In this From the Archives episode, we revisit a conversation with Tanya Branwhite, former Head of Portfolio Construction at TCorp, which was originally released in March 2023. Tanya takes us through her unconventional path into investing, from her early days as a credit analyst in the "whiz-bang" late 1980s, through more than a decade at Macquarie, to her move into asset owner organisations at the Future Fund and, eventually, TCorp.

In early 2023, TCorp was already wrestling with questions around how to best shape the total portfolio approach for the organisation, as well as how to deal with higher inflation, rising rates and the true cost of implementation, topics that have only grown in relevance today.

We did a deep dive into TPA at TCorp and why it thinks about risk rather than asset classes. We spoke about how equity, duration, credit and FX risk together explain the vast majority of portfolio behaviour, and how a "prepare but don't predict" mindset shapes decisions on liquidity, implementation and diversification.

Overview of Podcast with Tanya Branwhite, TCorp:

01:00 Starting out as a credit analyst with Elders Finance Group: "It was a fairly interesting baptism of fire…" 03:00 The Macquarie years. The 'loose/tight' culture of rules and entrepreneurship 05:30 During the GFC, I wrote research highlighting that a number of Macquarie vehicles had significant financial risk. That wasn't well accepted within the organisation at the time. But I learned to stand by the rigour of my analysis. 07:30 Ultimately, it made my career at Macquarie, because I became sought after for client work 09:00 Leaving Macquarie for the Future Fund 11:30 The Future Fund didn't feel like it was a restrictive environment from a government-owned perspective. It is a company that is owned by the government, not a department of the government 13:30 How has a Total Portfolio Approach changed the investment portfolio? 17:00 Risk is at the heart of what we do, because we can only control risks and outcomes are the result of that risk. 18:00 Equity risk is at the centre of this model. 21:00 Diversification away from equity risk in an environment where equity and bond correlations are positive 23:00 Not just unlisted assets, but illiquid assets can help diversification. For example, we own a number of hydroelectric dams in Canada. 26:00 Challenge in fixed income is even higher than before, because real returns are a challenge 26:00 Bonds almost had their own global financial crisis last year; it was a three standard deviation event 28:30 We prepare, but we can't predict 34:00 On valuation frequency of unlisted assets: we do try to de-smooth valuations of unlisted assets. And sometimes these assets need additional capital from investors during periods of crisis; that is not often thought about 36:00 Managing liquidity 39:00 We are looking at natural capital and opportunistic liquidity 40:00 Reducing the number of managers, has this work finished? 42:00 On implementation and efficiency

Full Transcript of Episode 143

Wouter Klijn 00:11

Tanya, welcome to the podcast.

Tanya Branwhite 01:21

Good morning, and I'm really pleased to be here, Wouter. Thanks for the invitation.

Wouter Klijn 01:25

Thank you. We always ask a little bit about people's background and how they got into investing. So what made you decide to pursue a career in investing? I think you started out initially as an analyst at Deutsche Bank.

Tanya Branwhite 01:38

Well, actually, if we really want to go back, I wouldn't say that I pursued a career in investing. It sort of happened, so I won't say there was any great design in where I've ended up. I actually started off as a credit analyst, and I did that in the whiz-bang years of the late 1980s and early 1990s. Being a credit analyst at that time, for Elders Finance Group, was a fairly interesting baptism of fire. We went from one extreme, operating in an environment where there was a lot of money available, to the other, and I ended my career with Elders Finance working out a range of corporate finance lending that had gone sour, with not many other people left in the organisation to work it out. So that's really how I started off. I then moved to Citigroup, and as part of what was still almost a graduate training programme at that stage, ended up in their investment arm, and that's how my investing career started. So it wasn't by any great design, but much more a journey of serendipity and opportunities presenting themselves.

Wouter Klijn

Fair enough. Now, you also spent a significant time at Macquarie, I think more than 10 years.

Tanya Branwhite

Yes.

Wouter Klijn

Can you tell us some of the highlights from that period?

