is reluctant to extract lessons for public company boards from the guardian’s governance model. “I wouldn’t try to give public company directors lessons — I am one,” he laughs.
While broadly similar — guardians are subject to the same diligence, skill and conflict-avoidance requirements — they must table audited annual reports in Parliament, are subject to Freedom of Information laws and are more intensely involved in strategy and investments. The board has its own legal identity and provides strategic direction, setting risk limits and asset allocations. The management agency gives recommendations to the board and implements decisions, but the board bears ultimate investment responsibility.
The guardians include Commonwealth Superannuation Corporation chair Patricia Cross FAICDLife, ex-investment banker and Scentre Group non-executive director Carolyn Kay FAICD, former EY Asia-Pacific and Oceania chair Michael Wachtel FAICD and former Treasury secretary John Fraser MAICD. Costello’s predecessors as chair were high-profile directors David Murray AO and David Gonski AC FAICDLife.
Costello prefers comparisons to other SWFs, a peer group in which he said the Future Fund is “regarded as probably the most independent and certainly the most transparent of the global SWFs”.
American economist Edwin Truman has ranked funds for the Peterson Institute for International Economics, assessing them based on transparency and accountability factors — most drawn from the 24 Santiago Principles drawn up in 2008 to address concerns SWFs were being used for political gain. In 2019, Australia ranked 10th of 64 funds, scoring 87 — well above the average of 66.
Costello argues the Australian fund is more independent than Norway’s, which is restricted to offshore investments and liquid asset classes. Some SWFs, like Ireland’s, are focused on domestic investments. Australia’s can invest where it wants, in assets it wants.
The global spread of the SWF
The label “sovereign wealth fund” was relatively new when Costello launched the Future Fund, despite half a century having passed since Kuwait set up its Investment Authority for surplus oil revenues in 1953.
Dozens of savings pools existed in 2005, when they were finally grouped and labelled as SWFs by Andrew Rozanov, then an adviser at asset management company State Street (incidentally, it is among the Future Fund’s investment managers today). His seminal piece, titled Who holds the wealth of nations?, was published in the Central Banking journal. They were managing at least US$2.6 trillion globally in 2007 when US economist Edwin Truman undertook his first ranking exercise for the Peterson Institute for International Economics.
SWFs manage an estimated US$8 trillion globally. Generally defined as a by-product of budget surpluses set up by a nation or sub-nation (like the Canadian province Alberta) and designed for the purposes of stabilising the economy, smoothing the highs and lows of resource revenues, supplementing pension funds, saving for future generations or development.
The largest and most well known, Norway’s Government Pension Fund Global, was founded in 1990 to invest the nation’s vast oil and gas revenue. In Chile, super profits from copper and molybdenum funnel into a fund to stabilise price fluctuations, which have fiscal and macroeconomic effects. Both invest only in foreign assets.
The Future Fund was seeded by budget surpluses and proceeds from the privatisation of Telstra, including 2.1 billion Telstra shares worth $9.2b. Global-turmoil-driven budget deficits ever since have deprived the fund of the hoped-for further injections.
Hitting $179b on 31 March 2021, the main fund has surpassed the initial goal of reaching $140b by 2020 to cover the projected level of unfunded Commonwealth superannuation liabilities it is designed to cover. So, too, has that liability. The 2021–22 Budget projected the government’s superannuation liabilities (two of which — judicial and military – remain open) to reach $269.9b within four years and $427.8b by 30 June 2050 (an estimate highly sensitive to the long-term discount rate applied).
Protecting the Future Fund from the “huge temptation” of covering shortfalls was a high priority for Costello. By law, the government could not make a withdrawal until 1 July 2020; in 2017, it committed to making no withdrawals until at least 2026–27.
Other governments have raided SWFs. Chile used funds in the 1980s and ’90s to try to stabilise petrol prices. Norway withdrew US$37b during the COVID-19 crisis; barely a dint in its US$1.3 trillion balance, even as net cash flows from petroleum plummet. Some argue governments are better off investing in productivity-enhancing measures such as tax reform or infrastructure building.
Apart from the fact that “the asset disappears forever” once spent, Costello says the fund plays a critical role in strengthening the balance sheet. “We’re living off a historical moment and we’re guarding that legacy, and I’m pleased to say it’s still there,” he says like a proud parent. “Without it the balance sheet would be weaker.”
Sustainable investment opportunities
While the Australian share market fell by more than a third in the first quarter of 2020, the fund dropped just 0.9 per cent for the 2019-20 financial year. By March this year, it had recouped losses and grown the main fund to a peak of $179b. Earnings were $16b across the year, with all six funds beating targets.
Arndt credits governments around the world for unprecedented levels of fiscal and monetary stimulus, but is concerned about withdrawal, especially with interest rates at zero.
“The world has examples of double-dip recession in the 1930s, and Japan in the 1990s, after withdrawing too quickly,” he warns.
The Future Fund has set a higher bar for illiquid assets and substituted it for different risk-taking measures beyond the “blunt instrument” of equities, which needs certain conditions — economic growth, falling interest rates, low inflation, stable margins — to drive returns.
Private equity is among favoured alternatives: rising markets are not necessary to make money and can generate better returns sustainably. Private equity was up by more than $1.6b in the March quarter compared to the previous year; comprising 14.6 per cent ($26b) of the portfolio, it is outweighed only by developed market equities (16.8 per cent and $30b) and cash.
