Queensland Investment Corporation’s (QIC) CIO of State Investments, Allison Hill, sees private debt as a key part of the $60 billion portfolio she oversees.

“We have introduced private debt as a dedicated stand alone asset allocation within a portfolio,” she says in an interview with Investment Magazine.

“The majority of our portfolio has a long term horizon. We’re leaning into private debt because of its floating rate nature. It has lower duration impacts on the portfolio, while still being able to earn a reasonable spread.”

The strategy comes alongside the fund’s concerns about the short term outlook for shares. “From a more tactical lens, we have short term concerns on valuations in relation to equities,” she says.

Hill says the share market has yet to fully reflect the potential for a downturn in company earnings after a year of significantly rising interest rates.

“We haven’t really seen too much flow through equity markets as a response to what will likely be a slowdown in earnings and potentially a contraction in margins associated with the fact that central banks globally are trying to slow economies.”

“Companies seem to have been able to pass through price increases to consumers to date, but if the consumer becomes a bit softer, companies may need to compromise somewhat on margins. We haven’t really seen any valuation impacts flow through from either of those outcomes,” she says.

QIC is confident about the long term outlook for equities, but cautious about the short term. “We certainly continue to be exposed to equities- but at the margin we are tactically underweight equities on the view that we do think there could be some softer earnings quarters to come,” Hill says.

Restraints on bank liquidity

Hill says increasing controls on the traditional banking sector have made issuing private debt attractive for some companies and the sector’s returns have also made it increasingly attractive for suppliers of private capital.

“Generally [issuers of private debt are] corporates that don’t want to go through the public markets for one reason or other. It might be that it is sub-investment grade, it might be that they want flexibility and ease of transaction outcomes.”

She says banks are increasingly restricted by capital adequacy regulations. “A lot of those are very important for the stability of the financial system but it means that their process is potentially a bit slower. So there’s a lot of companies that chose, for speed and expediency, to access private debt markets.”

“There is a lot of capital being provided into the market as there is quite a lot of demand. It’s an area that we have grown, but also many institutional investors have grown materially over the last few years.”

Hill joined QIC in January 2018, from her previous role as chief executive officer of DMP Asset Management. She was named chief investment officer of its state investments team in September 2021, overseeing the investments of a range of Queensland government entities, reporting directly to QIC’s chief executive.

Hill says the $60 billion portfolio she oversees now has an eight per cent allocation to private debt over the long term. “We have exposures domestically as well as mandates across Europe and the US.”

In August 2022, Hill’s team awarded a $500 million mandate to QIC’s multi-sector private debt team for loans originated in Australia and New Zealand which typically range between $20 and $50 million, increasing to as much as $75 million per transaction.

QIC’s growth

Her role is an important part of QIC. Set up in 1991 as the Queensland government’s specialist investment advisor and whole of fund manager, QIC now manages around $100 billion for both state government entities and external third party investors.

As CIO of its state investments team, Hill works with Queensland government entities to handle their investment needs. “We work with a range of boards across government entities,” she says.

“We sit down with our clients to make sure we carefully understand the risk tolerances of that entity and other parameters such as future cash flow requirements. From there, we build diverse asset allocations that the clients agree on and are approved on an annual basis.”

“With those objectives, for the majority of our clients, we have full delegated authority to invest in the best way possible within a strategic asset allocation.” She says the role includes recommending new asset classes to invest in, a process which has included private debt.

QIC’s role has grown significantly since it accepted third party investment mandates for its special investment funds.

Some $40 billion of its total $100 billion in assets under management are invested on behalf of more than 100 external institutions both in Australia and overseas, including superannuation funds.

As CIO of Queensland state investments, Hill’s team invests about half of its funds through QIC’s specialist funds and half with external third party managers.

“We have really good relationships with our internal team,” she says. “It’s a really good advantage for us.”

Her group invests in “the same structures and strategies” that third party institutions do with QIC. She says third party institutions which choose to invest in QIC products are “an independent verification from clients globally” of their quality.

Some 35 per cent of the portfolio under her management is invested in long term, illiquid assets.

Her role also includes working on the state government investments for Brisbane’s new Cross River Rail project which involves four underground train stations and above ground development as well as technology and innovation projects for Brisbane office precincts.

