Disrupting the fee chain | listed equities

In a recent meeting with the Future Fund we discussed how to achieve greater impact in improving the value proposition for the end saver. In the spirit of collaboration Future Fund gave us permission to write up a couple of case studies describing how they have sought to increase the flow of value to their fund. This case study concerns listed equities.

The background

The Future Fund has an absolute return (inflation-plus) return objective. The role of listed equities in their portfolio is therefore, partly, to help meet that return objective. In addition, globally-diversified listed equities are seen as an efficient way of harvesting the equity risk premium, and they also provide a source of liquidity if or when needed.

The listed equities program started in 2007, and following the global financial crisis equities offered strong prospective returns. The program consisted of external active and passive long-only managers, although a short portfolio was added in 2010. Since inception, the program outperformed its benchmark net of fees.

The changed environment

Following years of strong equity returns, forward-looking returns compressed significantly, meaning that fee drag became a much more significant issue. In addition the lessons the Future Fund took from their experience included:

  • Macro factors (eg declining interest rates) dominated individual stock-picking
  • Listed equity managers in general weren’t particularly good at making macro calls
  • Managers were knowingly, or unknowingly, taking significant factor positions
  • Managers often had opposite positions which netted out in Future Fund’s aggregate portfolio, therefore offering no value.

The Future Fund are happy to pay for manager skill, but are not happy to overpay for exposures they can buy more cheaply via another route.

The revised approach

Following a substantial review, the board of the Future Fund redefined the objectives for the listed equity program as below:

  1. Capture the equity risk premium over the long term (beta) and be a tool to adjust total fund risk
  2. Harvest long-term equity factor premias (alternative beta), which may vary through time
  3. Deliver good risk-adjusted, skill-based returns with low correlation to market returns over the long term (alpha), and
  4. Allowing them to access desired exposures from a whole-of-fund perspective.

As a result the executive have substantially reshaped the listed equities portfolio, and almost all long-only active managers have been removed. Exposure is now via market-cap index tracking, factor index tracking, and long-short market neutral hedge funds. On reflection, if an investor of the size and sophistication of Future Fund has divested completely from long-only active listed equities this could be a defining moment for the industry.

The shift is partly about a more efficient fee budget, more efficient risk allocation, and targeting return with zero correlation to equities to protect during market falls – but it is also about the reality of the advance of technology. The hedge funds they now use are not the ones they used to use. The hedge funds they now use have some of the world’s largest supercomputers, purchase thousands of independent and proprietary data sources, employ more than 1,000 coders or quants, and invest around A$1 billion per annum into their business (largely on technology).

Why is this important?

I infer from this case study that the Future Fund have a smart and edgy investment belief: the current and prospective technological reality means that the traditional route to producing alpha will no longer work – instead it is about access to data and the computing power to process it. If this belief is true it suggests substantial, perhaps transformational change for long-only listed equities managers.

Not all asset owners will be able to follow the Future Fund’s example here – nor should they. But they should reflect on it, and be clear about what their listed equities exposure is for, and how it should be structured in the light of shifting value propositions.