The Future Fund Investing for the benefit of future generations of Australians
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1 The Future Fund Investing for the benefit of future generations of Australians Investment model and process October 2014 Australia s Sovereign Wealth Fund
2 02 Contents Introduction 02 How we invest 03 Governance 08 Growing for the future 08 Introduction The Future Fund is Australia s sovereign wealth fund and long-term savings vehicle. It was established by the Future Fund Act 2006 (the Legislation ) to assist the Commonwealth of Australia with growing and protecting the wealth of all Australians. The establishment of the Future Fund was particularly important in view of the pressure that Australia s ageing population is likely to place on Commonwealth finances into the future. The Future Fund received total contributions of $60.5 billion from a combination of budget surpluses and the proceeds from the sale of the Commonwealth s holding of Telstra. Its Investment Mandate is to maximise returns on that capital within an appropriate, but not excessive, level of risk targeting a return of at least CPI + 4.5% per annum over the long term. The Board of Guardians, with the support of the Future Fund Management Agency, is responsible for managing the Future Fund independently of Government. An overview of the governance of the organisation is provided on page 6. The Board and Agency have also been given additional responsibilities through the Nation-building Funds Act 2008 and the DisabilityCare Australia Fund Act Under these pieces of legislation the Board and Agency manage other investment portfolios on behalf of the Commonwealth. This document focuses on the Future Fund portfolio itself. More information on the other portfolios is available on the Future Fund website. The Future Fund is designed and invested for the long term. No withdrawals are permitted before July 2020 except for the purpose of meeting operating costs (unless the value of the assets exceeds a certain threshold test, which it is unlikely to do in practice). While annual withdrawals are permitted from July 2020 to help meet the Commonwealth s unfunded superannuation liabilities, those withdrawals may not exceed the value of the liabilities falling due in the year in question. As such, the organisation s focus on growing and protecting the assets of the Fund looks many decades into the future. Future Fund Australia s Sovereign Wealth Fund
3 03 How we invest During 2006 and 2007, with the Future Fund s new Board in place and the investment team beginning to form, a significant amount of thought was given to the Fund s Mandate and purpose, and how best to organise its resources to deliver it. Our approach continues to be based on the insights and beliefs formed at that time. This document has been prepared to help interested parties better understand the parameters within which the Future Fund operates, its investment processes and how it goes about making investment decisions. More detailed information is available in the Future Fund s annual reports and other documents which are available on our website: The website also provides information on the legislation, investment mandates and investment strategies for the other portfolios managed by the organisation. Investment model External constraints At its inception the look and feel of the Future Fund was influenced by a number important considerations. The Legislation stipulates that the Fund must invest through external investment managers and in financial assets only. The clear implication was that the Fund would need to rely heavily on relationships and expertise from the private sector, and harness these skills so as to ensure strong alignment to the Fund s core purpose and investment strategy. Moreover, the requirement to use external managers reflects an expectation that the staffing of the Fund would be kept relatively small. This means thinking carefully and creatively about the structure of the team and the skills required to effectively manage a portfolio of the size and scale of the Future Fund. From the outset we wanted to create a small and nimble team of experienced investment professionals that would be able to meet regularly around one table, share investment insights and views from their differing sector perspectives and challenge each other robustly. We felt this integration of specialist skills and knowledge would allow us to get the best out of ourselves and our external managers. COMPARATIVE ADVANTAGES INVESTMENT BELIEFS CORE INVESTMENT PRINCIPLES INVESTMENT PROCESS INVESTMENT RESOURCING/ OUTSOURCING MODEL CULTURE AND VALUES EXTERNAL CONSTRAINTS The investment model can be thought of as the way we do things around here. The design of the investment model is a complex affair. In shaping the core parameters of the investment principles and processes, and how they are resourced, the design must have careful regard to the organisation s advantages, beliefs, culture and constraints. As the schematic illustrates, these factors are all highly interdependent, such that changing one will have an impact on a number of others. Investing for the benefit of future generations of Australians
