Asset correlations no longer apply, says Future Fund CIO
Australia's Future Fund has been taking stock of its investment processes and the manner in which it calculates asset correlations, in response to what new chief investment officer Sue Brake describes as “a really turbulent year”.
In an exclusive interview with AsianInvestor, she said the unique circumstances of the global pandemic have created “a new paradigm that has changed the conditions for investing”.
That has led Brake and her colleagues to question long-held beliefs about asset correlations.
“I would even go a little stronger and say that historical correlations no longer apply," she said. "We haven’t thrown diversification out; those things are still true. It’s the assumed correlations between bonds and equities, the defensiveness of bonds in this environment and that they have a certain risk profile. I don’t know that those things are true anymore.”
Brake took over as CIO at the A$218 billion ($167 billion) sovereign wealth fund in December 2020, having stepped into an interim role earlier in the year following Raphael Arndt’s promotion to chief executive officer. It was a baptism of fire to some degree as organisation's portfolio volatility increased and its short term returns took a hit.
“The world has gone through some fairly seismic shifts for an investor as a result of the pandemic. These shifts were happening anyway and we were monitoring them as part of our investment process. But the pandemic was really quite remarkable in the way it fed into each of them," said Brake.
“The narrative coming from central banks in 2020 has been that fiscal policy has to do the heavy lifting from here. And through March and April we saw governments come in and really make that change for the markets. So now we’ve got an interesting coordination between fiscal and monetary policy, which has led to this buoyant stock market.”
A further shift, which is a direct result of the pandemic, has been the shift from laissez faire government to a much more active and involved government by necessity, said Brake.
But it is the societal changes, in technology and demography, as well as shifts in the social norms that have coalesced in forging what Brake describes as “a remarkable investment environment”.
“When we were in the midst of the crazy time in 2020 and we became aware that these shifts that we had been talking about were suddenly here rather than on the horizon, it made it obvious we needed to consider whether this was the right way to build portfolios”
QUESTIONING ASSET ASSUMPTIONS
She noted that investors are particularly grappling with the key application of traditional cashflow analysis “and what’s the right discount rate in this environment – which is the one that everybody’s grappling with – and therefore where valuations should be”.
The keys to the Future Fund’s success in generating a 10-year return of 9% per annum against a target of 6.2% lie in its long term asset allocation and the overlays it uses to optimise risk levels.
While the sovereign wealth fund boasts a strong long-term track record, 2020 was not its finest hour. Last week, it announced a 1.7% return for the calendar year, falling short of the 4.4% target return. The one-year figure was boosted by a fourth quarter return of 4.9%, reflecting the year-end rally in listed equities.
Future Fund had previously posted a negative 0.9% return in the 12 months to the end of June 2020, its first yearly loss since the global financial crisis of 2008-2009. As acting CIO at that time, Brake shifted into more defensive portfolio positions and sold down international private equity and alternative asset positions in favour of more domestic exposures, to shield it from an even worse result.
“We got over the initial liquidity crunch that we saw in March," she said. "Then we knew that things were changing. So we had to gather an already tired workforce and analyse what was going on.”
The deep dive with the fund’s external managers and its wider network resulted in what Brake described as “a remarkable piece of work that we presented to the board in December, talking about what’s changed and what we need to think about now to construct a portfolio to meet the long term mandate that we have.”
Among the conclusions of this ‘new paradigm’ thinking, Brake expects many external developments to weigh on the investment team's decisions. These include greater government intervention, more regulation and more volatility, to name a few.
“There is more complexity; it’s not just monetary and fiscal policy or demographic change, it's social change, disruption," she said. "It’s a more complex world than a lot of our models have assumed in the past. The greater potential to be caught on the wrong side makes the whole thing more uncertain.”
These changes are set for the long term. Brake does not think there will necessarily be a reversion to earlier norms of relative valuation and correlation.
“I think the world is constantly evolving and that norm is always changing. The debt burdens now are so huge, it will certainly be a long time until we get back to anything that looks like the environment that we’ve come from. And at the same time these demographic shifts and technological changes are fascinating in terms of what they do to cashflows.”
Look out for part two of this interview, where Sue Brake talks more about the Future Fund's current asset allocation