The chairman of the board of guardians at Australia's Future Fund has warned of the risks for all investors of an environment of protectionism that might result from the actions of the new US administration. He was speaking during the release yesterday of the sovereign wealth fund's latest portfolio performance report.

Peter Costello, who is also former treasurer for the Australian government, said he spoke for all investors in wanting to be able to invest globally, unhindered by political interference either in the US or Asia.

“For any investor, the best kind of investment climate is one where there is free movement of capital flows,” he noted. “We are looking to invest around the world and anything that hinders that kind of investment doesn’t help our returns. We would say, from every global investor’s point of view, if there are restrictions on trade, it’s not going to help us.”

Australian prime minister Malcolm Turnbull has been pressured to speak out against US president Donald Trump’s controversial travel bans and “extreme vetting” of American residents with links to certain Muslim-majority nations in the Middle East and Africa. He has refused to do so, on the basis that it would be harmful to Australia’s national interest.

Costello would not be drawn on the travel ban.

Robust performance

The Future Fund, with A$127.66 billion ($96.5 billion) under management, posted a strong fourth quarter, returning 2.4%. This contributed to a calendar-year return of 7.8%, the same as the annualised 10-year return for the fund. This is very respectable given the difficult market environment for investors.

However, as the institution and other state investors, such as Singapore's GIC and New Zealand Superannuation Fund, have said, the coming years will be tougher.

While the fund’s internal management team consider their strategy, they are increasingly having to look at the likelihood of drawdowns by the government in 2020 when the fund’s initial investment mandate expires.

The Australian government has yet to give an indication of whether and to what extent it will start drawing down in 2020. “It doesn’t have to, but it can,” said Costello. It is important, he noted, that the fund is given as much notice as possible, so it can invest accordingly.

If the government were to draw down on the total of its unfunded pension liability, of around $9 billion a year, said Costello, the fund would wind down fairly quickly.

Without timely guidance, it will have to start provisioning for maximum drawdown, he noted. That would mean shifting to a more liquid portfolio, which will have an effect on the returns. “I wouldn’t say that, four years out, it’s affecting us now, but it will increasingly affect us as we get closer.”

Over-ambitious target?

Another issue the fund is grappling with is its return target amid an outlook of continued low growth. The fund is mandated to achieve an annual return of Consumer Price Index plus 4.5%.

Over the next five to 10 years, the global economy will not support the same level of returns, said Costello, citing as an example 10-year US government bonds yielding as low as 2% in the recent past. “That’s almost zero in real terms. So we have questioned the government on whether [the current return target] is the appropriate mandate for the next 10 years.”

While the fund has made submissions to the government, Costello would not say what he thought the target return should be.

“We have been told to avoid excessive risk, but the government wants us to get 4.5% real [return],” said Costello. “Those two objectives, which we have managed over the last 10 years, will be rubbing into each other over the next 10.” (See table, below)

Throughout 2016 the Future Fund reduced risk and raised its cash exposure to as high as 22% (though in the latest reporting period, this fell to just under 20%) on the basis that markets and monetary policy were both getting more extended.

In respect of the Future Fund's asset allocation, there haven’t been any big changes, apart from in the infrastructure and private equity segments. For example, the fund completed a large investment in the Port of Melbourne in September, alongside Australian asset manager QIC. Infrastructure is quite significant at 7.9% of the portfolio, said Costello, and the fund is interested in investing more in the asset class.

The fund has a particularly big allocation to hedge funds (14.2%, see 'alternative assets' in the table), and that is likely to remain the case for the time being. But it has also gone into other assets less linked to the broad market, such as insurance-linked investments and catastrophe bonds.

Meanwhile, Costello suggested that the recent US equity rally “may have run in advance of the actuality. They are anticipating a lot of growth and construction. Let’s hope that it happens, but it won’t happen tomorrow.”