One of the sites is Woollongabba which is the location of the Olympic Stadium. “It will be transformative to the Brisbane CBD and the Brisbane skyline. The opportunities we have from these sizable pieces of land can help build the city of Brisbane in the future.”

The simultaneous decline in prices in equities, government bonds and corporate credit on a scale not seen for many years hit global charitable foundation £34.8 billion Wellcome Trust’s portfolio last year. But in its latest annual report, the charity established in 1936 with legacies from pharmaceutical magnate Sir Henry Wellcome, states that its allocations to property, some hedge funds and holding most of its assets in currencies other than sterling, also stood it in good stead, helping the portfolio return 1.7 per cent in the year to 30 September 2022.

Black spots

One of the worst hit portfolios was public equity, although Wellcome had prepared for a more difficult environment by holding fewer equities (its lowest allocation this century) and more cash. The £13.7 billion public equity portfolio returned -12.7 per cent in absolute terms and was the principal cause of weakness in the broader portfolio, although the internally managed equity portfolio (the Global Compounders Basket) did better than mandates with external managers.

Indeed, Wellcome’s £4.0 billion portfolio of outsourced equity had a “very poor” year. No manager outperformed their underlying benchmarks with the worst performance in absolute terms coming from global growth where the portfolio was down -37.4 per cent. Still, the report states, “We can tolerate this kind of volatility given our long-term perspective – this manager has been in our portfolio since 2003, during which time they have delivered annualised returns of +11.6 per cent.”

Now Wellcome Trust is watching for an opportunity to deploy capital back into public equities, which, it says, (at the right price) should be the default liquid asset class for long-term, unconstrained investors.

(Some) hedge funds do their job

Wellcome’s £4.9 billion hedge fund portfolio (12.4 per cent of total AUM) protected value and delivered a positive return of +5.7 per cent. However, there was wide dispersion within the portfolio. The absolute return funds, which are hedged with sophisticated risk systems and can seek profits in any asset class, delivered +33.7 per cent. In contrast, the £2.3 billion allocation to equity long short hedge funds failed to protect on the downside and delivered a worse return than global equities at -13.3 per cent. Cue possible changes ahead.

“There will be some changes to composites from next year,” the report states. “As a group [long short hedge funds] have underperformed the long bull market in equities and failed to protect our capital as the market has turned. This has led us to consider carefully our exposure to these vehicles.”

However, the report also notes a wide dispersion among long short managers, indicating that some have adapted more rapidly to a very different environment than others. The best performing manager was up +16.2 per cent, while the worst was down -50.0 per cent.

Going forward, Wellcome plans to aggregate reporting on the equity long short funds with its public equity exposure, given the high correlation with equity market returns. This reflects the objective for these managers to deliver a superior return to equities through the cycle by adding value on both the long and the short side. “It is, as we have seen, a tough task,” states the report. The absolute return funds will continue to be reported separately.

Stalled private equity

Despite a one-year return of +7.7 per cent, Wellcome’s £14.8 billion private equity portfolio has not escaped unscathed from drawdowns in major liquid asset classes. Sizeable mark downs are linked to underlying companies requiring fresh capital, something Wellcome expects will be repeated more widely across private assets over time. Moreover, cash flows from the private portfolio have turned negative as IPO markets have slowed down and distributions dried up. However, Wellcome will not pare back investment. “With capital now scarcer, our PE partners are more likely to seek willing co-investors and we are open for business.”

The investor is also keeping more cash on hand in anticipation of distributions remaining thin. “We are keenly aware that cash holdings are rapidly eroded by inflation but for now, we remain content to retain the optionality of a higher than-normal cash balance, especially as it seems likely that distributions from PE will remain subdued for the foreseeable future,” states the report. The largest portion of the private equity portfolio lies in VC funds (£8 billion) bringing exposure to “some of the most exciting, innovative companies in the world.”

Strategies relying on access to abundant cheap leverage will face a particularly difficult future, adds the report. Inflation is a key challenge for all investors but our portfolio strategy of holding real assets (equity and property) and issuing fixed rate nominal debt should provide some protection over the long-term, states the report.

ESG

Emissions in Wellcome’s public equity portfolio have fallen 35 per cent over the last year. A year-on-year decline Wellcome links to its exits from holdings in BP and Shell, sold as part of a strategy of reducing exposure to cyclical stocks. “Of course, our exit from these holdings has not reduced overall carbon emissions, simply those that are linked to our own portfolio.”