Tanya Branwhite

Look, my career at Macquarie was an extremely fulfilling, challenging, and enjoyable part of my career. At the time I joined Macquarie, I'd certainly been on the asset management side, the asset manager's side, in listed equities, but I'd also worked on the broking side at Deutsche Bank, writing research. So having had the opportunity to see both sides, the client side and being a client, I think that really gave me a very good perspective. Macquarie is, as we're all well aware these days in Australia, a very unique organisation, very successful, and there's no doubt culture is at the heart of that success. They have a very clear way of encouraging you, though I'm not sure to what degree people are aware of how their culture has been described internally. When I began, it was called "loose-tight," which meant there was a set of rules you had to obey, but once you understood those rules, they encouraged you to be as entrepreneurial as possible, to see it as your own business, take ownership, and be empowered. I'm a few years out of Macquarie now, so I'm not sure how they describe their culture internally these days, but it later became known as "freedom within boundaries," which is probably a clearer way to articulate it. Boundaries and risk are at the heart of the organisation, but within that set of boundaries, people are fully encouraged and empowered to bring their best ideas, find opportunities to do new things, and challenge others.

Wouter Klijn

What were the highlights at Macquarie?

Tanya Branwhite

Well, I was at Macquarie through a really turbulent period in investment markets. I started in 2004,

Wouter Klijn 05:06

right,

Tanya Branwhite 05:07

and I didn't leave until 2015. So in 2004, we rode the whole wave leading to the GFC. Macquarie, like many other investment banks, had to stand back and reassess itself and its business model, but one of the things Macquarie is extremely good at is pivoting, and it pivoted very quickly. Some of the research I wrote, particularly around the GFC, under the understanding that we were completely independent in the securities division writing institutional research, highlighted a number of Macquarie vehicles as having significant financial risk. That wasn't well received internally within the organisation at the time, and it caused me quite a lot of angst in terms of what it feels like when the organisation's pressure bears down on you, challenges you, and really tests your resolve as to whether you stand by that research. When I wrote the research, the full GFC had not really occurred, and this wasn't crystal-ball gazing, it was straight financial analysis. We were analysing the cash flows of companies right across the listed spectrum. A number of Macquarie vehicles were highlighted through that analysis, and I simply shared those companies, as well as a number of others, that were in a business model which, from a cash flow perspective, would come under pressure if the environment we were operating in at the time continued. And that proved prescient. But I learnt to trust not my instincts but my analysis, trust the rigour of that analysis, and be prepared to stand by it if I truly believed that what I was writing and the work I was doing were the right insights to share with our institutional clients at that time.

Wouter Klijn 07:10

Because you stayed on for quite a while after that, it obviously didn't cause any sort of permanent disruption for you?

Tanya Branwhite 07:17

No, it didn't. In fact, in some respects it made a little bit of my Macquarie career, because in having stood my ground, and the organisation, people talk, particularly at senior levels, so my name became known through that period. I was then sought after internally, over the ensuing six, seven, or eight years, to help other divisions, the investment banking division, see investment banking clients, and give advice on some of the transactions they were looking at. So it actually opened up a much broader engagement internally and with a broader client base ultimately. So for a short period of very deep pain, there was some very nice payoff, ultimately, for my career at Macquarie.

Wouter Klijn 08:06

Yeah. So that almost harks back to what you mentioned about freedom within the rules. You did have enough freedom to have a bit of a critical voice out there.

Tanya Branwhite 08:15

Yes. I think that's absolutely correct, and real credit goes to the person who was my divisional director at the time, Roy Laidlaw. He asked me directly, amid all the angst going on, "Do you stand by the research? Do you think there are any errors in it? Are you confident about what you've written?" And I said, "Yes, I am." And he said, "Fine, that's all I need to know." So he was very much the one who stood behind me and beside me against some of the other people within the organisation who were, to put it mildly, very angry with me.

Wouter Klijn 08:51

Yeah, so a true merit-based system.

Tanya Branwhite 08:53

Correct. A true merit-based system.

Wouter Klijn 08:55

So, from Macquarie you joined the Future Fund, which is a government organisation. I imagine that would be quite a different environment from the corporate environment at Macquarie.

