After decades of relative calm, geopolitical tensions have started to impact the investment portfolios of institutional investors again. We speak with Craig Thorburn about how the Future Fund is adjusting its allocations to deal with these influences.
For some time, the Future Fund has argued that the world is in a ‘new investment order’, where markets will be more volatile and overall returns are likely to be lower.
This new environment is partly the result of a more complicated geopolitical environment around the world, especially the rising tensions between the West on one side and China and Russia on the other.
Although the Future Fund doesn’t quite see the unfolding of a new cold war just yet, and says those who are calling a Cold War 2.0 are off the mark due to global connectivity, the fund does see a situation of heightened competition, which it expects will impact certain regions and sectors of the global economy.
Faced with this scenario, institutional investors would do well to take geopolitical trends into account when setting their investment strategy. The fund has set out its current thinking on this in a new position paper, “Geopolitics – The Bedrock of the New Investment Order”.
In the paper, the fund warns that geopolitics is here to stay for a while.
“We believe geopolitics is not a transitory force, but is expected to be longer term in nature and impact. This requires geopolitics, as an increasing and potentially misunderstood risk, to be managed,” the paper says.
The new investment order has real-life implications for the investment portfolio, the fund says. Since first speaking to its Board in May 2021 on the new investment order, it has made some $70 billion worth of physical changes in its portfolio, which currently stands at $225 billion.
One of the key challenges of the new world order is it makes diversification more challenging. Geographic diversification requires a rethink, the fund says, as certain jurisdictions may not be as open to free capital flows in the future, potentially due to capital controls or sanctions.
But diversification across asset classes might also become more challenging as the Future Fund expects geopolitics to contribute to higher inflation, higher interest rates and volatility in the future.
Higher interest rates and inflation have already caused correlations between asset classes to change. In particular, it saw the correlation between equities and bonds become positive, a development that causes headaches for investors that take a traditional approach to portfolio construction, where bonds are used to offset the risk of investing in equities.
“In the traditional sense of portfolio construction, everybody wants a negative correlation between equities and bonds. That is the secret sauce of portfolio construction traditionally,” Craig Thorburn, Director of Research and Insights at the Future Fund, says in an interview with [i3] Insights.
“But in a sticky inflationary environment, in an environment where inflation is higher and more volatile, one needs to be cautious when it comes to that desire for that negative correlation between equities and bonds.
Everybody wants a negative correlation between equities and bonds. That is the secret sauce of portfolio construction traditionally. But in a sticky inflationary environment..., one needs to be cautious when it comes to that desire for that negative correlation between equities and bonds
“We’ve seen in recent times that it has been positive and what it means is that we’re not using solely bonds as a diversifier. A lot of people in a traditional 60-40 portfolio would look at it and say: ‘Well, we would own bonds as that diversifier.’ That’s not something that we are keen to do going forward.”
This doesn’t mean the Future Fund will no longer invest in bonds, but rather that it is seeking additional sources of diversification to build a resilient portfolio.
“There is a role for bonds in our portfolio. There will be certain scenarios, more traditional economic downturns, where you would expect bonds to do well,” Thorburn says.
“The concern we’ve got is that there’s a host of other scenarios out there that for 30-odd years we probably haven’t really had to contemplate too seriously. But going forward, we have to consider those scenarios more carefully.
“And it’s in those types of scenarios – a higher inflationary environment or environments where you’re looking at funding costs rising for whatever reason – that we’re struggling to see how that correlation [between equities and bonds] can actually be negative on average.
“In other words, bonds may not provide that power of diversification as it used to do, certainly over the last 20 to 30 years.”
He says there is no silver bullet out there to solve the diversification problem and so the fund has taken a number of measures to protect the portfolio from too much volatility.
“Commodities and gold are two examples where in certain scenarios they would actually do well and help diversify our portfolio against other forces at play,” he says.
Alternatives and hedge funds are another example and the fund singled out global macro and market-neutral strategies in particular in the paper.
Team Structure and Functions
The conviction that the world is in a new investment order has not just led to changes in portfolio allocations, but also to the way the Future Fund has organised the structure and functions of the investment team.
For example, the fund has built a dynamic asset allocation (DAA) function, under the leadership of Sam Killmier, who is Head of Dynamic Asset Allocation at the Future Fund.
Killmier’s team looks at dislocations in the market over a number of time horizons and recommends or decides exposures to take advantage of longer-term trends.
