Asset owners should rethink their relationships with outsourced managers and can begin by asking some fundamental questions, says BBC Pension Scheme chief investment officer James Duberly.

The £16 billion fund ($22.4 billion) has experienced a transition in the type of manager it has used, due to an increase in alternative assets. As a result, it has had to rethink the type of relationship it wants to have with managers.

All of the fund’s assets are handled externally, across about 35 mandates.

“We are highly reliant on our fund manager relationships,” Duberly told delegates at the UK’s Pensions and Lifetime Savings Association investment conference, held in Edinburgh at the beginning of March.

At the BBC fund, the largest five managers run about 60 per cent of assets, and many relationships are long term.

“More than 20 managers have had relationships [with us] for five years or more, and some have had relationships [with us] for more than 30 years,” he said.

The managers with the largest allocations are Pimco, which handles global and UK bonds, and two active equities managers – Baillie Gifford and Sanders Capital.

The fund doesn’t have many traditional active managers. Since 2001, it has moved away from active listed strategies, with the percentage of such assets in the fund decreasing from 38 per cent to 16 per cent. At the same time, there has been a significant increase in private and alternative assets.

“We have a disproportionate number of managers in that space – more than 25,” Duberly said.

While the fund increased its allocation to alternatives, it also tried hard to keep a lid on fees and costs.

“For a lot of managers we’ve added, we are not paying performance fees, it’s only in private equity and more aggressive strategies we pay performance fees,” he explained, adding that since 2001 the fund has reduced fees by 40 per cent. But he also pointed out that some things are more important than the price tag.

“Knowing what you’re buying generates a more constructive dialogue and more focus for the manager on working in our interest,” he said.

Duberly gave delegates a checklist of questions to ask themselves in rethinking their manager relationships – questions he and his team of five asked themselves:

  • Do we have too many managers?
  • Should we focus on specialist or broader relationships?
  • What should we delegate to whom, or at what point do we not invest?
  • What’s the driver of manager selection, is it to find skill or is it asset sourcing?
  • How should we think about alignment with managers, is it just financial or are there softer ways to find ourselves more aligned?
  • When and how do we interact with managers? When do we get them to speak to the investment committee and what about? What do we do when their performance is bad?
  • Look at the importance of contracts. How can tight contracts help in difficult situations?
  • How can we set up our managers so that they are able to do a better job for us?

The $1.4 trillion Government Pension Investment Fund of Japan is using ESG as a better beta strategy, to improve the market as a whole, rather than to seek excess returns.

Professor Yasuyuki Kato, finance professor at the Graduate School of Management At Kyoto University and board member of the $1.4 trillion GPIF, said a fund that size cannot beat the market, because it is the market, so it needs to focus on creating wealth not trading it.

Giving the fifth lecture in a series to honour the 91-year-old Harry Markowitz at the University of Washington’s Foster School of Business in Seattle, Kato said improving the market as a whole was especially important in Japan, where local shares have experienced very low returns over the last 10-15 years.

“If ESG ratings are reflected in stock prices, the stock price will go up if the ESG ratings in the company improve,” he said. “Because of our size, we can only buy and hold, and end up with the market average. We can only improve performance by improving the market return; we are expecting ESG will contribute to this.”

The fund has slowly been moving out of domestic bonds, first diversifying into domestic equities and then gradually into international assets. In the last five years, GPIF has doubled its allocation to domestic equities, so market return is more of a concern to it than it has been in the past.

In 2007, about 72 per cent of the fund was in domestic bonds. Asset allocation by the GPIF at the end of September 2017 was domestic bonds (28.5 per cent), domestic equities (24.35 per cent), foreign bonds (14.02 per cent), foreign equities (24.03 per cent), and cash (9.10 per cent).

GPIF is reasonably new to ESG investing and became a signatory to the PRI only last year. At the moment, 3 per cent of Japanese equities, about $10 billion, is allocated to ESG investments, and the fund is planning to increase this allocation to 10 per cent.

Kato, who was formerly head of research at Nomura, said there is a big opportunity in the Japanese equities market for companies to improve their ESG.

This upside exists in part because ESG is not factored into current share prices of Japanese listed companies. In fact, Kato’s analysis shows that only governance is factored into the Japanese market. Social and environmental factors have not been. This is unlike other markets, such as the US or UK, where ESG factors are already factored into the share prices, he said.

In the past, Japanese companies had a very low return on equity, but since corporate governance has improved, thanks largely to Prime Minister Abe Shinzo and Abenomics, return on equity has also improved.

“They are statistically linked,” Kato said.

 

Two paths to better beta through ESG

The GPIF is using two methods to achieve better beta using ESG. The first is to invest in the whole market passively and engage with companies. Currently, about 90 per cent of the fund’s equities allocation is passively managed to the Tokyo Stock Price Index, which includes about 2000 companies.

