Future Fund flags need for ‘more true diversifiers’ in face of geopolitical risk

The Future Fund has cautioned investors to familiarise themselves with the complexities and potential implications of geopolitics, emphasising its pivotal role in shaping a new investment landscape that will profoundly impact financial markets, macroeconomics, and policy decisions.

In its latest position paper, the $233 billion fund said this new landscape means a more volatile, challenging, and complex longer-term investment environment, one in which forward-looking returns will be more difficult to earn.

This, the fund said, is giving it cause to refresh how it invests to continue to achieve its investment purpose.

One of its primary strategies involves a renewed commitment to diversification across geographies and asset classes, driven by the shifting dynamics of high inflation and interest rates, which have pushed the equity-bond correlation into more positive territory. In fact, the fund declared that "the era of using government bonds to diversify equity-related risk is over," marking a significant shift in investment strategy.

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“Instead of relying solely on government bonds for that much-needed diversification - as per traditional portfolio construction - we are turning to more true diversifiers in our portfolio: exposures that come from non-directional alternative/hedge fund strategies such as equity market-neutral or systematic macro strategies, for example,” it elaborated.

Currently, its position includes owning gold and commodities, more domestic assets, and different currency and regional allocations.

Moreover, highlighting four broad trends - changing trade dynamics, a rise in strategic competition, growing populism, and increasing risk of conflict - the Future Fund identified significant potential for major technological breakthroughs in various sectors.

“It is entirely plausible that this world of government-driven investment and research in critical industries leads to significant technological breakthroughs in areas such as green energy, quantum computing, and artificial intelligence, as well as associated major productivity gains,” the fund said.

As such, it recommended increasing domestic holdings in clean energy and technology sectors, reassessing alternative investments for better diversification, improving liquidity management and currency hedging to mitigate populist risks, and capitalising on active management opportunities.

Regarding exposure to different geographies, the Future Fund advised a reconsideration due to varying market and policy cycles experienced by countries.

“Whilst historically this has been seen as a ‘free lunch’, in a world likely to be re-shaped around potentially different alliances - and at risk of morphing into something akin to trading blocs - investors need to re-think this approach,” it said.

“Certain jurisdictions may not be as open to free capital flows in the future, with the spectre of capital controls or sanctions under certain extreme scenarios. 

“As well, the rising share of some countries in emerging market equity and bond indices may lead some investors to reconsider the use of standard market-cap indices.”

Previously, former Future Fund deputy chair Alicia Gregory flagged that the sovereign wealth fund is exploring alternative avenues beyond a traditional bond-equity portfolio having realised that structurally higher inflation could undermine the defensiveness of bonds.

“Investors may need to search for alternative forms of defensiveness through that type of environment, perhaps through shorter duration of private credit, differentiated hedging, or seeking assets with a higher, pass-through domestic inflation,” Gregory explained at the Australian Wealth Management Summit in Sydney.

Prolonged impact predicted

The Future Fund explained that as a long-term investor, its role is to focus on geopolitical developments that are likely to occur over the horizon.

Noting that geopolitical risk had become less prioritised over the past three decades, resulting in geopolitics being "underappreciated" and largely overlooked by a generation of investors, it said the impact of geopolitics is likely to remain for generations to come, and that investors needed to prepare accordingly.

“Geopolitics results from the nexus of geographic factors, policy decisions and cultural norms - the rules, risks and opportunities by which economies operate - and its impact on economies and financial markets has been a reality for investors for generations.

“We believe it is likely to remain so for generations to come, ” it said.