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“Being an investment strategist is a lot like being an anesthetist: It’s the most boring job in the world. Anesthetists hang out in the operating theater, and it might be three years between emergencies—but suddenly you have to use your skills in a five-second period or someone will die.”
Tony Day had such an emergency as head in-house strategist for the Future Fund, Australia’s young sovereign wealth vehicle—and one of very few funds to pull through the global financial crisis without serious complications, or worse. In 2008, the country’s total retirement assets fell in value by 17.2%, according to Towers Watson data. It was worse in the United States and United Kingdom, where roughly one-quarter of defined contribution and pension assets vanished. The vaunted Harvard Management Company lost 27.3% of the university’s endowment in the fiscal year ending June 30, 2009.
During that same period, the Future Fund fell just 4.2%.
As with an anesthetist, an asset owner’s ability to act quickly and save the day depends on skill, preparation, and a measure of pessimism. Assuming crises won’t occur only ensures a bad outcome when they inevitably do. Plan and train for the wrong kind of emergency, and the result’s the same as having not planned at all. But investing and anesthesiology diverge at the break-even point: No patient ever stopped breathing during knee surgery only to emerge from the operating room with a fixed joint and a rejuvenating facelift, purely due to a savvy anesthetist. But John Paulson, founder and president of hedge fund Paulson & Co. and the man synonymous with success during the crisis, not only survived the subprime emergency—he turned $13 billion of investor capital into $28 billion. Institutional funds, by nature and by mandate, rightfully cannot place whole-portfolio bets of that scale. The John Paulsons among asset owners shielded their funds from the typical devastating drawdowns, while also making active plays for profit. The Future Fund had such people.
A Bear in a Bubble
As financiers worldwide reveled in the bullish years following 2002, Tony Day was waiting for the other shoe to drop. “My sense of macroeconomics suggested that we had been surviving on loose monetary policy for quite some time, and a day of reckoning was coming,” he says. The Federal Reserve’s policy of maintaining low real interest rates even in boom times was, according to Day, allowing the US economy to cannibalize its own future. He’d held this stance for quite some time. Before joining the Future Fund, Day was head strategist for Australian asset manager QIC. He spent years trying to persuade the Queensland government—one of QIC’s biggest clients—to reduce its equity exposure. “My impression was that the portfolio was carrying risk well in excess of what fiduciaries had in mind,” he says. “We’d had such a large bull run that there was no concept of markets going down and staying down—that was rated as zero probability. Mine was a very quant-y view of risk, and I spent a lot of time walking them through it. I was bearish.” Day succeeded in talking his client down from its 90% equities allocation circa 2001 to approximately 40% in 2007—a shift that it surely appreciated the following year.
But that wasn’t a fight Day hoped to repeat. In Australia’s newly minted sovereign wealth outfit, he saw a rare fund in which he wouldn’t have to.
The Future Fund Act of 2006 established a mandate, governance structure, and funding schedule for the vehicle, with the aim of “strengthening the Australian Government’s long-term financial position by making provision for unfunded Commonwealth superannuation liabilities,” according to the legislation. The act bars anyone but investment staff from touching the fund until 2020, when pension obligations are set to begin weighing down an aging populace. Seed money wasn’t an issue: Australia’s booming resource industry led to years of bountiful federal budget surpluses, as did the 2006 privatization of Telstra, the national telecom agency.
On behalf of Queen Elizabeth II, Australia’s governor-general signed and sealed a proclamation bringing the Future Fund into existence as of April 3, 2006. A month later, the federal government made good on its promise and transferred AUD$18 billion in cash into the fund’s coffers. The board of guardians now needed advice on what to do with it. Unbeknownst to them, the future chief investment officer and head of strategy would recommend leaving things as they were: in cash.
