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Skill, not luck: Future Fund backs active small caps

The Future Fund is thinking of restarting its active equity programs with investments in small caps, according to CEO Raphael Arndt, but commentators are split on whether it will find the returns it needs.

While the Future Fund has eschewed active equity management for more than six years, changes in the domestic market have made small cap equities attractive “for the first time” and the Future Fund has commenced a new program to invest in them.

“Conditions have changed. Economies are diverging and companies can better distinguish themselves in a more challenging environment,” Future Fund CEO Raphael Arndt (pictured) said in a speech on Thursday. “As a result, active alpha-seeking strategies in our $65 billion listed equities program are increasingly attractive, provided that we can be confident that returns are driven by skill and not luck.”

“We are using new technology to better understand the drivers of returns being delivered by investment managers – to better understand whether skill actually exists or whether managers are just applying a mechanical strategy which can be re-created cheaply.”

The Future Fund would not disclose more detailed information about the program, including its size, who was managing the money and whether it had actually commenced; a number of fund managers and CIOs polled by ISN expressed skepticism about the ability of the Future Fund to generate significant returns relative to its overall FUM in the small cap space (while noting that even Norges Bank Investment Management, the largest sovereign wealth fund in the world, invests in funds and strategies that some might consider sub-scale). Most posited that the Future Fund might instead be running a small pilot program to explore the feasibility of returning to active equity management generally.

They also questioned whether any small cap managers would be willing to suffer the counterparty risk of taking Australia’s sovereign wealth fund as a client, though some hypothesized that the program could be run as a bespoke strategy through one of its existing Australian equity managers (Macquarie Asset Management/UBS Securities).

But Datt Capital’s Emanuel Datt tamped down on questions of counterparty risk and questioned whether the bulge bracket firms that the Future Fund retains as its existing Australian equity managers had the right skill set compared to boutiques. He also sees the Future Fund’s interest in the asset class as a sign that the “sentiment is turning” on small caps.

“I think that we have definitely seen a number of small caps grow into large caps over the past five years; companies like Afterpay that were floated as a very small cap culminated in the largest recorded corporate transaction in Australian history,” Datt said. “By investing in small caps the Future Fund is really taking a forward looking approach – it obviously wants exposure to companies that could be the future of the Australian landscape. Business models can be and are disrupted over time.”

In 2017 the Future Fund began to cut all active managers from its listed equity program, which was established with the fund itself in 2006-2007, with Arndt saying at the time that “we need to get more bang for our listed equities buck”. In the same speech, which was delivered to the i3 Investment Innovation Institute, Arndt warned that large funds face liquidity constraints in the domestic equities and that “there are many challenges for long only active managers in the Australian market which are operating at a scale that the Future Fund needs.”

“The last eight years of declining interest rates have meant that macro factors – whether falling interest rates or commodity prices – have dominated individual stock-picking,” Arndt said in the i3 speech. “Listed equity managers in general aren’t particularly good at making macro calls.”

“Likewise, when we analyse positions in our portfolio, we are increasingly discovering managers are knowingly, or unknowingly, taking significant factor positions. For example, an active manager with a strong value style may have a process which effectively hugs a value index and does not add much by way of true stock selection risk… The concern here is whether we are paying managers for their stock picking skill.”

In his speech on Thursday, Arndt also referenced The Death of Traditional Portfolio Construction?, a position paper released by the Future Fund in early 2023, warning that “forward looking returns are challenged” in a world of rising rates and heightened geopolitical tensions.

“Alpha and skill-based strategies have always been integral to the Future Fund’s approach,” Arndt said. “In today’s environment, where the role of beta is challenged, the role of alpha in portfolio construction is more important than ever. In other words – just having capital is no longer enough to ensure decent returns.”

“A previously considered safe investment like an office building or shopping centre is no longer safe. A large cap company can be split up, regulated or its markets disrupted. There are no set-and-forget investments anymore.”

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