What the Future Fund Can Teach Us

One of the biggest investment funds in Australia is the Future Fund, with assets of around $243 billion at the end of December 2022. That’s a portfolio that manages the equivalent of around $10,000 for every man, woman and child in Australia.

Described as Australia’s sovereign wealth fund, with assets set aside to assist in events such as drought and emergency relief operations, the Future Fund’s 12-month return to the end of last year was -3.7 per cent, a reminder that 2022 was a tough year for investors, large and small.

But over five years, the Future Fund has returned a cheerier 7.1 per cent per annum. The Future Fund is transparent in the way that it produces public documents and those documents provide a number of valuable lessons for individual investors and how they might choose to manage their portfolios.

Targeting Returns After Inflation

The Future Fund has a clear focus on producing returns above the rate of inflation. Sometimes the impact of inflation can be forgotten on returns, particularly following the extended period of low inflation we have seen leading up to 2022 — inflation has simply not been an issue. In reality, the only returns that matter to investors are returns relative to inflation. After all, it is only returns above the rate of inflation that will increase the purchasing power of an investment over time.

So, first — keep inflation in mind when thinking about returns (and yes, that makes 2022 calendar year returns a little worse than they seem at face value).

Compare Short- & Long-Term Returns

In the latest Future Fund quarterly report, returns are set out for all periods from 10 years to one year and are compared against the target return for the fund. There is often an excess of information about short-term investment returns, for example global shares performing poorly in 2022, which overlooks the acceptable longer-term return from an investment or asset class.

The second lesson – keep both short and long term returns in mind.

Diversification

The Future Fund portfolio has exposure to a number of asset classes:

• Australian shares
• Global shares
• Emerging market shares
• Private equity
• Property
• Infrastructure and Timberland
• Debt securities
• Alternatives
• Cash

Each of these asset classes has an exposure in the Future Fund portfolio of 5 per cent or more. There is often discussion about the role of diversification in portfolios and a range of views on the topic exist. Exposure to a variety of asset classes, with reasonable returns over time, will tend to dampen volatility in portfolios. This is shown in the volatility reported in the quarterly report, ranging from 4.6 per cent to 6.4 per cent over different time periods. For a portfolio that has returned 7.6 per cent per annum since it started in 2006, this is a low level of volatility, suggesting there are benefits to thoughtful diversification.

The third idea – exposure to a variety of asset classes in a portfolio is worth considering.

Equivalent Equity Exposure

In the “Performance” section on the Future Fund website, there is focus on a phrase I had not come across before – “Equivalent Equity Exposure”. This refers to the amount of market exposure the Future Fund portfolio has at any one time.

This mirrors one of the most profound investment decisions an investor has to make – what is the split of growth (generally equity) and defensive (cash and high-quality fixed interest investments) in a portfolio?

The Future Fund provides a graph of the proportion of equivalent equity exposure over time (below) and it seems to sit between 55 per cent and 60 per cent over the last four years.

The lessons from this for an individual investor seem to be two-fold. Firstly, know what that growth/defensive allocation is in a portfolio. Secondly, the Future Fund perhaps has a slightly lighter equity exposure than many might expect of a long-term portfolio. This, however, does leave the portfolio in a strong position when there is a period of poor share market returns.

The famous investment saying, ‘shares let you eat, and cash lets you sleep’, suggest an important role for both equity and defensive assets in a portfolio – and keep in mind there is no way of undoing the impact of a market downturn if your share market (equity) exposure is too high.

The fourth lesson – know your defensive/growth split, and don’t forget the important role that defensive assets play in a portfolio.

Keeping a Cap on Costs

In general terms, the direct costs for the Future Fund portfolio are low – in 2022 they came to 0.22 per cent of the value of the portfolio. Of course the portfolio should have significant economies of scale being as large as it is, so perhaps this is not surprising. That said, it is a reminder to investors that the returns from investments have to be shared between the investor and any fees paid, and therefore keeping costs low makes sense.

As well as the direct costs, the Future Fund sets out “Look Through” costs, which are the other costs incurred in the management of the portfolio. These are somewhat higher, just over 1 per cent in the 2022 financial year – and 1 per cent of $240 billion is a significant sum of money.

The fifth idea – keeping costs low allows investors to keep a greater proportion of their returns.

Regular, Not Daily, Statements

The Future Fund produces a clear report on the progress of the fund every three months and has done so for years (they are still available on the fund website). This seems to be a rational way to consider investment performance.

For many investors, the habit of daily checks of investment values, with the constant ups and downs of markets, becomes a source of stress. A quarterly review of asset allocation, returns against benchmarks, and market conditions provides a more thoughtful way of doing this. I take the time to put together a statement of investment assets and benchmark that against market movements every two months.

The sixth idea – making a regular practice of taking a close look at your portfolio, perhaps every two or three months, might replace some of the stress of watching daily market movements and encourage investors to be more strategic in their decision-making.

Conclusion

While we cannot directly get our hands on the $10,000 that the Future Fund is investing for every Australian, we can use the reports generated by the fund managers to find ideas for our own investment management.

To sum up, the six ideas that strike me are:

• Keep inflation in mind when thinking about returns (which makes 2022 calendar year returns a little worse than they seem at face value).
• Keep both short and long term returns in mind.
• Exposure to a variety of asset classes in a portfolio is worth considering
• Know your defensive/growth split, and don’t forget the important role that defensive assets play in a portfolio.
• Keeping costs low allows investors to keep a greater proportion of their returns.
• Building a regular practice of taking a close look at your portfolio, perhaps every two of three months, might replace some of the stress of watching daily market movements, and encourage investors to be more strategic in their decision-making.