4 04 Investment beliefs Essential to the design and development of the Fund s investment process was agreeing a set of core investment beliefs. While these beliefs have been refined over time, their essence is unchanged. They have anchored the Fund s strategy and decision-making, and profoundly shaped the Fund s DNA the way that the investment team behaves, how it interacts, and how it reaches decisions. As an example, the beliefs that portfolio management should be focused on the specific objectives of the Fund, and that a portfolio is most efficiently managed as a whole rather than as a collection of individual portfolios, have shaped the Fund s one-team, one-portfolio approach. Portfolio management Single portfolio Risk management Dynamic management Market-related risk Diversification Inefficient markets and adding value Costs Portfolio management should be focused on the specific objectives and risk definitions of the Fund. Portfolios are most efficiently managed as a whole, rather than as a collection of individual underlying sub-portfolios. The assessment and management of risk should emphasise qualitative considerations, through a deep understanding of the investment environment and its potential impact on the portfolio. Quantitative measurement is considered an important tool to both support and test this process. Prospective returns and risks vary materially over time in a way that is at least partially observable and hence exploitable. The amount of risk taken should therefore be managed dynamically as conditions change. Focus should be on the appropriate level of market-related risk because it is a stronger driver of long-term total portfolio risk and return than skills-related risk. A higher expected return per unit of risk (investment efficiency) can be obtained from a broadly diversified allocation across different return drivers. In addition, the long time horizon supports a tolerance for illiquid assets. Markets can be inefficient, albeit that the degree of inefficiency varies across markets and over time. Skilful management can add value after fees, and such added value can be uncorrelated to market returns over time and can therefore be highly beneficial to the total portfolio investment characteristics. Capturing skill-based returns requires an appropriately resourced and disciplined process. The management of costs is very important to maximising returns. The investment beliefs have anchored the development of the investment process. Future Fund Australia s Sovereign Wealth Fund
5 05 Culture As the organisation explored its potential advantages and worked through potential constraints including its distance from many of the major investment and financial markets of the world it began to very deliberately and carefully define its own specific culture. The Future Fund has built a relatively small investment team of skilled investment professionals who have the intellectual flexibility to develop and express their own investment views while accessing and engaging with best-of-breed external managers from around the world. The Fund has created a highly collegiate, team-based environment, with a coherent culture that supports effective multi-sector and cross-organisational decision-making and significant effort and time is put into maintaining and embedding this approach. The Fund s culture has been further strengthened by the fact that its head office and all staff are based in Melbourne, rather than in offices around the world. Dynamic investment process Having started with what was essentially a blank sheet of paper, and the intent to leverage some of the Fund s inherent advantages and turn potential constraints into strengths, the team set about designing a dynamic and integrated investment process. The Fund has developed a structured and comprehensive methodology for forming its investment strategy, which aims at blending qualitative and quantitative inputs from the bottom up and the top down. The strategic process is designed to: deliver understanding of the medium-to long-term macroeconomic, market and policy context that ultimately shapes the level and path of investment cashflows; understand the available opportunity set for investment; and enable the creation of robust portfolio solutions that target the mandate and deal practically with the realities of the investment landscape. We try to position the portfolio over the medium term to capture returns when markets are positive, while avoiding excessive levels of risk. We try to ensure we have genuine diversification in the portfolio and a sound perspective on the potential scenarios for economies and markets over the years ahead. The Fund s internal strategy team sets out specific macroeconomic themes and scenarios. Using these inputs as well as their own fundamental, qualitative research, asset class teams (called sector teams at the Future Fund) are able to both source opportunities and test their portfolios. The Future Fund s total-portfolio approach means that the senior investment team must be fully informed of, and involved with, the assessment of opportunities across all sectors in order to compare the merits of any one investment versus another. Foundation inputs Beliefs Mandate interpretation Portfolio construction Construction of long-term investment strategy Macro environment Cyclical view of the world Strategic themes Scenario analysis Sector risk and opportunity analysis Top-down market valuation and risk premia analysis Bottom-up opportunity and risk analysis by sub-sector Sector management Construction of a portfolio of managers and assets to implement the TAA Target Asset Allocation (TAA) Construction of a medium-term target strategy Overlay management Use of synthetic instruments to modify the portfolio to obtain desired risk exposures within Board controls Scenario planning Iterative process to plan for expected changes in portfolio given potential shifts in current state Qualitative Inductive reasoning and stress tests Quantitative Risk modelling Risk and return assessment The Fund seeks to marry a quantitative view with a more qualitative, fundamental approach to asset allocation. Investing for the benefit of future generations of Australians