Outside of public markets, Wellcome notices increasing recognition that buyouts managers’ longer investment horizons and advantageous governance structures mean they can play a significant role in catalysing the transition. “But there is much work to be done here.”

Wellcome has written to its buyout partners to share examples of best practice and set out its view of gold standard net zero target setting in private equity. “Positively, some of our buyouts managers already have net zero targets, which include commitments to require this from portfolio companies,” it states.

China

Wellcome’s annual report also alludes to the impact of decoupling trends. There remains every prospect that the economies of many Asian countries, including China, will grow faster than those in Europe and North America, it states. However, as the last two years have demonstrated, it is not always easy to translate economic growth into portfolio returns. “The assumption that we can access investment opportunities across the world in a relatively unimpeded way may no longer be valid if we see increasing fragmentation in the global economy and a retreat from integration.”

 

 

It’s possible that a traditional 60:40 passive portfolio could get close to a target long-term return of 7-8 per cent this year in a trajectory not seen for the last 12 years, according to Rich Hall, CIO of $65 billion University of Texas endowment. The brighter outlook comes after one of the most torrid years for investors in over a century and is a view different to some investors that are questioning the validity of 60:40.

 

It is possible that a traditional 60:40 passive portfolio could get close to a target long-term return of 7-8 per cent this year in a trajectory not seen for the last 12 years. So said Rich Hall (pictured), chief investment officer of $65 billion University of Texas/Texas A&M Investment Management Company (UTIMCO) speaking at the firm’s last board meeting together with president and chief executive, Britt Harris.

“Instead of a headwind, we could have a tail wind pushing us along for the next ten years based on where asset classes are right now,” Hall predicted.

The brighter outlook comes after one of the most torrid years for investors in over a century and it’s a view different to some investors including the Future Fund that recently published a paper on the death of traditional portfolio construction (see interview with Future Fund CEO, Raphael Arndt, Investment industry needs to rethink strategy).

“2022 was a year like no other that any of us in this room have ever experienced. We just went through a 150-year event by a wide margin,” said Hall, adding that last year was the first time since the 1870s that both equities and long bonds were down by more than 10 per cent in a double whammy that has wreaked havoc on many portfolios.

Reflecting on a tumultuous year – and his reason for forecasting brighter climes ahead – Hall began with a little financial theory.

The rate on cash is a key component of the discount rate used to value assets like stocks and bonds, he said. The discount rate and asset prices have an inverse relationship whereby the discount rate goes down and asset prices go up. In another rule of thumb, the price investors pay when they buy an asset has much to do with the return – and the higher price they pay, the lower return they can expect.

In a third norm, Hall described how investors expect higher returns for holding risky assets – cue that upward slope on a risk premium line. It’s why over the last 40 years of a secular declining rate environment, assets prices have crept relentlessly higher.

Investor strategies through this time have included levering their portfolios with an all-weather approach while others have built up their private investments or tried to lower costs, said Harris who described returns over the last decade as lower and taking longer to achieve – like flying in a helicopter rather than a jet plane. “It took us for ever to get across the pond, but it [financial repression] kept us in the zone of growing financial markets,” he said.

When COVID hit unleashing monetary and fiscal stimulus, real rates turned negative and nominal rates went to zero sending asset prices even further north. “Asset prices soared in 2021 and everything was feeling pretty good. Then inflation emerged and the story changed,” said Hall.

The machine swung into reverse with the Fed raising rates, causing multiples to compress and asset prices come down in a painful adjustment. Rates are now around 4 per cent and expected to climb to 5 per cent or above in a trajectory that is causing bond prices to fall and corporate PE multiples to compress. “The market is still trying to sort it all out,” said Hall.

If the Fed is successful in fighting inflation, Hall said expect a reversion to the mean whereby short end rates come down creating positive returns – however he cautioned that it is still unclear what will happen in equities. Expect near term volatility as the market settles into a new equilibrium, he predicted, adding that longer-term the outlook has improved materially from last year: long term capital assumptions for asset class returns are much healthier and returns should increase.

Portfolio implications

UTIMCOs portfolio is split between a 16 per cent allocation to stable value comprising long treasuries, hedge funds and cash; a 65 per cent allocation to global equity (25 per cent of which is private equity) and a 10 per cent allocation to real return made up of assets like natural resources, infrastructure and inflation-linked bonds.

