Credit pioneer shaped by a crisis

Having joined Australia’s A$85 billion ($78.1 billion) sovereign wealth fund when it was set up in July 2007, David Neal has been instrumental in shaping the Future Fund’s investment approach.

He was a consultant to the institution while at investment consultancy Watson Wyatt (now Towers Watson), before taking up the role of chief investment officer. He has lived and worked in Australia since 1999.

Neal speaks to AsianInvestor about how the Future Fund was inevitably moulded by the financial crisis that struck as it was building its initial portfolio.

Q It must have been tough building a fund just as a major financial crisis hit.

A We started investing in July 2007. We didn’t have a team at the time, so the initial activity was about starting to accumulate some simple passive equity portfolios to get some risk into the portfolio.

By the time we reached October 2007, we had 15-20% in equities and the rest in cash, and thought ‘this doesn’t look good’.

It wouldn’t be fair to say we foresaw what did transpire [the Lehman Brothers bankruptcy and subsequent market collapse], but we realised the potential risks of our position and we stopped investing at that point. Since we have a real return objective of 4.5–5.5%, that was a tough decision, as we knew that having 80% in cash was not going to achieve that.

Q So what did you do then?

A After the crisis hit, we built up a fairly large banking and corporate loan portfolio through the end of 2008 and into 2009. We were worried about what equities might do in such a fragile environment. It struck us that with really strong credit analysis, you could get equity-like returns from credit, given those assets had so dramatically repriced.

Q You don’t hold any sovereign debt, I think?

A That’s right. We did have a modest exposure to have a category for debt, or credit in our case.

Q How is your portfolio positioned now?

A Towards the end of last year we felt there was a theme emerging – that the level of conviction and determination by many of developed-world central bankers would drive asset prices higher, reduce potential left-tail risks and help generate improved economic outcomes.

So we felt it was time to increase our risk profile again – and that’s what we have been doing in the past six months. We’ve reduced our credit

Q That’s a big hedge fund portfolio, especially these days – why?

A We allocated most of it in 2009. We felt there were lots of opportunities for skilled managers to add value amid all the volatility and dislocation. And we were a bit nervous about market risk. So this seemed a good opportunity [to take more hedge fund exposure].

Q Do you invest mainly in bigger hedge funds?

A We want a smaller number of relatively large relationships. We worry about the risks of portfolio sovereign interest rates until the end of 2010, but then we sold out of the position given its strong returns, the low level of nominal yields and the potential sovereign risk issues.

In hindsight, of course, we were too early.

Q How about your alternatives exposure?

A We view ‘alternatives’ as predominantly hedge funds, as well as other niche assets like insurance-related investments. We class private equity under equities along with listed stocks; we have a ‘tangible assets’ category, for property, infrastructure, timberland etcetera; and we and alternatives allocations and increased our exposure to equities.

We felt credit had completed its run and was unlikely to provide as much of a benefit as equities in the new environment. We have also been very selectively building other parts of the portfolio – private equity, property and infrastructure.

The rough breakdown right now is: 38% (32.9% on June 30, 2012) in listed equities, 7% in private equity (6.4%), 15% in tangible assets (12.8%), 15% in credit (18.3%), 16% in alternatives (19%) and 9% in cash (10.6%).

Q That’s a big hedge fund portfolio, especially these days – why?

A We allocated most of it in 2009. We felt there were lots of opportunities for skilled managers to add value amid all the volatility and dislocation. And we were a bit nervous about market risk. So this seemed a good opportunity [to take more hedge fund exposure].

Q Do you invest mainly in bigger hedge funds?

A We want a smaller number of relatively large relationships. We worry about the risks of portfolio complexity and we want to build deep relationships with those managers. We would prefer a senior professional to know a lot about 10 managers than a little about 40.

So these tend to be quite big mandates, which leads us to the larger organisations.

We have just one Asia-based hedge fund manager – Pacific Alliance Group.

Q What’s your take on the rising importance of emerging markets?

A We believe in the secular story of relatively higher economic growth in emerging markets, including Asia. But we don’t believe that, just because emerging markets will grow quicker than developed ones, we should blindly invest in EMs and expect a higher return.

Q How do you play emerging markets?

A We have a thematic theme we play: the rising consumer, which we suspect may not be fully priced in. True, a lot of consumer stocks in emerging markets are expensive – maybe too expensive – but you don’t have to invest in EM stocks to benefit from this trend. We have a range of mandates that seek to benefit from that thematic, which are agnostic as to where they invest.

Q How much do you have invested in Asia?

A We have just over 7% of our portfolio invested explicitly in Asia. In a number of the hedge funds there will likely also be some Asian exposure that our system records as US dollar exposure.

The vast bulk of this exposure is through listed equities. We have a modest amount of real estate exposure in Singapore, Hong Kong and Japan and private equity and debt investments across the region.

Q To what extent do you use external managers, and for which types of assets?

A The Future Fund Act requires us to use external investment managers for all of our portfolio management. That doesn’t stop us from making our own decisions in conjunction with them and partnering them as they manage assets for us. We have a hybrid approach and a 44-strong in-house investment team.

For example, in tangible assets, like property and infrastructure, we commit to external manager funds or separate accounts, and we like co-investing with them. But we will also do transactions on a highly selective basis and then use a manager to run the mandates.

For example, in the last year we completed a transaction to buy the assets of an Australian listed infrastructure trust – comprising a range of airports. We did that [deal] ourselves.

We work with a relatively small number of PE managers, and we are starting to move more into direct investment in PE.

Q How about for public markets?

A Buying stocks is always done through external managers. But we do think about ourselves as portfolio managers of listed stocks; we think about the thematics we want, the geographic split – and we change these over time. And we don’t feel hostage to an index; we don’t manage our tracking error relative to the MSCI or anything like that.

Q Is the approach the same for credit?

A We have very little allocation to corporate bonds, as we feel they are the least exciting part of the credit spectrum. We focus more on private debt, loans and securitised credit.

Q What’s your approach to risk management?

A We manage currency and interest rate exposures of the portfolio with derivatives overlays – typically forwards and futures, but also swaps.

Broadly, we hedge our foreign exposure so as to maintain an exposure of around 15% of the portfolio to developed-market foreign currency and around 12.5% to emerging-market foreign currency.

Q How concerned are you about the slowdown in China and the effect that is likely to have on the Australian economy?

A Clearly a slowdown in China would be a concern – the links are very strong between the Australian economy and how China is faring. Now is probably a fairly important moment for us [as a fund] – we construct our portfolios using a variety of scenarios and have to manage risk around that.

Much of our portfolio is global – around 70% of our assets are outside Australia, so that’s a mitigating factor for risks related to our domestic economy.

Still, China has some strong stimulus firepower at its disposal, and has done a pretty good job of deploying it historically. So this is not something we fret about every day.