6 06 As a result, all of the sector teams regularly meet to debate market views. Sector teams formally present their sector reviews twice a year, resulting in a formal sector review every month or so. Team members are encouraged to challenge and to be challenged robustly. The result is a fluid and iterative process with ongoing collaboration, comparison and communication between the sectors teams, the strategy team and the wider senior investment team. The intention is to uncover the best investment ideas across all sectors, rather than the best ideas in each sector, and then to act with conviction on these ideas at a total portfolio level. Core investment principles The investment process is based around a few key principles. Best ideas The Fund seeks to allocate capital to the best investment opportunities in a given environment, rather than targeting a particular return. Idea generation is therefore highly valued. Robust discussion, collaboration and challenge is encouraged. With this best ideas approach the management team requires very broad coverage of as much of the investment universe as possible. Specialist sector teams ensure that the management team has centres of excellence and expertise across all the major asset classes. Sector heads are responsible for deploying their skills and resources to develop a deep understanding of the broader universe and find the best available investment opportunities within their own asset classes. The Fund is perhaps unusual for an outsourced style of fund in the level of granularity it brings to its search for the best strategic opportunities within sectors. This desire to pick the eyes out of a sector universe sees it construct portfolios which bear very little resemblance to the traditional benchmark structure used across the industry. It is for these reasons that the team de-emphasies benchmarking for its portfolio structure. It remains firmly focused on whether the aggregate portfolio is best suited to deliver the long-term real return target. We don t spend much time benchmarking the portfolio weights because we want to remain squarely focused on the ultimate mandated objective. We don t have geographic or sectorspecific targets or asset allocations. We are free to pursue opportunities if they stack up, or not if they don t. The Future Fund assesses investment opportunities on a net-of-fees basis. In an environment where the best risk-adjusted returns can be achieved by, in some areas, pursuing more complex, more expensive strategies, the Fund s costs might look higher than in an environment where simpler and cheaper investment strategies offer compelling returns. The departure point for assessing an investment is therefore its net-of-fee potential, rather than the nominal associated cost. We look at fees as a function of the investment environment and opportunity set. If we think a particular opportunity has merit, the next step is determining the best possible access point, which involves selecting the best net of fee return available. So our first question is is this is a great idea? not how much will it cost? One team, one portfolio The Future Fund s single total portfolio strategy the one team, one portfolio strategy has become a real and tangible strength of the Fund s investment process. This idea of one team, one portfolio has become our mantra. It s even written on our coffee mugs. The idea is for the team to collectively channel its best ideas, irrespective of asset class, up to the total portfolio. Diversification is important and actively managed at a total portfolio level, but sector managers are discouraged from trying to create individually balanced portfolios. The team is encouraged to consider a larger exposure of a particular investment opportunity more than they would be comfortable having in an asset-specific portfolio because for large funds such as the Future Fund overdiversification at a sector level, and the associated cost, complexity and dilution of quality that comes with it, is a common problem. To reinforce the shared sense of purpose across the team, the Future Fund has tied the Agency staff s compensation depending on the level of investing responsibility to total portfolio returns. Investment resourcing and outsourcing model Since inception, the Future Fund s investment team has endeavoured to remain as small and nimble as possible, and as large as is necessary to cover its investment universe. Of the Future Fund s employees, almost half are investment professionals. Sector heads are tasked with forming their own investment views as well as engaging regularly with managers to identify or critically evaluate opportunities, monitor performance and assess asset divestment potential. The model for accessing investments varies depending on the asset class and the nature of the opportunity. In listed equities, debt and alternatives the Fund will typically adopt an outsourced model, with the selection and execution of individual investments being fully outsourced to third-party managers. That noted, the internal team still actively monitors and manages the sub-sector strategic exposures, so this is far from a typical manager of managers approach. Future Fund Australia s Sovereign Wealth Fund
7 07 Investment decision-making structure Board MD/CIO veto Sector teams Listed equities Private equities Property Infrastructure Debt and Alternatives Strategy Emerging Markets ESG Manager Review Committee (MRC) Investment Committee (IC) Asset Review Committee (ARC) Senior Investment Team (SIT) Communication and discussion forums Macro and markets forum Ad hoc meetings Full investment team meeting Engaging staff from across the investment team in discussing, developing and testing the strategy is a critical part of the investment process. Discussion forums and cross-team meetings, together with a focus on building a collaborative and open culture, play an important role in the formal decision-making process In private markets, in addition to delegating management to external managers, the Fund may pursue co-investment opportunities such as with private equity managers; or, if alignment issues are significant, may choose to invest directly, and subsequently outsource management of the asset, when the commercial position is such that alignment may be achieved, for example in property and infrastructure. The Future Fund prefers fewer, more meaningful, external relationships, selecting managers for their ability to generate information and insight, their willingness to genuinely collaborate and share knowledge, and for the breadth of their collective coverage. Indeed, the feedback loop created to capture the views of external managers on markets, investing themes or specific opportunities is an essential part of Future Fund s investment process. We have built a small number of deep relationships with our external managers. This helps us understand