“Right from the very start we were concerned about valuation levels,” says David Neal, who started as the fund’s head consultant with Watson Wyatt in November 2006. “Risk premia across the board were very skinny. It didn’t feel like we were in a bubble in 2006 and early 2007, but the market was gradually getting more and more expensive. It’s challenging as an investor when all risk premia are skinny—what do you do? There wasn’t an allocation decision to make between risky assets; really, the only option was to reduce your risk profile. Are you in or are you out? And it’s tricky as a long-term investor to be completely out of markets.”
In the spring of 2007, General Manager Paul Costello invited Neal to continue leading the investment program from an internal position. Neal became CIO of the fund, which had grown to $42.6 billion, 91% of which sat in cash. Regardless of market prices, the role and assets came with an expectation of at least 5% returns—the minimum to keep up with the consumer price index. “The pressure was on to get it invested,” Neal recalls. “You can’t just sit around on this amount of cash. There was concern about valuation levels, but also the sense that there wasn’t a mandate to hold 100% cash.” The act did allow for a transition period for the portfolio, which bought Neal and the investment team some time amid the peaking markets. They set a public equities target of between 55% and 60%, and gave themselves 12 months to get there. “Certainly, we could have got the money into equities markets much faster than that,” Neal reflects. “Much faster than a year.”
The Future Fund’s protracted entry into stocks was well underway when Day joined the team in September. It halted quickly thereafter. Neal knew he was bringing in a bear by hiring Day, and the markets began to support his views. “When I was at QIC,” Day says, “David was the lead consultant at QSuper”—a major superannuation fund based in Brisbane. “We’d had many conversations before about macroeconomic problems and the state of the world, as well as structural strategy issues, as in what a balanced fund should really look like.” Indeed, the strategist wanted the job in the first place because it offered a rare chance to execute on his pessimism. Day had spent six years pushing QIC’s main client from a 90% stock allocation down to 40%. At the Future Fund, his starting point was closer to 10%.
“You need to stop. You need to stop investing”
By September 2007, Lehman Brothers’ bankruptcy was still a year away. The S&P 500 had softened over the summer, but recuperated to a near all-time high. There was another asset peaking in value, too: credit default swaps. By the month’s end, John Paulson’s Credit Opportunities Fund was up 340% for the calendar year. Scion Capital, FrontPoint Partners, and Cornwall Capital had taken spectacular profits on their big short of the subprime lending market, which inspired the title of Michael Lewis’ 2010 book.
Tony Day had signed on as head strategist for the Future Fund, which wasn’t yet two years old but held assets approaching $50 billion. It was also growing more exposed to equities by the day—markets which were persistently expensive but felt less and less sound. “We began to be not just concerned about market valuation but also serious, systemic risk issues,” Neal recalls. “The subprime crisis started to be really alarming.” The fund turned to a series of market participants for advice, ranging from professional analysts and economists to investment bankers. (Neal: “One of the nice things about having $50 billion in loose change kicking around is that there are a fair number of people quite keen to talk to you.”) None of them changed Day’s mind.
Neal agreed with his strategist’s conclusion. “We discussed it, and Tony was prepared to make a very bold recommendation,” the CIO says. “At the time we were typically buying equities twice a week in fairly large trades, and things didn’t look good to us. So in October ’07, we went to the board and said, ‘You need to stop. You need to stop investing. We need to halt this ramp-up. And the board agreed. We did very little investing for the rest of ’07.”
The Call
“I look back now, and it’s very easy now to underplay how hard the decision to stop investing was,” Neal says. “The pressure to allocate was significant, and I give Tony a lot of credit as it turns out to have been a really strong decision. But it was a tough call.” Not so for Day—or at least he says so in hindsight: “It was really a matter of thinking that the world was coming to an end, and just refusing to buy any more equities.”