“This strategy is easy to explain but difficult to implement,” Kato said. “There are a number of issues, including who takes the cost of improving beta through engagement, and how to monitor performance. These are still unsolved issues.”

One obstacle here is how to engage with that many companies and perhaps a solution could be to engage with fewer of them. Kato points to research by AQR that demonstrates a negative correlation between ESG ratings and value shares and indicates value and small-cap shares could be targets for engagement.

A second solution to better beta is to allocate to an ESG index. Last year, GPIF allocated 3 per cent of equities to three indices developed with FTSE and MSCI – the FTSE Blossom Japan Index, MSCI Japan ESG Select Leaders Index, and MSCI Japan Empowering Women Index.

Kato said the GPIF was not expecting additional returns above the market from investing in these indices, but is attempting to improve the overall market.

“ESG index management means only the companies with high ESG ratings are selected and invested in,” Kato explained. “GPIF believes companies want to be part of that index, and so will improve their ESG ratings, and thus improve the market overall. I call it the incentive index.”

GPIF is also now searching for global share index providers.

 

Dear editor

I refer to your recent article by Sarah Rundell, published on February 21, 2018 GEPF shows value of governance.

There are a number of points we would like respond to.

  1. 1. It should be noted that the GEPF is a defined benefit fund, and so the movement in the value of individual investments does not affect the benefits to members and pensioners. The benefits to which members and pensioners are entitled, are safe and guaranteed by the Government of South Africa.

2. The bridging finance granted to Eskom by the PIC is a short term money market instrument which is to be repaid in 30 days and it is fully backed by a government guarantee. It is not a bail out, as stated in the article. The bridging facility is not a bond, and it falls within the cash and money market instruments (short-term fixed interest) category of the PIC’s investment mandate.

3. The PIC conducted a due diligence process prior to approving the loan and acted within its mandate to provide the bridging finance facility of R5 billion to Eskom. The PIC certainly did not breach the GEPF’s mandate as stated in the article.

  1. 4. The potential investment returns for the GEPF in this transaction are above the benchmark return prescribed by the Fund’s investment mandate.
  3. 5. The GEPF’s strategic asset allocation provides for an allocation of 4% of the total portfolio to cash and money market instruments, within a range of 0-8%. This allocation largely serves to accommodate the Fund’s cash flow needs (to pay benefits, administration and asset management fees and other operational disbursements) and as a repository of income (dividends, interest, redemptions, etc.) until decisions are made on how such cash should be invested. The money is deposited into short-term fixed interest instruments; bank deposits and similar instruments issued in the money markets by various issuers, of which Eskom is one.
  5. 6. This means that Eskom was already in the universe of the GEPF/PIC cash and money market instrument issuers.
  7. 7. It would not have been prudent for the PIC not to accept an obviously commercially attractive opportunity. Importantly, this investment had the potential to avert a further downgrade of Eskom’s credit, thus protecting the rest of the Fund’s domestic portfolio from the adverse effects of such a downgrade. A downgrade would not only affect the bills and bonds issued by Eskom, but it could also trigger the downgrade of other State Owned Enterprises, thereby impacting the Fund’s other investments.

The GEPF would like to assure your readers that it is guided and operates within the Government Employee Pension (GEP) Law and Rules which define precisely how the Fund should be governed and how it should administer pension and other related benefits to members and pensioners.

All investment decisions are taken in the best interest of members, pensioners and beneficiaries and the PIC always acts in line with the GEPF’s mandate requirements and the investment risk parameters stipulated by the mandate.

Regards

GEPF

Fees associated with active asset management have come under increasing scrutiny in recent years, with pressure from regulators, consultants and asset owners. Some argue that the value received is low while the asset-management industry continues to make supernormal revenue, regardless of the outcome.

The combination of suppliers earning excess revenue and unsatisfied customers is normally a recipe for a shake-up in an industry; either new, low-cost providers will come in, or a different model will emerge. Such an evolution has yet to take place in the investment industry, but it’s only a matter of time; the current position is unsustainable. In this paper, we consider the causes of this problem and how they might be addressed.

The current structure

One pillar of support for existing fee structures is a willingness to pay for perceived skill without any guarantee of additional return. Both the overconfidence of investors in believing they can select successful active managers and the overconfidence of managers in their expectations of outperformance lead to fee levels that are excessive in aggregate.

Setting aside fee levels, an additional problem with existing structures is their asymmetric nature, creating a bias in favour of the asset manager, regardless of outcome. Two types of fee structures are dominant in the industry: ad valorem (based on a percentage of the value of the portfolios managed) and performance-based (which includes an ad valorem component and a value-added element). Both fee structures have merits; both also have much more significant flaws.