The Future Fund favours non-brand name managers investing in capital-hungry emerging and growing companies. The only investments barred by the Future Fund are in weapons and tobacco. The Future Fund has attracted media scorn in recent years for investing in Adani coal, but Arndt says there was no simple do-or-don’t proposition. “It was a more sophisticated approach to say, ‘Do we believe Australia will continue to export massive amounts of coal to places like Japan, Taiwan and China and what risk premium would we apply?’ We track our exposure to it just like we track exposure to interest rate changes.”
The fund’s investment stewardship team is focused on concerns broader than environmental, social and governance (ESG) and works across the entire organisation, ensuring investment managers are asking questions of investee companies around inclusive policies and redefining what a social licence to operate might look like.
Can those issues stop an investment? “Absolutely,” says Arndt. JP Morgan has predicted COVID-19 will prove an ESG turning point, highlighting that total ESG fund assets more than doubled in 2020 to an estimated US$7.2 trillion.
Long-term trends embracing climate-change solutions and the low-carbon economy transition are being embraced by SWFs, International Forum of Sovereign Wealth Funds Secretariat CEO Duncan Bonfield noted in a recent review. Whatever the opportunity, SWFs are poised to capitalise. One estimate put direct investments by SWFs in 2020 at around US$179b — almost double the rate of 2018.
Patiently capitalising on COVID
Dr Geoff Warren, an associate professor at ANU, says the Future Fund is positioned to benefit from market fluctuations. Warren, who spent more than two decades in investment markets and sits on a number of advisory boards, says that long-term investors like the Future Fund are well placed to exploit situations when markets move out of kilter. This can occur for reasons such as investors chasing the latest “theme” and sending prices too high or low, industry-specific funds attracting investors and being driven to buy regardless, or developers collapsing and dumping property.
“Longer-term investors with patient capital are often well placed to jump in when there’s stress in a market that throws prices out of line with fundamentals,” says Warren. “You don’t have to have a view of where the market’s going. You just have to be able to identify what’s been overbought and oversold and be able to wait for markets to readjust.”
Put simply, the right combination of patient capital and sound governance structure can allow “smart people to invest successfully over the long- run”. For the Future Fund, those smart people are based inside and outside. Their investment mandate requires the use of external managers (subject to ministerial exemption). This nestles the fund between the Norwegian model of investing largely in liquid listed markets and the Canadian model of investing directly in assets such as infrastructure and private equity managed by large internal teams.
The fund’s list of asset managers reads like a who’s who: Macquarie Investment Management, UBS Securities Australia, Archer Capital, Brookfield Asset Management and Citic Capital, among others engaged in contracts worth more than $224m.
The fund’s relatively small, tight-knit management team allows everybody to be involved in decisions and takes a total portfolio approach rather than creating silos or protecting patches. “Under an asset-weighting approach, an infrastructure manager may be allocated funds and is under pressure to find something just to fill the bucket,” explains Warren. “The Future Fund won’t do that. They’ll ask if an asset stacks up versus everything else.”
This fits with Arndt’s insistence that no asset lives in isolation. Across everything, the team approach prevails. “If Japanese stocks underperform, you don’t want to go to your equities team and say, ‘You’ve underperformed’,” says Arndt, who held the role of chief investment officer before his promotion in mid-2020 (Sue Brake is now CIO).
Warren says the Future Fund also benefits from something other funds could never emulate: an absence of concerns that its investors might “walk out”, giving it room to invest in illiquid areas and the comfort to take a long-term view.
“In the fund management industry, it is often very hard to sit back and say, ‘I’m going to make this investment even though I’m not sure it will pay off, but I think it’s cheap and I’m going to sit back and wait patiently.’ There is constant pressure to deliver shorter-term performance.”
The fund’s governance structure deviates from the textbook standard of very clear separation of board from management, but Warren believes it is a source of strength. Rather than sitting at an arm’s length, the board of guardians has a closer relationship with the management team and “go along for the ride” in terms of investment decisions.
The advantage of this approach is that the board can better understand why investment decisions are made and see them in a total portfolio context, rather than judging on performance alone. This helps when an investment goes awry. The conversation can then turn to whether the decision was appropriate in the circumstances, rather than whether the management has failed.
Still, the Future Fund has not avoided staff turnover. In 2018–19, the rate jumped to 18.6 per cent from 5.2 per cent due to a restructure. Last year, it was 10.8 per cent. Departures included high-profile and senior figures, some having been there for more than a decade. But Arndt says the turnover before that period was too low. “You do need fresh blood.”
The Future Fund is engaged with investment managers to ensure they take a similarly forward- thinking approach. “Forcing more cognitive diversity — whether gender, background, bias, race — into investment decisions is an imperative for the industry to be successful going forward,” he says.
“The world’s going through fundamental change and it’s important to not fear change. Older, more experienced people — our bias is to see the world through our own experience. No-one has a monopoly on good ideas.”
For Arndt, this is not an empty mantra. His first task as CEO was to conduct a listening tour, despite the predominantly Melbourne-based staff being in lockdown. An app allows any employee to anonymously ask questions and a wiki-poll of all staff generated 70 ideas, which was narrowed to 10- 15. This year, staff returned to a new open-plan office designed for collaboration and connectivity.
Arndt speaks to Company Director from that very office in a balanced and no-nonsense tone and when the video link appears lopsided, he has a practical suggestion: “Sometimes if I pick up my laptop and move it, it fixes it.” Sure enough, it does.
He might speak for the fund, but Arndt is adamant the challenge belongs to the entire team. “We don’t have the luxury of thinking we know what we’re doing — no-one knows what they’re doing,” he says. “I’m really the coach — that’s my job.”
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