UTIMCO’s exposure to both equities and the oil price – via oil and gas leases on 2.1 million acres in West Texas – provides a powerful source of diversification. When oil was range-bound in the five years prior to the pandemic, stocks rose. Post Covid, stocks have been down, but oil has been up at $120 a barrel and is now around $80 sending royalties coming into UTIMCO’s Permanent University Fund through the roof.

“It’s how diversification works really well,” said Hall. Still, Harris noted that OPEC’s “huge mistake” to flood the world with oil on the eve of the pandemic had grave consequences for oil prices – and for that diversification.

UTIMCO CULTURE and Management

Away from markets, Harris reflected on UTIMCOs management and culture. The asset manager’s technology function was struggling in a way that was “effecting everything” until personnel changes solved the issue, he told the board. Elsewhere, personality problems that had plagued the legal and compliance group acting as one have been ironed out.

The most opportune management structure within an organization is having around 40-50 per cent of the team in middle-ranking positions, reflected Harris. Twenty per cent should be in the top echelons and the remainder in junior positions.

“This demographic makes sense,” he said, noting that challenges can occur if an organization has too large a pool of junior people and lacks muscle in the middle.

He also noted that value systems and priorities of younger generations are different. Although younger staff can do things faster than their older peers, they may lack professionalism around deadlines or keeping their word. Indeed, UTIMCO makes much of its culture of integrity and character.

“You either have it or you don’t have it. And if you don’t have it, we don’t care what else you have.”

Reflecting on a team that often work close to 24/7, Harris said that achieving a work life balance in the investment industry remains an enduring challenge because it is irreconcilable with outperformance.

“What people really want is a work life balance. My response is that I want this as well, but I can’t say I have a great work life balance. How do you have a life that is healthy, and outperform?”

One way to address this is via playing to people’s natural strengths. This requires self-awareness, and putting people into the areas they are most suited so they do less hours and can achieve more.

 

 

Better internal investment integration and co-ordination will underpin long-term returns for two of the world’s largest investors, but they’re also closely focused on how cultural issues – including diversity and team-building – affect whole-enterprise performance.

When the Canada Pension Plan Investment Board was initially endowed with C$200 billion (then around US$146 billion) in 1997, it did what it had to do: it went out and built an investment capability, across asset classes, and across geographies.
But as the fund turns its attention to how it’s going to operate as potentially a C$1 trillion ($730 billion) fund, CPP chief investment strategist Geoff Rubin says a siloed structure won’t work.

Now, the fund is examining how it can integrate and foster better communications across its investment and administration operations, not only to reduce costs but to also improve investment performance. But CPP is contemplating more than just a structural reinvention; it’s also thinking hard about how cultural factors affect team success.

“The solution to the problem was very clear 15 years ago: go build active investment capabilities to transition that passive liquid portfolio into active investments that can generate superior returns at the same level of risk,” Rubin says.

“That was it: go build it. Go build a real estate investing team and capability and go build private equity, and credit and hedge funds, go build these teams – oh, and go build a risk department and an HR department and all of these enabling functions.”

Now, Rubin says, as CPP Investments plans for the day it reaches C$1 trillion in assets it’s facing a different challenge.

“It’s about orchestrating those active capabilities in the most effective ways,” Rubin says.

“And it’s about building connections among them to help develop and sharpen some of the edges [of competitive advantage] that we talked about earlier.

“This is a really important evolution for our organisation, because for about 10 years, we were an organization [that] could do it all, because we had this huge liquid passive portfolio to draw upon. Now we’re in a land of constraints.

“This need to prioritise is increasingly becoming a demanding challenge for us as we transition from this organisation that has been building capabilities to one that’s orchestrating them in the most effective ways.”

It’s about more than investing

The operational and logistical issues that come with connecting the organisation’s disparate internal elements into a coherent whole are significant. But Rubin says “you can throw all that stuff on the fire and burn it if you don’t have the culture that people are really indexed to and enthusiastic about the overall organisational mission”.

“When we were in silos, people felt identity and fidelity to their group or their team as much or even more so than the total organisation,” he says.