each other better, improves the exchange of ideas and information and also gives us the practical ability to move quickly on new opportunities. The Fund s focus on alignment and building relationships has improved the quality of investment opportunities available to it, and also helped to make the Fund s integrated investment process more efficient. Long-term investor The Future Fund has a long-term investment horizon, which provides it with a number of advantages, including the ability to take on greater levels of market risk; the ability to accept capital being locked-up in illiquid assets or structures; and the ability to be counter-cyclical, patient and opportunistic. The Future Fund seeks to benefit from its long-term investment horizon in a number of ways. First, by maintaining meaningful exposures to riskier assets, given the higher expected long-term rewards. Second, by searching hard for opportunities to extract strong excess returns for locking capital away in less liquid investments. And finally, by managing the portfolio risk dynamically to reflect substantial changes in conditions. While the portfolio strategy is under regular review and will be adjusted as the relative attractiveness of different sectors changes, meaningful changes to the Fund s risk profile are only expected upon substantial changes in external conditions. One aim of this dynamic approach is to have capital ready to deploy into areas of market weakness. With the portfolio now fully invested, the ability to actively manage the portfolio and exit from investments will start to play an increasingly important role. We ll keep the portfolio fresh - buy and hold is not our default mindset. Environment, social and governance issues The Fund believes that effective management of environmental, social and governance (ESG) issues will, over the long term, support the requirement to maximise returns. In particular, the Fund believes that there is a positive relationship between good governance and investment value. The Fund actively exercises its ownership rights, including voting rights where relevant, across the broad range of its investments. ESG factors are also considered when selecting external investment managers and assessing particular opportunities. In practice this means that the Fund applies ESG risk management both through its own governance activities and investment decisions and through its external investment managers, as well as through participation in industry initiatives designed to improve investment outcomes for long-term investors like the Fund. Investing for the benefit of future generations of Australians
8 08 Alignment The Future Fund has a single focus delivery of the risk-adjusted returns set out in the Investment Mandate. This means that a major focus is ensuring that all staff are focused on pursuing that and on ensuring that governance, policies and procedures all contribute to that level of focus. More broadly, the Fund is playing its part in a broader shift in the investment industry, which is witnessing a rebalancing between asset owners and intermediaries in the financial system. The Fund s constraints and advantages, its investment beliefs, dynamic investment process and perspective as a long-term investor all mean that the Fund can benefit from, and contribute to, the development of a financial system that serves the needs of owners. Practically, this plays out in the Fund s focus on deep relationships with external managers and other service providers, and an emphasis on alignment and shared value, as well as the emphasis on building a skilled team with a collegiate, open culture and a willingness to constructively test and challenge. Governance The Board of Guardians is an independent body comprising seasoned individuals selected for their expertise in financial services, investment management and corporate governance. The Board s members are called Guardians, as part of their function is to safeguard the independence of the Fund. The Board is responsible for ensuring that the Fund s assets are invested in line with its legislation and the Investment Mandate. The Board receives recommendations and advice from the Future Fund Management Agency and signs off on the investment strategy developed by the Agency. The Board reports on investment performance to the Federal Finance Minister, and through an annual report to Parliament. The Federal Treasurer shares responsibility with the Finance Minister in making any Board appointments or changes to the Investment Mandate. The Agency is responsible for day-to-day management of the Fund, including: providing investment advice to the Board; making recommendations on the appointment of external investment managers and other third-party advisers, and monitoring subsequent performance; monitoring and reporting on the performance of the portfolio; managing the relationship with the Fund s custodian and other specialist service providers; managing the financial reporting of the Fund; providing a risk management and compliance framework for the Fund; and managing communication with stakeholders. From the outset the Future Fund has been recognised for the clarity of its governance structure and has played a leading role in developing the Santiago Principles (Generally Accepted Principles and Practices for Sovereign Wealth Funds) and in establishing the International Forum of Sovereign Wealth Funds. Growing for the future The Future Fund s fundamental purpose is clear to grow and protect the capital entrusted to it for the benefit of future generations of Australians. Its robust statutory and operational governance and strong investment performance has been acknowledged with the organisation entrusted with the management of additional portfolios. The Fund is committed to maintaining its position as a trusted and innovative participant in the global and Australian investment community. For more information visit: Future Fund Locked Bag Melbourne VIC 3001 Phone: contact@futurefund.gov.au Future Fund Australia s Sovereign Wealth Fund
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