Ad valorem fees

These fee structures – for example, 0.50 per cent of assets under management (AUM) – are the industry norm and are simple and transparent. Their flaws include:

The size of the fee is unrelated to the manager’s succes

The fee is also unrelated to the manager’s cost

The biggest influence on a manager’s revenue is size, creating an incentive to maximise assets under management, regardless of the effect on alpha potential.

Rising markets bring managers windfall gains – unearned increases in fee revenue.

There is little alignment of interest between investment managers and clients. Managers are incentivised to maximise AUM, whereas clients want them to focus on generating added value at a reasonable cost.

Performance-based fees

These are almost always structured in the form of a base fee plus a performance-related element. Although less simple and transparent than ad valorem fees, performance-based pay should ensure a greater alignment of interest between asset owner and manager. But the inherent asymmetry ensures managers can win more than they lose. However bad their performance, they earn the base fee. Meanwhile, if performance is better than benchmark, the manager shares in the increased value.

Principles of a better way

To establish a better fee model than either of these, it’s necessary to define the basic principles first. These appear to be very simple: fairness and alignment. Fairness would involve the asset owner paying a fair rate for services, given a realistic projection of the outcome, and the manager receiving fair compensation for work and skill. Alignment would mean ensuring an appropriate level of risk on both sides, linked to skill and the opportunity for it to be applied.

Improving fairness

How should investors determine a fair ad valorem fee for active management? We believe three factors should be considered:

The realistic expected excess return from active management

The fair share of the excess return that should accrue to the manager

The cost of the passive alternative (if it exists)

Essentially, a fair fee can be determined by multiplying the expected active return (outperformance) by the share the investor agrees to pay.

Calculating realistic expected returns

Excess return targets vary by asset class and strategy. They can provide a useful guide to the potential rewards associated with an active rather than a passive approach. They are also used by managers to help position fees.

In determining a fair management fee, it’s important to consider the probability of achieving the return target. Again, this varies by asset class. If we take the global equity universe as an example, our analysis shows only 26 per cent of strategies achieved the average universe excess return target (2.7 per cent) over the last 10 years. Across a selection of developed-market, large-cap equity universes, the range was 24 per cent to 38 per cent.

The simplest approach to estimating a realistic return is examining what success looks like based on what managers have delivered. Mercer has calculated the average return from active management across a range of universes. The average figure for large-cap developed-market equity universes (excluding the US) was about 1.1 per cent per year over the last 10 years.

Determining a fair share of alpha
How to share the returns from active management in an equitable way is an entirely subjective judgement. However, since managers make no promises about an ability to deliver on stated performance objectives, it’s difficult to justify an entitlement to half the outperformance. We believe a reasonable number might be somewhere in the range of 5 per cent to 25 per cent. 

Calculating a reasonable fee range

Starting with a realistic expected return and agreeing on a fair share of alpha – taking into account the cost of passive alternatives – allows us to construct a simple framework for setting more appropriate fee ranges.

An example of this framework is outlined in the chart below. We’ve used a conservative realistic excess return target of 1.1 per cent, based on Mercer’s experience of the average returns from active management in large-cap developed-market equity universes. The stated manager return target is based on the average target across a range of developed-market equity universes in Mercer’s global investment manager database (GIMD). Last, we include the passive fee range for a mandate of $50 million to $100 million – what we consider the lowest possible fee level. For example, for an assumed “share of alpha” of 15 per cent, the minimum fee would be 0.06 per cent to 0.14 per cent (that is, the cost of an index tracker), with a realistic fee range of between 0.165 per cent and 0.435 per cent.

MA N A G E R  SH A R E
Fee ranges 5% 10% 15% 20% 25%
 

Minimum

(passive fee US$50 million to US$100 million)

  

 

0.06%-0.14%
 

Conservative

(realistic excess return; for example, 1.1%)

  

 

0.055%

  

 

0.110%

  

 

0.165%

  

 

0.220%

  

 

0.275%
 

Maximum

(stated manager target; for example, 2.9%)

  

 

0.145%

  

 

0.290%

  

 

0.435%

  

 

0.580%

  

 

0.725%
 

This methodology can be applied across a host of asset classes.

Isn’t skill worth more?

The top end of the fee spectrum outlined above can be increased only by assuming asset managers are allocated a higher share of active returns or that they will exceed their stated targets (relatively unlikely). One might argue that asset owners should be prepared to pay more for exceptional skill. However, we maintain that a manager can justify a higher fee only if the prospects of delivering outperformance are commensurately higher. Within a group of highly regarded strategies, it’s difficult to determine the probable best performers in advance. Our analysis suggests higher-fee strategies do not (on average) provide higher returns to compensate for the additional cost.

We believe fee structures should reflect the probability of a strategy achieving its objectives based on an unbiased assessment of the chances of success (or failure) and the expected return from active management in each asset class.

