Some advice on investment strategies for the Federal Government's new 'Future Fund'

The most robust approach to the issue of setting up a Future Fund is that argued by Alex Erskine - do not try to invest on behalf of us all, give the money back by cutting income tax and let individual Australians make individual choices.

If this point is dismissed, as this government has done, there is the question of how the money should be invested. Our colleague Ray Block has provided an excellent lead on several issues relevant for the Future Fund. He has pointed in particular to the New Zealand Superannuation Fund as a potential model, and commented on its approach to a number of issues - whether it is taxed or free of tax is one vital issue to sort out.

The Australian Future Fund can learn a lot from the New Zealand Superannuation Fund. Parliament has to provide the basic marching orders, and I’d suggest the basic objective be to “maximise the value of the fund with a widely diversified portfolio of assets to limit risk”.

One of the controversial issues will be how much to invest overseas. If a truly global approach is taken, around 98 per cent of the fund could be invested offshore. (Think Nauru if you object to this.) However, we might justify investing more than the “natural weight” in Australia on the grounds that we know the local opportunities better than we know the overseas opportunities. This is of course a difficult argument to sustain, and going too far down this track is likely to lead to investing in some really dud companies. Would the Future Fund have invested in HIH, for example? If it did not, would the Treasurer have had to put up with strong representations from Ray Williams and Rodney Adler, for all I know great providers of donations to both major political parties.

Is BHP an Australian company? Or Rio? Or News Corporation? The board of the Future Fund should accept the various stock exchanges’ definitions and invest in index funds in each of the main markets as a way of minimising both fees and selection risk. Although fund managers prefer to ignore the point, “active” managers rarely outperform market indexes by enough to justify fees above the minimal amount charged by managers of index funds. In fact, the last time I looked, the average “active” manager in the United States underperformed the index. In Australia, “active” institutional managers did rather better, it seems because overseas investors and non-institutional domestic managers do relatively badly. “Active” managers need to be selected very carefully, and given a mandate to manage relatively small portfolios.

All this relates to listed equity markets. There are particular areas in the Australian market where local knowledge should help Australian fund managers find special value. Small cap listed stocks are one example. Private companies ready for serious growth or even some start-ups if chosen wisely could merit some allocation. There would be a case to include a predetermined allocation to infrastructure funds. The safest approach is to create a preset allocation for each category and leave it to the board to decide how to build a relevant portfolio in each category.

Should the Future Fund include property in its portfolio? “Probably not” is my answer, as Australia is over-invested in property already. Some diversified fixed interest investments will improve the risk-reward profile of the fund, and there will therefore be an allocation to the world’s leading bond markets. Cash will accumulate in a special account in the Reserve Bank.

Should the Future Fund include an allocation to hedge funds? This is another controversial question but as this is an asset class being used by some major pension funds it is likely also to improve the risk-reward properties of the overall fund. (I must declare an interest as a proprietor of an Australian-based hedge fund.)

A baseline portfolio might be constituted as follows: 

These suggested weightings would need to be approved by parliament on the basis of expert advice. Choosing portfolio weights is more of an art than a science, but any relevant expertise would be used in making the basic recommendations to parliament or to the Treasurer if he were asked to approve all operational aspects of the Future Fund.

I would not recommend attempts to actively manage asset allocation - i.e. vary the weights in the asset allocation table. The hedge fund component of the Future Fund could be larger if active asset allocation were seen as a major potential source of added value.

I would not attempt any “in house” investment. In all cases the investment process should be outsourced. Advisors such as Mercers and the Russell company would be employed to recommend the managers to be used, and for both Australian and global equities most of the relevant portfolios would be index funds. Only where there was a strong case that active managers could add value over and above their fees would such groups be used. The prestige of running the investments should lead to some very competitive bids.

It would be possible to give the government's holdings of Telstra shares to the Future Fund to sell down gradually, although until the holdings were down to index weight the fund would have an unbalanced portfolio. The offset would be lower fees for the sale of the rest of Telstra.

It goes without saying that the process by which managers were hired and fired would be subject to the highest standards of propriety and transparency. Relations with the managers and advisers would need be conducted in a similar manner. Any temptation to get inside knowledge, for example about future movements of Australian interest rates, would need to be resisted firmly.