“We would do these annual offsites where the teams get together, and they would just kind of glower at each other from different corners of the room. There was something culturally missing around a real excitement to not just connect, just for kind of baseline reasons, but [also] to connect in order to make ourselves better investors, in order for us to be the most effective private credit investor in the world, to have those people really hungry to connect with their colleagues in ways that they can draw upon their relationships or their insights or their techniques and use that in their investing area.”

Rubin says CPP’s rebuilding will be “a combination of some of these structural elements of how we allocate capital and how we evaluate the portfolio, but it’s really going to rely on this cultural piece of making sure that that people’s identity in this organisation is CPPIB”.

Diversity is crucial

An appreciation of cultural issues has also informed how the $307 billion CalSTRS has rethought its approach to investing. The fund’s chief investment officer Chris Ailman says diversity within an organisation is critical to support better decision-making and producing better outcomes for fund members.

“The best way I can put it is, if your entire staff was all hired from one university or one business school, you actually probably would be a little bit worried,” Ailman says.

“And then on top of that, they’re all the same. Let’s say they’re all from one part of Australia. It’s not very diverse. It wouldn’t even matter if they were different ethnic backgrounds. You would look at that and say, ‘well, it’s kind of close to groupthink and I’m a bit worried about that’.

“And that’s really the way we tried to approach this is from an investment standpoint, which is, diversity brings out better diversification, better thought.

“There’s a reason it was called Lehman Brothers, rather than Lehman Sisters or Lehman Family. I often say to people, just think of your families. Things are usually debated heavily before decisions are made. And that’s what you want in an investment process.

“You want somebody who can look at things from all different sides and really debate it out. We know from biology and human psychology that people think in different patterns. And that’s a good thing.

“So instead of having everybody, you know, look like me – pale, male and stale – and think in a little A-B-C-D-1-2-3 kind of linear pattern, I want people who are different, come from different backgrounds, different schools and think about it totally differently.

“And boy, we have that. And it leads to lively debates, which are good because I think it yields better investment decisions. It doesn’t mean we avoid all the risks, but you certainly know when you get people with different backgrounds, they just look at the issues in different ways.”

You get what you pay for

Rubin says CPP aims to align remuneration and compensation structures with the concept of being a single investment entity, but this has some clear challenges. It’s not always obvious how a single individual’s effort contributes to the whole-enterprise result. Some will resist the idea that their compensation might be dependent on the performance of others in the organisation as much as their own. Sometimes non-monetary rewards can produce the required outcomes.

“Historically, folks have expressed limited ability to impact and have line of sight to exactly how their efforts are driving the total fund,” he says.

“In a big organisation it can be difficult [to define] this line of sight, this conductivity of incentive and alignment, and drive to what you’re trying to achieve at the total I think is that is vitally important. Comp is a piece of it.

“It’s not going to be the whole, and some of it is reward beyond compensation – it can just be what culturally people really prize internally; or the success stories; or the congratulation emails; or are the promotions centred around those who are making the organisation a better investor, or is it around people who are just focused on their narrow P&L to the exclusion of what’s happening elsewhere?

“I think we need to work through all of that and comp is going to be a big piece of it.”

One of the many challenges inherent in today’s unpredictable financial markets is holding a defensive position that is also nimble enough to benefit from sharp movements in equities, bonds, and currencies like those witnessed at various points last year.

With this in mind, Pablo Bernengo, CIO of AP3, the SEK464.9 billion ($45.6 billion) Swedish buffer fund, currently oversees a lower-than-normal equity allocation –  42.1 per cent of total AUM at the end of June 2022. The cautious strategy is also manifest in tilts to defensive sectors and quality factors within equities, whilst in fixed income, the fund has begun to shift to longer duration assets after positioning for rising interest rates for most of last year.

The belief is that inflation (which he says is waning but still far from beaten) and recession will continue to impact economic health and markets.

“The current market regime is not a good one for risk assets, but from time to time we have rallies that we need to use for the good of the portfolio, so we do need to be nimble,” he says.

AP3’s ability to actively navigate and benefit from volatile markets is rooted in a reform process undertaken by Bernengo when he joined as CIO in 2019. It involved restructuring the portfolio by replacing decade-old, separate alpha and beta allocations with a traditional asset class structure and appointing new asset class heads.

“We have undergone a lot of changes in both the way we view the portfolio and the organization,” he says.

One driver of the reform process was AP3’s portfolio managers requesting bigger investment teams and a better platform via which to share ideas and discuss asset class-specific strategies.