Improving alignment
As discussed earlier, one of the major flaws in ad valorem fee structures is the windfall gains managers receive from rising market levels. The simplest way to address this would be to establish fee structures based on monetary amounts, breaking the link with market values.

This suggestion might seem idealistic or unrealistic, but Mercer does work with competitive managers that charge monetary-amount fees.

For performance-based fees, the approach to alignment needs to be symmetrical, with increases and reductions linked to outperformance or underperformance.

A pure approach would be a zero base fee and a participation rate of 5 per cent to 25 per cent. Performance fees would be accrued and paid over longer periods. The manager would need a high degree of confidence (backed by risking capital) that they could deliver above-benchmark performance over a reasonable time frame. There could be variations on this theme, such as a base fee equal to passive management fees and a lower participation rate. Such a fee structure might also encourage clients to stay invested longer, as the manager shares the pain of underperformance.

An alternative approach could be setting performance-based fees such that monetary amounts would increase or decrease by an established percentage. For example, a standard cost of $500,000 would be $750,000 if performance was, say, 3 per cent ahead of benchmark (over five years) and $250,000 if performance was 3 per cent behind benchmark.

We don’t believe these proposals are unrealistic or impractical. There are examples of managers offering performance-based fees structured around a zero base fee. And managers have certainly offered symmetrical performance-based fee structures in the past. We don’t see insurmountable issues to overcome; what’s needed is a willingness to change.

Monetary-based fees are one example of a practical solution; however, other more radical approaches to improving alignment are also worth considering. One example is discussed in Mercer’s paper Rebuilding Trust: Guaranteed Active Management Anyone?

Conclusion
Mercer’s manager research process already incorporates a reference to fees charged, as sourced from our GIMD, identifying where fees seem egregious. As outlined above, Mercer is building a framework of appropriate fee ranges for strategies in each universe as a further consideration when assessing which strategies are most likely to help clients achieve their objectives.

We recommend clients also consider this framework when assessing their existing fee arrangements and discussing alternative structures that better align their incentives. This may include propositions such as monetary-based fee models, well-structured performance fee schedules or other, more radical, solutions.

Only by embracing meaningful change will we be able to address the issues inherent in existing fee structures.

Nick Sykes is a partner within Mercer’s Wealth business. Richard Dell is the global head of Mercer’s Equity Boutique.

The Wisconsin Alumni Research Foundation, a $3 billion endowment funding scientific research programs at the University of Wisconsin-Madison, has helped finance life-changing scientific innovation, from human embryonic stem cell treatments to the processing technologies that underpin modern computing.

An equally bold and experimental ethos underscores investment strategy at the fund.

A risk parity strategy with a portable alpha overlay, applied across the whole portfolio rather than just a portion of assets under management, repeatedly exceeds its benchmark and ranks as one of the US’s best-performing endowment and foundation portfolios over the last 10 years.

Tom Weaver, then-chief investment officer, introduced the strategy back in 2005, to escape the rollercoaster of WARF’s large equity allocation. Two years later, when Weaver left to join one of the hedge funds in the portfolio and Carrie Thome became CIO, the strategy was still bedding down and had its sceptics. Nor was 2007 the ideal time for risk parity and an overlay, because equity-centric portfolios were doing better at that time than diversified ones.

“People were starting to ask, ‘What did we agree to?’ ” Thome recalls.

Beta

Thome makes light work of simplifying the complex portfolio. The key to understanding it, she says, is to separate the risk parity and portable alpha strategies into beta and alpha, respectively. The risk parity portion comprises leveraged market exposures that are largely passive or semi-actively managed, with strategy following the ideas pioneered by Bridgewater Associates and its founder Ray Dalio, so that the different risk profiles of the assets match and balance.

The entire portfolio is split three ways. The first third lies in domestic equity, developed market equity, and a smaller allocation to emerging and frontier markets. Thome also has in this segment an allocation to domestic private equity that targets the best venture capital from around the country; independent of that, she also seeks out top-tier firms that might take an interest in innovative start-ups spun out of, or still on, campus.

The second third lies in inflation-linked bonds and nominal bonds, and the final third is invested in core real estate, commodities, and recently added style premia, including trend-following strategies.

To ensure that the fixed income allocation has the same risk as more volatile asset classes, such as equities and commodities, Thome uses leverage, in the form of derivatives, to amplify WARF’s bond exposure.

Getting the balance right and weighting the portfolio accordingly requires a certain amount of reworking.

“We’ve gone back and forth,” she says. “Real estate is an example where we mulled whether to allocate it to growth or inflation, or something else altogether. There is a fair amount of modelling, but it’s also common sense.”

