Australian super funds are encountering a number of headwinds, including operating in a low-yield world, all while trying to meet their ever-shifting and, at times daunting, liabilities. Passive equity investing, though low in cost, has proven to be too volatile for many of these super funds to embrace. So the question remains, how can they properly position themselves in this market cycle? Michael Maduell, President SWFI, sat down for a conversation with State Super CEO John Livanas to garner some sage advice about investments and strategies in this market.
Maduell: Please tell our readers what makes State Super unique and how the superfund has transformed investment-wise?
Livanas: We are a US$ 40 billion fund. We support the pension liability of the state of New South Wales in Australia. We are constituted as a trust with an independent board of trustees. What makes us unusual is the need to pay benefits to the extent that there is a call on the capital of the fund on an annual basis which is 7% to 8%. The magic of compounding is continual money and allowing it to grow and compound itself. In our case, we have the exact opposite of compounding, with a payout of 7% to 8% a year. We have to solve a problem and make up the difference between capital sending and capital received.
Of course this means that every time the market drops, the fund crystalizes the losses. This is the problem we looked to solve five years ago; making 7 – 8% p.a. with low volatility and protection in down markets.
Maduell: That sounds like a tall task, 7% to 8% per year. Can you elaborate on how your fund approached the complex issue?
Livanas: Five years ago, we took a top and bottom approach on how we managed money. Managing the downside and volatility was a key factor, as was the need for liquidity. And most importantly we felt our portfolio would need to meet our ESG principles that we have committed to as part of our policy settings.
This resulted in the need to significantly change our portfolios.
We developed a three layered process: by understanding and managing aggregate risk (at a fund level), including the risk of currency and volatility in public markets; by hiring managers that displayed decision making processes that would protect the downside and manage liquidity, and yet still strive for strong growth; and by developing flexibility and decision rights through a strong delegations framework.
All this started with the need to build a team capable of achieving our goals. I felt that the prudent approach was to hire the team from the top, appointing experienced people as Head of Growth Assets (including Equities), Head of Defensive Assets (including fixed income and derivative programs), a Head of Alternatives charged with direct investment and governance oversight , and a Head of Strategy and Risk. And a CIO with superior team building skills, who would take on the direct load and allow me to manage the organization as a whole.
Maduell: Let’s analyze some of your allocations. Can we start with listed equities?
Livanas: Within the equities space, what became clear was that, while passive investment has a place, it has a risk character equal to the market. Our requirement was to develop exposure to equity risk premia in a way that would complement the overall risk of the portfolio and enhance the downside protection requirements. So we rotated to having far more exposure through active management, and where we retained passive investment for convenience, we ensured appropriate overlay management to manage risk.
A cornerstone of our change in our portfolios was the need to develop and implement a strategy to increase direct investments in infrastructure and other real assets.
Maduell: How about fixed income?
Livanas: Normal fixed income benchmarks create unintended exposures. We looked at smart beta, and examined alternative approaches to benchmarking in bonds.
In addition, in the current environment, our allocation to fixed income was very low. Where we have an exposure to fixed income, it’s largely with sovereigns, and we maintain a short duration to our Defensive strategies.
Maduell: In our research, we see more asset owners engaging, or at least, wanting to do direct investing. What opportunities lie in direct investments?
Livanas: A cornerstone of our change in our portfolios was the need to develop and implement a strategy to increase direct investments in infrastructure and other real assets. However we set specific principles in order to complement our overall portfolio requirements for risk management, as well as responding to the need for liquidity.
Our principles are: we should generally have at least negative control as well as governance rights such as the appointment of a board director. Furthermore, to enhance liquidity, and manage our governance needs, we also had a principle of only partnering with like-minded investors.
We partnered with a number of prominent institutional investors. We participated in the acquisition of A-Train AB, the operator and manager of Arlanda Express and the Arlanda Rail Link in Sweden, having as co-investors the SAFE Investment Company and another Australian superfund, SunSuper.
Maduell: How did you construct risk exposures in your infrastructure portfolio?
Livanas: Determining the factor exposure in equity portfolio is pretty straight forward. With infrastructure it was more challenging. We were able to break out the exposures by asset to factors such as those that were GDP-related, interest rate sensitive, and others. This was key to our total risk management.
Maduell: What about foreign exchange risk and current events such as the U.S. Presidential election results?
Livanas: Our largest informant of risk is our asset allocation, but the second most important impact on risk is foreign exchange exposure. 40% of our investments are exposed to foreign exchange risk.
We manage this exposure through a currency framework that factors in purchasing power parity, momentum and event risks. For example, we model potential impacts of events such as Brexit and Trump or the debt bubble burst in China. These event risks manage our risk budget and tolerance settings, not our trading strategies.
Maduell: Back to co-investors, can you shed some light on finding opportunities in infrastructure?
Livanas: Partnering in infrastructure is very hard. It is a long process and highly competitive. We often work with investment banks such as JPMorgan, UBS and other major institutions to find opportunities. We also work with the asset owner side such as SAFE, other Australian, Canadian, Swedish, Dutch funds and American funds like TIAA.
Maduell: Thank you for the discussion.
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