The Future Fund has restructured or replaced two-thirds of its hedge fund managers, or $14 billion worth of assets, in a four-year overhaul of its hedge fund portfolio.
The aim of the restructuring was to reduce exposure to bulk beta to ensure the $166 billion sovereign fund is getting true alpha for its fees.
“Our debt and alternatives team of 10 people has worked incredibly hard over the last four years refining our hedge fund strategy to maximise our expectations of diversification, increase the impact of that diversification on the fund and deliver the most efficient portfolio possible in terms of capital, fees and risk,” Raphael Arndt, Chief Investment Officer of the Future Fund, told delegates at the [i3] Investment Strategy Forum in Torquay, Victoria, last week.
“This work is nearing completion, and has entailed substantial portfolio restructuring to reduce exposure to bulk betas and to ensure that our managers are complementary with each other.”
In an exclusive interview following his presentation, Arndt says the overhaul also reflects the changes that have occurred in the hedge fund industry following the global financial crisis (GFC).
[Hedge funds] had to get real about whose capital they are investing. It can’t be this blank wall of: ‘We do magic and you just pay us high fees’
“Obviously, hedge funds didn’t perform as was expected, which resulted in some cleaning out of the industry. But the managers that have survived have become more transparent,” he says.
“They essentially had to get real about whose capital they are investing. It can’t be this blank wall of: ‘We do magic and you just pay us high fees.’
“Today, we have a much more transparent discussion around strategy, systems, what is working and what isn’t, combined with a provision of data to back that up.”
Besides the change in mentality, the improvements in analytical technologies and access to data have also helped the fund dig down into the activities of the managers.
“The availability of data at the investor level is one thing and I think the hedge funds themselves are investing in those capabilities and improving how they invest,” Arndt says.
In Search of Risk
The Future Fund sees its hedge fund portfolio as a diversifier, which enables the fund to take more risk in its allocations to infrastructure, private equity and property, as well as equities.
And although the new portfolio remains to be tested in a real crisis, Arndt is confident the hedge fund allocation would hold up in a downturn when correlations tend to move closer to one.
“Obviously, we have a conviction that it will be okay, otherwise we wouldn’t do it, but you also want managers who are adaptive to the market environment. You don’t want a manager who has one idea and is pursuing that idea forever,” he says.
“The reality is that these strategies only make money because not everyone is doing them. Now, over time people identify the problem and compete away, or arbitrage away the problem and the manager has to find new ways to make money.
“But in terms of macro managers, we do look for changes in positions and try to have dialogue with them about why they changed their view. If they have changed their position and it doesn’t play out, we look for them to hold that position with conviction, or explain why they have changed their view to test that they haven’t lost their confidence in themselves and their own risk-taking.
“That gives us some level of confidence that in a crisis-type of scenario they are able to adapt.”
No Bond Replacement
In the current market environment, increasingly more institutional investors are looking at hedge funds rather than fixed income for diversification. But Arndt says the fund’s 15 per cent allocation to hedge funds should not be regarded as a bond replacement strategy.
“What we are trying to do here is build a hedge fund portfolio that is uncorrelated to equities throughout all market environments,” he says.
“Bonds can be very attractive in different economic scenarios where they would be priced differently, but in the last few years they haven’t been very attractive because the returns are very low.
“And in an environment of economic growth and rising interest rates you expect bonds and equities to be [positively] correlated. So the mindset that bonds are negatively correlated with equities throughout all market environments is inaccurate.
“If we thought bonds were likely to be negatively correlated with equities, and in particular that the price of holding bonds is lower because their price is lower, then we would buy more of them.”
Scaling It Up
One of the challenges the Future Fund faces is to maintain a meaningful exposure to hedge funds.
Arndt says he expects the fund to reach $250 billion over the next decade, following the government’s decision to defer drawdowns until 2026/27, which would mean a $37.5 billion hedge fund portfolio if the fund was to maintain its 15 per cent exposure.
Although Arndt emphasises the importance of having an exposure that moves the dial, he wouldn’t pursue a 15 per cent exposure for the sake of it.
“We wouldn’t keep funding it if we couldn’t identify the skill. It is not that we have a top-down asset allocation that says: ‘We need a 15 per cent allocation,’” he says.
“We have found enough [strategies] that we think are worth having. If for some reason the universe shrunk, the capacity available was such that as the fund grew we wouldn’t think we could have a meaningful program at all, we would cut the whole program.”
If for some reason the universe shrunk, the capacity available was such that as the fund grew we wouldn’t think we could have a meaningful program at all, we would cut the whole program
But to avoid such a scenario, the fund is constantly looking for new strategies and is willing to seed strategies it deems promising.
“We work hard on finding partners, new strategies and new people with new ideas that we can invest into so that we can grow with them,” he says.
“We certainly wouldn’t invest in substandard managers. Then we would have to think of something else to protect the tails of the return distribution. But we think that at the moment this is the best strategy.”
The Future Fund concentrates on three hedge fund strategies in particular: macro-directional, alternative risk premia and multi-strategy relative value.
“We identified those three strategies, because we believe that that is where we find skill and get uncorrelated returns,” Arndt says.
“For example, we used to have what you might call activist equity managers and they might have quite a lot of skill, but the reality is that you get a great deal of beta with that. We decided that wasn’t an effective way to deploy our capital.”
A Call to Action
Arndt says the restructuring has resulted in a portfolio that is more liquid and has almost zero correlation to equity markets.
In his address to the forum, he called upon other asset owners and consultants to do their own reviews and reduce their dependence on equity markets.
“I encourage industry participants to consider such a program in their portfolio to protect against the risks associated with a repeat of a GFC-type event in equity markets,” he said.
“The fees paid, while unquestionably high, are worth paying for skilled managers who collectively can add significant value to the portfolio overall.
“I also call on consultants, who might currently rank funds according to fees paid, to properly assess the risks associated with equity market exposure.
“Doing so may lead to increased appreciation of the true value of diversifying strategies.”