Alpha

Rather than tie up capital in the risk parity strategy, Thome uses derivatives – typically futures and swaps – to mimic the market. This frees up money for the pursuit of alpha; in this case, an allocation to 16 different hedge fund strategies uncorrelated to the beta portfolio, targeting consistent returns regardless of what is happening in the market.

By not using capital for the passive portfolio, she frees up $1.5 billion to invest in alpha strategies, much more than what the $3 billion value of the portfolio would typically allow.

Moreover, she estimates she has a similar $1.5 billion additional exposure through leverage.

“I end up with a portfolio that has a notional exposure, including the hedge funds and leverage, of about $6 billion, against our $3 billion of capital,” she explains. “The value of the overlay depends on not having to use capital on the market exposure piece.”

The hedge fund portfolio, run by Ryan Abrams, includes industry ‘granddaddies’ like Bridgewater’s Pure Alpha but it is also small and manageable enough to take a chance on boutique or new managers.

Abrams has focused on finding strategies that deliver upside returns, despite the portfolio being designed to protect on the downside.

Measured against cash, it’s also a challenge to ensure the portfolio doesn’t have any market or beta exposures. It targets an information ratio of 1 and looks for a contribution at the total portfolio level of about 200 basis points. This means the portfolio runs at 4 per cent to 5 per cent volatility, although Thome says individual managers, such as one for a currency strategy, might be more volatile than that average.

Innovation

Change and innovation are constant themes at WARF. Take, for example, the way Thome is comfortable switching assets between the alpha and beta.

The recent addition of style premia to the beta exposure is a case in point. Rather than bring this in as a new allocation, she simply assigned it from the hedge fund portfolio.

“We don’t tend to change assets in the portfolio, we just change the configuration,” she explains. “We took the hedge fund wrapper off it and moved it to risk parity.”

She also applies leverage to the hedge fund portfolio.

“We think of it as partially funding the account,” she explains. “While the manager might run a $100 million notional exposure for us, we fund it with only $50 million of capital. It’s about being able to take existing portfolio managers that you really trust and getting creative in your structure. It is all about implementation.”

It’s this comfort with risk, and engrained desire to innovate, that is driving current discussions at the fund. When WARF switched to a risk parity strategy back in 2005, it targeted a level of volatility of 12 per cent to 14 per cent. Yet the benefits of diversification, and current low levels of volatility anyway, mean that level has always been much lower, at about 10 per cent.

“Should we increase our risk, which we could comfortably do, and aim for a higher return?” she asks, rhetorically. A decision on that could be made when WARF reviews its asset allocation this May. The fund targets long-term returns of 7.25 per cent.

Fearless

WARF is also mulling other ideas, such as taking on an investment management role for other institutions. The conversation follows the endowment’s management of the Morgridge Institute of Research, a scientific body that also partners with the university.

The idea is still a long way from being actively pursued, but whether the endowment is entertaining such possibilities or displaying a comfort with derivatives and leverage that would daunt many, WARF’s board and investment committee give the crucial support Thome’s fearless approach requires.

Investments must support WARF’s operations, but one of the benefits of being an endowment is that Thome doesn’t have to report to a donor or beneficiary base; another advantage is the university alumni, who provide for a rich seam of corporate chief executives and investment experts to call upon. For example, board trustee and University of Wisconsin alumnus Jeff Sprecher, founder, chair and chief executive of Intercontinental Exchange.

“To be able to have [Sprecher, who is also] the chair of the New York Stock Exchange, at a meeting, walking us through implementation, is just fantastic,” Thome says.

She is also able to draw on WARF’s close relationship with the $117 billion State of Wisconsin Investment Board, where she and associate director of investments, Alain Hung, used to work. SWIB and WARF recently set up a venture fund, now open to other limited partners.

“SWIB was trying to find ways to invest in Wisconsin and contribute an economic return that didn’t hit financial returns,” Thome recalls. “We don’t have a big pocketbook, but we are knowledgeable about what’s going on around campus.”

WARF runs its nominal exposure, setting the model, weights and targets across the portfolio itself, but its asset manager, Minnesota-based Parametric, executes all the futures and swaps. The hedge fund portfolio is expensive, but Thome says she can cut costs via “creative structuring”, as seen in the introduction of leverage with smaller managers.

“We probably run a more expensive portfolio than others, but we are very careful not to pay for beta,” she says, adding that the relatively small allocation to private equity and the core real estate exposure also help save on cost.

When Thome took over, she was one of two in the investment team. That has now grown to eight but she says she won’t build a “big bench”.

More than anything, she wants to create a structure that is not dependent on people and can stand on its own. It’s another challenge, given so much of the current strategy, and its success, have been shaped and driven by her.

Some short-term optimism in the global economy has led the Future Fund to increase risk, chief investment officer Raphael Arndt has said.

This is reflected in the portfolio by an increase in global equities, and a decrease in the cash allocation, during the last six months.

