Inflation has reached its highest point since the 1990s in Australia. We speak with the Future Fund’s Wendy Norris about how the fund is building resilience into the portfolio.
Last week, inflation hit 6.1 per cent in Australia, a level not seen since the 1990s if we ignore the price effects of the introduction of the goods and services tax in 2001.
And it is likely to get worse. The Reserve Bank of Australia expects to see a further rise to 7 per cent by the end of the year before inflation might come down again.
This high inflation level poses a problem for institutional investors, particularly those with Consumer Price Index (CPI)-plus targets as it raises their return objectives dramatically. The situation is made worse by the expectations of lower growth in the years to come.
Wendy Norris, Deputy Chief Investment Officer – Change & Innovation at the Future Fund, spoke with [i3] Insights about the work the fund has done to reposition the portfolio for a world of higher inflation, increased volatility and lower returns.
Norris says inflationary pressures had been building for some time, even before Russia invaded Ukraine, causing a steep rise in food and energy prices. And so in its recent strategic investment review, the fund decided it was time to shift the portfolio towards more inflation-resilient strategies.
We identified the increasing importance of inflation and so we continue to look at ways that we can build more inflation resilience into our portfolio. We're doing that through an increase in private markets and specifically in the tangible space
“We identified the increasing importance of inflation and so we continue to look at ways that we can build more inflation resilience into our portfolio. We’re doing that through an increase in private markets and specifically in the tangible space,” Norris says in an interview with [i3] Insights.
“We really think that there is a benefit to be had for continuing to emphasise and build out our property and infrastructure exposures.”
Infrastructure and property are tried and tested assets when it comes to inflation protection, but they are not the only place the Future Fund is looking for resilience. The fund has been expanding its alternatives portfolio too, Norris says.
“We’ve got quite a large and nuanced alternative portfolio that has a lot of different sub-strategies in it. We’ve been specifically looking for things that have got inflation resilience, which includes things like trend following and commodities,” Norris, who will be speaking at the upcoming [i3] Asset Allocation Forum in Terrigal, says.
“There are different parts of the hedge fund universe that we can access that will give us more access to inflation-resilient strategies.”
Currency and Resilience
Besides a greater allocation to private markets and alternatives, the Future Fund also tries to mitigate the worst effects of inflation through actively managing its currency exposure.
It uses a dynamic asset allocation (DAA) approach to respond to changes in the market environment. Some of the biggest levers it applies are under and overweights to equities, as well as adjustments to its interest rate overlay program.
The fund doesn’t hold any direct bonds, but takes its exposure to the bond market through the derivatives market, which allows it to move relatively quickly.
We start from the fundamental idea that we would hedge all of our currency exposure back to Australian dollars, but then we make an active decision to take some currency exposure, whether that is unhedging our physical exposures or actually going out and buying a synthetic exposure to currencies
Currency is the third pillar to the fund’s DAA program.
“Currency is a really important part of where we build overall resilience in our portfolio because as Australia is a pro-cyclical currency and we’re an Australian dollar investor, we really can’t afford to ignore the currency effect on our portfolio,” Norris says.
“We start from the fundamental idea that we would hedge all of our currency exposure back to Australian dollars, but then we make an active decision to take some currency exposure, whether that is unhedging our physical exposures or actually going out and buying a synthetic exposure to currencies.
“We’re constantly looking at the bucket of currencies that we are investing in and assessing their resilience. We treat them almost like individual assets and then dynamically decide how we want to change the bucket.”
Investment Objective and Inflation
Despite the numerous ways the Future Fund is building resilience to inflation in the portfolio, the ability to meet its CPI plus four to five investment target will prove to be difficult in the current environment.
Norris acknowledges this, but also points out this objective is a long-term one and the Future Fund’s mandate specifies this target should be pursued with “an acceptable but not excessive level of risk”.
“Fundamentally, we think that our objective is a long-term objective and it is difficult for any portfolio anywhere in the world to respond to such an extreme spike as we are seeing in inflation right now,” she says.
We attempt to gradually build our inflation resilience over a longer time frame, so I'm certainly not going to suggest that when CPI is 7.5 per cent that we're going to produce CPI plus five in the one year
“We attempt to gradually build our inflation resilience over a longer time frame, so I’m certainly not going to suggest that when CPI is 7.5 per cent that we’re going to produce CPI plus five in the one year.
“But over the longer term, we think that we’re building a portfolio that can respond to the underlying inflation level. We now have a portfolio that is better positioned to respond to that situation than five years ago when inflation was still on the downtrend.”
Private equity is another asset class among the private markets that the fund has been allocating to, although not specifically for inflation reasons.
The strategic review concluded the outlook for growth is likely to be somewhat subdued in the years to come and this warranted an increase in the overall risk in the portfolio, with private equity being one of the beneficiaries from this decision.
But while the asset class has produced a great performance in the past financial year, valuations in listed markets have dropped, which has raised concerns the coming year is shaping up to be less of a stellar year for those with large exposures to private equity.
Asked whether Norris is concerned about the performance of private equity going forward, she answers that, again, it all comes back to taking a long-term view.
“We might have a bumpy ride in private markets in the next little while and often it creates a buying opportunity for people who can see through the noise,” she says.
“In the long term, we believe private markets do add value over and above what you can get in public markets, so we do expect that the private equity portfolio will continue to perform well over the long term, even if it has a down year.”
Wendy Norris, Deputy Chief Investment Officer – Change & Innovation at the Future Fund, will speak at the 10th annual [i3] Asset Allocation Forum, to be held in Terrigal on the New South Wales Central Coast on 18 and 19 August. For more information, please click here
[i3] Insights is the official educational bulletin of the Investment Innovation Institute [i3]. It covers major trends and innovations in institutional investing, providing independent and thought-provoking content about pension funds, insurance companies and sovereign wealth funds across the globe.