“Teams were a bit siloed and fragmented, and we wanted a better platform to lever our capability,” he recalls. “We wanted to work as an entire organization, and in larger rather than smaller teams, with common goals and purposes. The world is complex, and this was an effort to simplify it as much as we can by making things transparent, both for internal and external purposes.”

Above all, the restructuring made it easier to understand the investment process, particularly around risk.

“Risk analysis of the entire portfolio was somewhat complicated by the old portfolio structure and organization, and we wanted to remedy that,” he says.

more In-house

The reform process also involved bringing more active equity management in-house so that the internal/external split is now 60:40 in favour of internal management – the reverse of when he joined – although allocations like small caps and emerging markets where AP3 doesn’t have the expertise remain outsourced.

Alongside the realisation that AP3’s internal team were more than capable of running the allocations themselves, other factors drove the inhouse strategy. It has lowered costs (expenses in relation to fund capital amounted to 0.08 per cent in 2021) and has also allowed the fund to increase the active risk it needs to meet a return hurdle of 3.5 per cent over time.

Around three quarters of the whole portfolio is now managed in house by a team of around 30.

Sustainability

Bringing assets in-house to get a better handle on active risk also fits with Bernengo’s ambition to accelerate sustainable integration across the portfolio and take greater control of AP3’s sustainable investment process. The new structure and organization has become a central pillar to sustainability strategy, he says.

“Active risk and sustainability go hand in hand. Sustainability is really the biggest thing occupying my mind and it should be the case for every other asset owner. There should be a sense of urgency in the ESG space of which climate is the most acute.”

Sustainability strategy has been taken out from under a team that also looked at macro issues relating to the entire portfolio and put in a standalone division tasked with taking sustainability to “the next level.” The focus is on supporting the equity team, fixed income, and alternative portfolio managers to achieve sustainability in the different asset classes, he says.

Integration has been easier in some allocations than others. For example, Bernengo notes particular success in real estate (AP3’s largest alternatives allocation) where the fund’s ownership stakes in successful property companies allow it to control strategic direction. Like Vasakronan, Sweden’s largest real estate company, which owns, develops and manages commercial real estate throughout the country and is owned by AP3 in partnership with sister funds AP1, AP2 and AP4.

Call to action

Going forward, Bernengo says the sustainability strategy will increasingly focus on corporate engagement. Here his aim is to sift through the multiple initiatives and layers that tend to complicate engagement to focus on a hands-on approach and AP3’s core rationale: to reduce emissions.

“The problem is not that hard to grasp,” he says. Some of the companies in the portfolio have a large carbon footprint, and the fund is now mapping these companies and engaging with them.

“We don’t want to get to net zero by selling our brown assets because if we sell them, we achieve nothing on the ground,” he says.

The listed equity portfolio contains around 1,600 companies and ownership varies from small stakes in large foreign companies to significant stakes in smaller Swedish companies. In foreign companies, engagement usually involves collaboration in the Council on Ethics of the Swedish AP funds and with other institutional investors. When it comes to Swedish companies, AP3 is more active via dialogue and voting. In 2021, the fund voted at almost 1,200 general meetings, including 160 Swedish annual general meetings.

The biggest challenge is where to best focus AP3’s limited resources, concludes Bernengo. The fund’s advanced, active management is already resource-intensive, and engagement involves extensive work although data is making it easier.

“We are expected to do a lot, but our resources are not unlimited. There are so many things that need to be done,” he says. “We are capable, but we are not a large organization.” The solution, he says, is to “keep focused on areas where we can make a difference both for the good of our portfolio and society at large.”

 

Persistently challenging market conditions mean 60:40 needs a re-think according to Raphael Arndt, chief executive of the A$240 billion Future Fund.

“The conditions where that worked don’t exist anymore,” he said. “It’s time for investors to take notice of it and act.”

He said there was a need to rethink investment strategies to cope with the difficult era ahead of stagflation, uncertainty and volatility, the response to climate change and populism increasingly shaping government decisions, prompting them to take a more aggressive approach to regulation.

Arndt said markets would be impacted by central banks withdrawing liquidity from markets- reversing policies which had been provided tailwinds for investors since the global financial crisis, a growing US Federal budget deficit which would “suck in liquidity” from investors around the world, and the pressure for decarbonisation and investment in renewable energy.