The increase in allocation to global equities was split between developed markets, which rose from 14.9 per cent to 18.6 per cent of the portfolio, and emerging markets, which rose from 6.9 per cent to 7.7 per cent. The fund’s cash allocation decreased from 21 per cent to 16.4 per cent in that time.

 

“The global economy is exhibiting synchronised growth – job creation and economic growth is occurring across developed and developing economies,” Arndt said. “This has led to us recently increasing risk in the Future Fund marginally, in light of the more positive shorter-term economic outlook; however, we remain cautious over the medium to longer term.”

Arndt, speaking at the 15th Annual Private Equity & Venture Forum Australia & New Zealand, said that in the current environment the team was attracted to flexibility and the ability to move the portfolio as its view on value, or the risk outlook, changes. He also said the team was seeking strategies that were uncorrelated with equity returns and focused on genuinely adding value to businesses, not just financial engineering or strategies that involve leverage.

About 12 per cent of the fund’s portfolio is in venture capital and private equity. Arndt said this was an integral part of the fund’s response to macro changes in the economy, including generational change and technological disruption.

“The PE program continues to play an important role in the Future Fund’s portfolio – currently standing at A$17 billion ($13 billion), and having delivered returns in the mid-to-high teens since inception,” he said. “Within this program, we seek to access strategies that invest into innovation and small company growth.”

The Future Fund private equity team of eight uses fund of funds, external managers and co-investments.

Disruption is something the team takes seriously, incorporating it into its process in three ways: offence, meaning investing in disruption; defence, or avoiding certain investments; and application, which means using the lessons from investments in its portfolio to improve how the team operates.

Joel Posters, who leads the fund’s ESG and investor stewardship function, is charged with working with the sector teams to share insights on disruption.

Arndt said all thoughtful investors need to be thinking about the impacts of disruption and generational change.

“Disruption creates winners and losers,” he explained. “Investors who are open to change will be rewarded in this environment and those who fail to engage with the changes that are occurring will risk failing.”

Below is Arndt’s full speech at the conference.

 

Speech by Dr Raphael Arndt, Chief Investment Officer, at the 15th Annual Private Equity & Venture Forum Australia & New Zealand, in Sydney.

Good morning, and thank you for the opportunity to speak to you today.

My organisation manages five funds on behalf of you – the people of Australia. In total, we currently manage about A$164 billion ($127 billion) on behalf of future generations of Australians.

The largest of these funds, the Future Fund, currently stands at about A$139 billion – and is Australia’s sovereign wealth fund. The fund was established in 2006 to strengthen the Australian Government’s long-term financial position.

Our mandate is to achieve a return of at least inflation plus 4 per cent per annum over the long term, without taking excessive risk.

Current Positioning

Let me begin by touching on the Future Fund’s current thinking and positioning.

I have been saying for some time that it is an incredibly tough time to be an investor – over the longer term the real economy faces headwinds from ageing demographics and a significant debt burden, with expensive asset prices supported by interest rates currently at unprecedented lows.

However, interest rates are now poised to begin rising as the world finally works through the surplus capacity created following the global financial crisis.

This challenging longer-term outlook remains – and is compounded by risks associated with growing populist movements across the world that have resulted from wealth inequality arising from the response to the global financial crisis.

In the long run, more protectionism can only detract from economic growth and create uncertainty for business.

However there is some reason for optimism when looking at the economy in the shorter term.

The global economy is exhibiting synchronised growth – job creation and economic growth is occurring across developed and developing economies.

This has led to us recently increasing risk in the Future Fund marginally in light of the more positive shorter term economic outlook; however, we remain cautious over the medium to longer term.

And we saw the return of volatility in early February, reminding us that equity exposure carries risks, particularly at the currently elevated valuations compared with history, and in an environment of rising interest rates.

In the current environment, we are, therefore, particularly attracted to:

  • Flexibility – the ability to move the portfolio if our view on value, or the risk outlook, changes – and as such we are currently managing our liquidity closely, and ensuring that any illiquid exposure we do take is well rewarded;
  • Secondly, investment strategies that are uncorrelated to equity returns. We have an exposure of more than A$20 billion to hedge funds – and further exposures to venture and growth equity, which I will talk more about shortly; and
  • Finally, investment strategies that are focussed on genuinely adding value to businesses – not just financial engineering or strategies that involve leverage. These include:
    • Our active approach to Property and Infrastructure, where we have been prepared to back managers to deliver on value adding business strategies and turn the portfolio over once these strategies have been realised; and
    • Our approach to Private Equity and Venture that involves growing businesses, rather than just the financial engineering of leveraging and ‘flipping’ assets.

Macro-trends

In addition to this backdrop, there are a number of macro-economic changes which are likely to increase in importance over coming years. These are generational change and technological disruption. The world is changing and any long-term investor needs to not just be aware of this, but to respond to it.

