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‘Focus on the big game’ to stay competitive

Traditional portfolio construction might be dead. But that doesn’t mean there’s no way to beat inflation, even as investors anticipate it will continue to rise and fall over the next decade.

“Sometimes good news is good news and sometimes good news is bad news,” Rikki Bannan, IFM executive director for small caps, told the ASFA conference on Wednesday (February 22). “The market is very whippy and if there’s an economic print out that suggests the economy is stronger that should be good – but no, that’s bad, and it means the Fed is going to keep raising rates – and vice versa. The market keeps changing its mind about what it wants to see. It’s an interesting dynamic and there’s never a dull moment.”

The long-term view might be just as volatile. Deglobalisation is a clear trend, with countries valuing their security over supply chain efficiency, and while inflation will recede in the near-term it will likely keep spiking for years to come.

“We do expect inflation to be much more volatile,” said Alicia Gregory, Future Fund deputy chief investment officer. “If you have a view that inflation is at one, two, three, four and running like that for a long time, to build a portfolio is relatively simple.”

“But if you’re going to have these peaks and troughs and spikes of inflation, and you’re going to have equity markets extrapolating those to be the long-term version of whatever is happening, that’s a much harder environment to build portfolios in. So the scenario we’re thinking about and trying to build resilience for is that more spiky scenario where inflation doesn’t just settle somewhere.”

The Future Fund recently put out a position paper titled The Death of Traditional Portfolio Construction?, though Gregory stressed the question market at the end. There’s a high probability that traditional portfolios – 70/30, 60/40 – might not work as frequently as they used to, and a number of factors play into that, including inflation volatility.

“We’re not saying it definitely won’t work, but the probability of that working is lower today than it has been for the last 30 years. What does that mean?… There are some other building blocks that perhaps you want to have in your portfolios to provide some resilience and protection,” Gregory said.

“Specific commodities… we think they can play a role; alternatives, hedge funds; within infrastructure, private equity and property, more active management is going to be required in that scenario. A rising tide has lifted all boats, and more active management is going to be needed on the unlisted and potentially on the listed side.”

Rest CIO Andrew Lill is thinking about the same problem; the CPI+ return objectives of most super funds have “to be frank, over the last two decades been very easy to achieve”. But the reason it’s an objective, Lill said, is that at different points in history it’s been pretty tough to achieve.

“It’s certainly getting trustees’ attention because they’ve got this statement to members of what they’re going to achieve. Inflation is increasing, and using the experience of the last three years the returns have not been keeping up with inflation,” Lill said. “Looking further ahead, do we need to think about objectives management, do we need to think about changing the portfolio? What’s the right way of increasing the chances of beating an inflation plus objective?”

“Add on some other objectives; basically being competitive over a one, three, seven, eight, 10 year period and being competitive on fees it adds to the pressure of that portfolio construction…. Beating inflation, there are certain areas of private markets that might be useful. But effectively 50 per cent of my fee budget is taken up by 25 per cent of the portfolio in private market assets. Where fees are a competitive angle, we have to be aware of what our constraints are and make sure we’re spending that budget effectively with an inflation mindset in place.”

Lill said that the constraints of Your Future Your Super weren’t his first priority, but that
“you have to stay in the game”.

“So you have to pass the performance test,” Lill said. “That doesn’t mean you make decisions with that in mind; it just means you have to stay in the game. There’s some years in every eight year rolling period where a bad one rolls off and it gives more focus to the next 12 months. That’s just the reality of the way it’s set up.”

“Can benchmarks change? Yes, a little bit… Outside of that, I feel we have to focus on what’s important for the members and that CPI+ – for some shorter term products maybe cash plus makes more sense. You can’t control inflation in a two, three year horizon so how do you beat it? If you focus on the big game of beating inflation over a 10 year period you will stay competitive.”

Gregory also defended private market valuation techniques, which have become a sticking point for investors and some sections of the media after large falls in the public markets last year were not matched by similar falls in private asset valuations.

“On the private equity side, there’s IPEV – international private equity valuation guidelines – and there’s a fair bit of detail in there about how you go about valuing your assets and what you can do,” Gregory said. “I think in normal markets that worked really really well. These questions come up in much more volatile markets; when markets are falling this conversation comes up again.”

“…One of the things you see in private equity valuations is we’re continuing to see earnings. Multiples and earnings; it’s the same way you value a listed company. We had this phenomena that earnings were still growing and margins were still growing. If I look back 15 years, people just used to hold assets at cost until they exited it and then it would just get marked at what you exited it at. That has absolutely gone; a huge amount of work has gone into this valuation space and it’s actually very similar to how you value a public market company in terms of the data you use.”

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