Opting out of between half and two-thirds of its planned equities exposure proved to be the Future Fund’s key tactic in evading the worst of the global financial crisis—or “GFC” as the Aussies say. But it wasn’t their only tactic. As Lewis details in The Big Short, the now largely defunct hedge fund FrontPoint Partners implemented its call on subprime markets primarily by purchasing insurance on collateralized debt obligations, but also by shorting financial firms who’d suffer if those securities went bad. Likewise, the Melbourne-based investment team anticipated opportunistic plays that might arise in a bear market, and positioned the fund to capitalize on them. In early 2008, for instance, Bear Stearns struck a parting shot at all the levered financial institutions that refused it a rescue: Bear’s collapse combined with the liquidity squeeze to vastly widen spreads on nearly all bank debt. Many large Australian banks remained secure, in Neal’s opinion, but nevertheless had to compensate investors as if they weren’t. The Future Fund snapped up a significant amount of these assets, and eventually broadened the strategy into a large global bank-debt portfolio.
(It’s worth noting that this confidence didn’t extend to all of the major banks. The day before Citigroup’s bailout in November 2008, Days says the fund was considering the possibility that futures markets would shut down en masse. “The fund had only a couple of percent in futures markets exposure, but had zero counterparty risk. We were totally locked down—it was a good instance of feeling as though you’ve done your job correctly.”)
The team also saw opportunity with top tier macro and event-driven hedge funds. Investors’ panicked evacuation from the asset class meant otherwise inaccessible managers were open to new business. With real estate, some over-levered owners were likewise open to serious haircuts in order to offload their assets. Mid-credit crunch, the ultra-liquid Future Fund took full advantage of quality asset fire sales. Neal and Day only wish there had been more.
Getting Lucky?
Neal himself is careful not to engage in revisionism as he recalls the GFC. That criticism, of pretending to have known and understood more than one did at the time, has been raised about funds that performed well through the crisis. To what extent were they just lucky?
“I found that a lot of the public pension world got kudos for how they weathered the storm,” says one portfolio head from a major healthcare fund. “But the truth for a lot of them was simply that they had traditional 60/40 portfolios to begin with and didn’t redeploy capital proactively.” Indeed, many of the standout performances from institutional funds in 2008 and 2009 stem from luck—or long-term risk aversion—rather than tactical positioning. The Orange County Employees Retirement System (OCERS), for instance, outperformed 89% of its peers in the 2008 calendar year, according to Callan Associates’ public fund database. The pension system approached the crisis overweight in cash and domestic fixed income, and emerged from it with 300% returns on its Freddie Mac derivatives. But CIO Girard Miller isn’t tempted to revise history. Were the overweights a brilliant strategic tilt? Answer: “No.” The derivatives were selected by an outside manager and not driven by macroeconomic tactics. “OCERS has historically taken a more conservative approach to portfolio structure and asset allocation than many other public pension plans,” Miller says. “The overall asset allocation plan in place at the end of the last business cycle was designed to be a long-term plan that could weather downturns better than a traditional public pension.” To that end, it certainly succeeded.
As swiftly as Miller dismisses the role of short-term tactics in OCERS’ achievements, Day waves off the role of luck in the Future Fund’s. “Over the last 20 years, every time real interest rates climb, something breaks in the economy,” he says. “You hit ’06 and ’07, and rates jump along with inflation, while earnings took a turn for the worse. These fundamental indicators—and all are inputs to a discounted cash flow valuation of equities—just drive your estimate of the risk premia way down,” he says. “The stars were in alignment for something bad to happen.”
Day, Neal, and their colleagues share credit for their results with at least one factor outside of their control: cash. Or, more specifically, the Future Fund’s infant state taking the form of cash. Australia’s sovereign wealth fund might have come into the world like the Canada Pension Plan did, as a block of domestic sovereign bonds. It would have weathered the equities crash, of course, but cash was truly king during the GFC. Here, Day acknowledges the “L” factor: “If the fund’s investment team had the same view on markets today, I think it would be much more difficult to execute the strategy.” As of March 31, 2013, Australian and global equities accounted for 35.3% of the Future Fund’s $85.2 billion portfolio. “Selling is hard; it is easier not to buy. I think they got lucky because there was 75% to 80% cash sitting around.”
There is one more piece of evidence to suggest that investment skill and strategy, not luck, carried Australia’s sovereign fund through the GFC. Unlike John Paulson, the Future Fund is still performing.