Generation Y – the ‘millennial’ generation – will displace other generations in the decades ahead. They are currently one-third of the workforce and in less than 10 years – together with their younger siblings, Generation Z – they will make up two-thirds. These generations work, interact and consume differently to their parents. They are comfortable with technology, and want experiences, collaboration and technological enablement – and are less interested in material possessions and accumulating ‘things’. Technological disruption means that business models must evolve, and businesses and investors can’t rest on their laurels because technology will erode margins and returns unless businesses can reinvent themselves to remain relevant to their customers. The successful businesses of the past will likely not be tomorrow’s champions unless they respond to the changing environment. Investors and businesses that can’t adapt to technological disruption and generational change will be consigned to the dustbin of history. On the other hand, new winners are emerging. If the leading companies of today can’t or won’t adapt then they will be replaced by a new generation of winners.

I will return to how we at the Future Fund think about this disruption in a minute, but let me first outline the role of Private Equity in the Future Fund portfolio, and how it is integral to our response to these changes going on in the world.

The Role of Private Equity

In September 2016, I spoke in some detail about the role of Private Equity and Venture in our portfolio.

I won’t repeat myself – other than to say we see PE and Venture as an important access point to invest in real businesses.

The PE program continues to play an important role in the Future Fund’s portfolio – currently standing at A$17 billion, and having delivered mid-to-high teens returns since inception.

Within this program we seek to access strategies that invest into innovation and small company growth. These strategies do not rely as heavily on the availability of cheap and plentiful credit or economic growth as large buyout strategies.

These venture and growth strategies are focussed on smaller businesses where there is more scope to grow or improve a company rather than just carve it up or merge it with another one – and it is these strategies that we have the largest exposure to within the PE program, with an exposure of more than A$8 billion.

The Future Fund’s Private Equity team of eight – some of whom are here today – use fund of fund, external managers, and increasingly co-investments alongside our managers to access these drivers.

Disruption

Technological disruption is not new – and is not confined to any particular sector or investment asset class.

Let’s look at the auto industry as a study in disruption – quite topical at the moment, due to the emergence of electric vehicles.

But I am going to look back to a period before “EV” was a commonly used acronym for electric vehicles.

Detroit, Michigan grew from a population of 285,000 in 1900 to reach a peak of 1.9m in 1960.

Since 1960 the number of cars and vehicles in the US – and the world – has increased, significantly.

Despite this, between 1960 to now, Detroit’s population has fallen from 1.9m to 700,000 as auto manufacturers moved out of Detroit over the last fifty years and as manufacturing evolved to be less labour intensive.

This hasn’t just affected those who invested into automotive and related companies.

An investment in property – whether residential, commercial or industrial – in Detroit in the 1960s was a far worse investment than property investment here in Sydney, where population increased from around 2m to more than 5m between 1960 and today.

I hope this helps explain why investors need to think about disruption and its broader impacts.

By their nature, these types of changes are hard to predict, and come on suddenly. And by then it may be too late to change your positioning, especially if your holdings are illiquid.

So let me now explain how we at the Future Fund incorporate thinking about disruption into our processes.

We think of disruption through three lenses:

  • Offence – this is investing into disruption, principally through the venture program;
  • Defence – thinking about whether there are investments we should avoid;
  • Application – are there lessons we can learn from investments in our portfolio that we can apply to how we operate as investors, as we think about our own portfolio and activities. 
To put this into effect our Sector Teams have responsibility for investments relating to their area of expertise. 
And Joel Posters – who leads our Investment Stewardship and ESG function – has since last year had responsibility for working with our Sector Teams as a centre of excellence to share disruption insights across the investment team. 
We can look at an electricity network as a practical example. In this case, our approach to thinking about disruption, means we would seek to fully consider the impact of technological change and distributed generation such as rooftop solar PV if we were looking to invest in a regulated electricity network. It doesn’t mean we wouldn’t look at such an investment, but we would think about the payback period and we probably wouldn’t include an assumption that the experience of the last 30 years continues into perpetuity as our base case. 
This approach of looking at technological change and disruption could apply equally to thinking about: the impact of driverless cars on car-park assets; the impact of fintech developments on banks; and the impact of changes in the retail sector on shopping centres.

Importantly, in thinking about the impact of disruption, I want to make the point that those of us working in the financial services industry must not be complacent. 
For the Future Fund, we recognise that, like successful companies in every other industry, we cannot stand still. And we are part way through a significant multi-year journey to invest in our business – investing into new technology and systems that will give us more insight into our portfolio exposures in real time.

Australia’s private equity sector

Just as roles in stockbroking have been replaced by computers and online trading, Australia’s private equity sector won’t be immune from these disruptive changes that are occurring.