“The point of that is not just to go off and tweak here and trade there, but it’s actually under the construct of really strong governance arrangements – which report into our investment committee and report through to our Board – that we are able to be more dynamic in the way we allocate our capital,” Thorburn says.
“That group of (DAA) people are then able to be more adept in putting on positions, whether that be higher levels of equity risk, lower levels of equity risk, different levels of bond exposure or a different mix of currency risks.”
The DAA team is looking to implement trades over three types of investment horizons. The first horizon considers opportunities over less than three years, based on the cyclical outlook and price versus valuation signals, while the second one looks at a horizon of three to 10 years using a set of secular scenarios. The highest-level decision is based on a very long-term, 10-plus year horizon, he says.
“The idea is that you are, in essence, able to move more quickly to putting on these types of exposures, whether it is with that medium-term horizon, long-term horizon or even the very long-term horizon,” he says.
Thorburn gives the example of currencies. Geopolitics has changed the way the Future Fund looks at currencies and it has made some changes to its allocations.
“We’ve had to rethink our currency exposures and we’ve done that through a broadening of baskets and the way we focus on certain currencies as opposed to some others. That has been done partly through the DAA team as it is also about our asset allocation more generally,” he says.
We've tested our asset allocation with the Board at least once, sometimes twice a year, but we're now going through a process where we're looking to iterate that more continuously
The Future Fund has always been quite dynamic in its asset allocation and rejected the notion of a strategic asset allocation that is reviewed only once every three years or so from the start. But Thorburn expects the fund will review its asset allocation more frequently than in the past.
“We’ve tested our asset allocation with the Board at least once, sometimes twice a year, but we’re now going through a process where we’re looking to iterate that more continuously,” he says.
The Future Fund has also made some changes to its treasury function to give it an additional focus on portfolio flexibility and established a new Portfolio Risk function for the overall fund.
“There is a new function within the fund that deals solely with portfolio risk. In other words, not just risk in total – we’ve stripped out operational risk and that’s being looked at separate from portfolio risk,” Thorburn says.
“There is a team of people under Portfolio Risk being built out right as we speak. The idea being that we’re able to have a much richer conversation about where these risks lie, what these risks mean and, therefore, how we’re looking to manage those risks more proactively over different time horizons.”
He is quick to point out that managing risk is not the same as avoiding risk. The Future Fund’s mandate includes a risk-seeking investment objective and any attempt to make the portfolio more resilient should not be seen as positioning it conservatively.
“When people hear resilient, they worry that it means you’re being defensive. We’ve actually got a risk-seeking mandate, earning a return of CPI plus 4 to 5 per cent. That’s an aggressive mandate,” he says.
“We have to embrace risk. So even though we believe it’s becoming more challenging to earn that return, we still have to lean into that risk. And that requires us to be more active in the way we embrace alpha opportunities.”
Non-financial Information
Geopolitical data wasn’t very relevant to investors for many decades as the world was undergoing increasing globalisation and tensions remained relatively low, at least among the dominant world powers.
But as conflicts are rising and corporates reconsider the just-in-time global supply chain, geopolitics has become relevant again. Thorburn says existing financial analytical frameworks don’t always have a good way of incorporating these underlying geopolitical trends.
“We’ve seen that over the last few years, with geopolitics having crept back into the mainstream, that a lot of traditional financial market analysis is struggling a bit. I think that’s because a lot of traditional financial market analysis focuses on risk, but geopolitics is a type of uncertainty,” he says.
The Future Fund has a number of non-financial intelligence data subscriptions that shed more light on the geopolitical situation around the world. But Thorburn says these have been in place a long time and aren’t a recent reaction to the increased tensions around the world.
“[We receive] this extra level of information from geopolitical experts, who are probably a bit older, have been around for a long time and perhaps they haven’t really been listened to for a long time,” he says.
“But we’ve always had them in our bailiwick and we’ve spent a lot more time over recent years [with them] as we’ve developed this new investment order with geopolitics at its bedrock.
“We’ve spent a lot of time over the last two or three years really trying to understand not so much the events, but rather those trends that we refer to in the paper and what is underlying those trends and the direction of travel that those trends are heading in.
“We’re not suggesting that we can trade it. But what we are trying to do is spend more time focusing on what we think matters. Who could be the beneficiaries? Where could the risks be? And this is all in the context of resilience. How do we build a more resilient portfolio?”
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[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.