The ongoing Covid-19 pandemic and the unprecedented issuance of public debt and global stimulus to mitigate its economic impact means institutional investors are having to plot a course into unexplored waters.

For Australia’s Future Fund, one big worry is the wall of stimulus liquidity and consequent rise in asset valuations, making it hard to find returns without seeing balance sheet risk surge.

The A$205 billion ($150 billion) sovereign wealth fund’s new chief executive officer Raphael Arndt said this situation led the investment team to take a more cautious stance over the past year, raising liquidity over worries about the build-up of asset prices as a result of governments pumping money into their economies.

Raphael Arndt, Future Fund

“We’ve been concerned about where asset prices were for quite a long time and we’ve been building liquidity in the portfolio,” Arndt told the audience at an online investment conference last week. “At some point these issues need to be resolved and that doesn’t change with a vaccine.”

He noted that one of the asset owner’s responses has been to find new ways of addressing investment risk, because “there’s very little defensiveness in government bonds [due to their high prices and low yields]”.

Arndt’s point makes sense; the 10-year US Treasury’s closing yield on Friday (November 20) was 0.829%; that compares to 1.757% a year earlier.  

“The important thing here is to understand that the world is changing fundamentally and there’s not enough education on how things have changed,” he said. “Eventually something bad will happen in markets. It always does.”

SELECTIVE INVESTMENTS

There is no single strategy that asset owners like Future Fund can take when responding to these issues.

New Zealand Super, Future Fund’s equivalent in the neighbouring country, has also recognised that public sectors across the world are set to be far more indebted, while interest rates will likely remain at current historical lows for far longer.

Its strategy has been to pivot towards investing in alternative energy and climate friendly infrastructure investments.

Future Fund’s analysis suggests that selectively moving down the risk curve has helped it add about 1% per annum to its annual investment returns.

But managing risk is becoming harder. Having fewer defensive assets means that, under its 'whole-of-portfolio' approach, the fund has to trim its offensive assets and take fewer risks. This will eventually weigh on its returns.

Future Fund posted a negative 0.9% return in the 12 months to the end of June, its first yearly loss since the global financial crisis of 2008-2009. But the sovereign wealth fund said shifting into more defensive portfolio positions, selling down international private equity and alternative assets in favour of more domestic exposures, shielded it from an even worse result.

The fund is responsible for investing the assets of the Medical Research Future Fund (MRFF), which is currently valued at nearly A$21 billion. Earnings from the fund are used by the government to fund critical health-related projects.

As an example of how funding from the MRFF is being used in the Covid context, the Australian government announced in June that it is investing A$66 million to find a vaccine and treatments for Covid-19, as well as better preparing for future pandemics. Three new research programs at the University of Melbourne have received financial support to help develop new classes of medicines to tackle Covid-19.

INEQUALITY CONCERNS

Arndt believes another concern about overly-abundant liquidity is the potential for rising wealth inequality, and societal tensions as a result. He noted that “monetary policy has been effective at pushing up asset prices, but not that effective in helping the real economy,” leading to the widening income disparity.

“At some point there will probably have to be some wealth redistribution,” he said. Otherwise the trend of populist politics will continue, with the example of the US as a warning for other nations.

“[US president Donald] Trump got almost half the votes [in the November 3 presidential election that he lost] and there’s a lot of people not happy with how their lives are going,” said Arndt.

“Unless we solve the underlying problem – which is that people feel their lives aren’t getting better and governments aren’t supporting them – then those problems will continue.”

The concern could affect the future of superannuation. On Friday (November 20), the Australian government unveiled a 650-page Retirement Income Review, chaired by former Treasury official Michael Callaghan. It noted there is a clear trade-off between employer super contributions and employee salaries, while also stating that without superannuation savings, middle income workers will not be able to maintain their living standard in retirement relying solely on the state pension.

That sets the stage for a battle over whether the government sticks to an agreed increase in employees’ contribution rate, from 9.5% to 12% in 2025. Doing so will be especially important, say defenders, since super savings have been depleted by the ability of workers to withdraw funds during Covid-19. Official figures show that A$35 billion was withdrawn from superannuation funds between 20 April and 8 November 2020.