He said the period ahead was akin to the period in the wake of the US Civil War and the railway boom of the late 1880s which was followed by booms and busts in the US and Australia.

“We want to start a conversation on this as we think this is profoundly important,” he said.

The fund is keen for the investment community to start discussing the implications of the ideas in its latest position paper: The death of traditional portfolio construction.

Managing the portfolio

In response to the investment challenges Arndt said the Future Fund has reduced its exposure to equities, which are now down to 25 per cent of the portfolio − compared to a more conventional portfolio which could see equities as high as 60 per cent − and increasing investment in private equity, commodities including gold for the first time and infrastructure assets.

The Future Fund has also signalled that it sees value at home in the current environment where it expects the Australian dollar will do well and is cautious about the outlook for the US dollar.

“We’re looking for inflation protection in property and infrastructure assets, especially in Australian infrastructure assets,” he said.

“We think more domestic exposure for an Australian investor makes more sense than it did before because of political risk and deglobalisation issues.”

The Future Fund has picked up a 3 per cent stake in Sydney airport from the New York-based Global Investment Partners which was part of the consortium of institutional investors which took the ASX listed company private in a $24 billion deal finalised in early 2022.

Other recent deals for Australia’s sovereign wealth fund including being part of a consortium in 2021 which bought Telstra’s mobile phone towers in a $2.8 billion deal and buying a 24 per cent stake in Canberra Data Centre in 2020.

Ardnt said he expected Australia’s commitment to move to net zero would provide increasing investment opportunities locally.

In 2021 it bought renewable energy company Tilt in a deal with QIC which saw the company, which was listed on exchanges in Australia and New Zealand, delisted, and its Australasian assets split between two owners.

The Future Fund already had exposure of more than $1 billion to seven different infrastructure assets in Australia.

“We already have a lot of exposure [to traditional infrastructure in Australia],” he said. “We think there is a huge demand [for investment] to decarbonise the economy.”

Investment mandate

Under its enabling legislation, the Future Fund is not allowed to invest directly or to own companies, having to do its investments through external funds.

The mandate for the Future Fund itself includes an investment target of 4 to 5 per cent above inflation over the investment cycle with the other funds under its umbrella each having slightly different mandates.

Ardnt said achieving returns of CPI plus 4 to 5 per cent was “incredibly challenging” in the current environment.

“We’re using every tool in our kit and we have more than most. We think we can, but it will be really challenging for us,” he said.

Arndt, who has a long career in infrastructure investment, joined the Future Fund as head of infrastructure and timberland in 2008 after six years as investment director with infrastructure investment specialist, Hastings Funds Management. He was appointed chief investment officer in September 2014 and was promoted to the role of chief executive in July 2020.

When it was founded, it was feared the Future Fund’s investments could cause shock waves in the Australian share market if it were rumoured to be interested in a specific company or sector.

Arndt said the fund had “vastly reduced the amount of equities we hold” because of its view that unlisted assets such as private equity and infrastructure provided much better protection against inflation.

With expectations of a prolonged period of slow growth for the world economy, the fund believes that returns from the share market will be lower and more riskier than in the years past when they were fuelled by years of low interest rates and other aggressive stimulatory policies from central banks.

The shift in thinking has seen the fund make its first investments in gold.

“Commodities should do well in a period of high inflation,” he said and the push to renewable energy would lead to an increase in demand for commodities which Australia owns.

The next CIO

Arndt said the Future Fund would look for a new chief investment officer in 2023 following the departure of former CIO, Sue Brake, last June for family reasons.

Brake had been CIO since December 2020, taking over from Arndt when he became CEO after six years as CIO.

The Fund last year appointed three deputy CIOs reporting directly to the chief investment officer – Wendy Norris, deputy CIO in charge of change and innovation, Ben Samild, deputy CIO in charge of portfolio construction and Alicia Gregory, deputy CIO private markets. The Future Fund now had 85 people in its investment team.

Arndt said he had been doing the job of CEO and CIO in recent months since Brake’s departure because of the work being undertaken for the position paper but the fund would begin thinking about the new role early in the year.

Craig Thorburn, director, in the CIO’s office at The Future Fund will speak on the position paper at the Fiduciary Investors Symposium in Singapore from March 7-9. For more information and to register click here. For asset owners only.