To stay relevant and attractive to LPs, you need to be investing in your businesses – and when thinking about the value proposition you offer prospective LPs, you need to be as tough on yourself as you are on prospective investments.

 

This means knowing where you add value, and being able to articulate that.

We have no interest in supporting managers that simply rely on leverage and a prayer that debt will remain cheap and economic growth will continue for the next decade.

Our very best PE managers are investing in their business. They have developed teams that include dozens, sometimes hundreds, of people with an operational background who go into investee companies and drive real operational improvements.

For instance, we have an example in our portfolio of a manager who has sent in teams of people with an e-commerce background into a traditional bricks and mortar luxury goods retailer that had a pretty basic web offering.

The approach involved optimising their online presence, including installing the ability to combine real-time analytics with a dynamic website to allow each user to experience a tailored landing page.

So a user visiting the website with a history of searching for handbags will see handbags displayed when they visit the website, while someone who has bought shoes previously will see shoes displayed more prominently.

This is in addition to streamlining the purchasing process to create a user friendly experience, including enabling people to purchase using WeChat Pay and other new payment platforms.

To be clear, the experts in this example work for our manager as employees and do this time and time again for their portfolio companies – helping them grow while making returns for their investors.

This ‘operational excellence’ function currently exists in the best PE managers, and the successful PE firms of the future will be those who can invest in their own business by resourcing up with the operational skills required to buy into investee companies and leave them stronger and better businesses on exit.

 

If the industry can adapt, I am optimistic that we are seeing the beginning of a renaissance for Australia’s private equity sector.

As a significant Australian based investor, the Future Fund seeks to remain active within the local PE community, to support the development of Australian businesses and commercialisation of Australian innovation and ideas.

We do this through our PE investment program, and through our work with AVCAL and the industry to build the capacity of Australia’s PE sector.

With you, we have a mutual desire to see Australia’s PE and Venture industry thrive, and with it, Australia’s small and medium businesses get the capital and expertise they need to reach their full potential.

In August last year the Future Fund and AVCAL co-hosted a day-long workshop with Greenspring Associates, one of the Future Fund’s US based venture fund-of-fund managers, and one of the most successful venture investors anywhere in the world. Greenspring has a successful track record spanning nearly two decades operating in Silicon Valley and the US East Coast, including increasing global activity.

The workshop introduced Australian venture managers to Greenspring, who outlined the standards they look for in venture managers seeking to raise capital – with the intent being to help facilitate the development of Australia’s venture sector to be in a position to raise domestic and offshore capital.

Key insights included:

the importance of GPs specialising by sector or theme – and having real expertise in their area of focus; the role of thought leadership and proprietary deal flow for GPs; and the need for GPs to build relationships with entrepreneurs. And I am pleased to see the Australian venture sector is active and growing.

Following the workshop last year we have been working with Greenspring and the Australian VC community to help promote a world class venture capital sector here in Australia. 
As part of our mandate with them, we have asked Greenspring to specifically look for opportunities to support Australian VC managers. Greenspring are actively monitoring the market and capital will be allocated as suitably strong opportunities are identified. 
This program, in bringing one of the world’s leading Venture Capital investors to Australia, is an example of the work the Private Equity team has been undertaking to find ways for the Future Fund to support Australian businesses with their growth aspirations. Of course some businesses mature past the Venture stage. There is no shortage of growing small and medium Australian businesses requiring capital. Their success is important to the development and diversification of the Australian economy, including ultimately our listed market should they go on to IPO. While banks have been the main funders of these companies, they have not been able to support all of the growth opportunities this sector has generated. And these businesses are too small to access debt or equity capital markets.

Given the large size of the Future Fund, and our model, which involves a relatively small investment team, it has always been challenging for us to find an efficient way to invest in these types of businesses. 
We believe there are attractive investment opportunities in this sector in which the Future Fund can invest. This will have the added benefit of supporting small and medium Australian businesses to realise their growth potential.

We are therefore thinking about how we operate in the Australian market. In doing so we are actively considering ways we can invest in these types of opportunities in an efficient way, and we will hopefully have more to say on this in the near future.

In conclusion, I reiterate the need for all thoughtful investors to be thinking about the impacts of disruption and generational change.

Those allocating capital like the Future Fund must continue to innovate and be open to the changing world we live in and the changing investment environment we operate in.

Disruption creates winners and losers – investors who are open to change will be rewarded in this environment and those who fail to engage with the changes that are occurring will risk failing.

Australia’s private equity and venture industry is well placed to capitalise on the huge changes going on in the world. Indeed Private Equity is one of the few asset classes available for investors to obtain this exposure early in its cycle.

The Future Fund looks forward to working with our managers and the Australian industry as a whole to take advantage of these opportunities.

Thank you.