Tanya Branwhite 09:07

Yeah, it was. But that said, I made an active choice. By the time I left Macquarie, I had been in the listed equity strategy space for the Australian market for a very long period, over 20 years, and the teams I'd worked with had, I think, been recognised for doing very high-quality work. We were well rated by clients, both globally and domestically. There does come a point in your career where you say, "Well, I'm going to continue to do this," or "I'm going to jump off the cliff and do something a bit different." I won't say it was completely different, going to the asset-ownership side, but the opportunity to join the Future Fund presented itself. The Future Fund, I'm not sure to what degree, having been an insider, it's still an enigma, but I think it was an enigma at that time. In 2014, it had only really been established for about six or seven years, so it wasn't that well known and didn't have as much of a public face. So it was quite an interesting place, and even then there was a recognition of an institution of great quality doing things differently, and that intrigued me. I like to do things differently, I like to challenge boundaries, and to the extent that aligned with my own personal values, I was really delighted to go to the Future Fund. I moved to Melbourne as well, so from a personal perspective there was a bit of a change, moving from Sydney to Melbourne.

Wouter Klijn 10:44

Yeah, for sure. But was the government environment a bit of a culture shock, coming from a more hard-nosed commercial environment?

Tanya Branwhite 10:52

It's really funny. I've now worked for two government organisations, one federal and my current one, which is state. You do feel the effect of government being the client. As to the culture, though, I think the culture of government organisations can still very much be a reflection of the approach of leadership. Certainly there are constraints to working for a government entity, and remember, the Future Fund is not a government department, it's effectively a government-owned corporation, the same as T Corp is. So the Future Fund didn't feel like I'd gone from a free-flowing corporate organisation to one that was restricted by government ownership. The Future Fund, I felt, was very clear on its objective and very clear on its stakeholder and what it was there to do, and while that stakeholder has great, deep interest, oversight, and engagement, it didn't feel like a restrictive environment, if that's where your question was leading. We were still given a lot of opportunity to operate the investment model in the way the organisation had laid it out.

Wouter Klijn 12:15

Well, if the Future Fund is an enigma for you, then it's definitely one for me. I didn't have any preconceived ideas, but I could imagine the objectives and focus are quite different between the two organisations.

Speaker 2 12:28

Yes, but also

Wouter Klijn 12:29

I presume it depends largely on the quality of the people there, and the Future Fund has some very good people.

Tanya Branwhite 12:35

Yeah, and I think, to the extent that the Future Fund has an alignment with Macquarie, it went down the path of an investment approach that was different because it believed that brought better outcomes on behalf of the client. The profit motive is obviously the big difference, but you can somewhat transfer "profit motive" to "performance outcomes," and being successful in delivering the client's objective.

Wouter Klijn 13:09

So now you're at T Corp, and you focus on portfolio construction. We've seen a lot of changes recently, over the last couple of years, at T Corp, with the various mergers and new team structure, and one of the changes is that T Corp has embraced the total portfolio approach.

Tanya Branwhite 13:30

Yes,

Wouter Klijn 13:30

Can you tell me a little about how that changes your focus, and how it changes the investment portfolio in practice?

Tanya Branwhite 13:39

Given that the Future Fund had operated with a total portfolio approach, and each organisation can interpret what that means a little differently, broadly speaking the focus of a total portfolio approach is ensuring you're focused on whole-of-portfolio outcomes, not assuming that the pieces brought together will bring you the best outcome. A very simple, and perhaps silly, analogy is thinking about a recipe. You can have all the best ingredients, but if you don't know how to bring them together in the right way, the cake you end up baking may not be as good as if you'd really thought about how these things interact and come together. Are you exposing it, to use the cake example, to a particular underlying taste or flavour that, when brought together, might overwhelm the outcome? So a total portfolio approach is, first and primarily, a mindset change. If you don't think that way, and if the whole investment team isn't thinking about their role in that total portfolio outcome, then whatever structure or data you put in place, you're not going to be successful. The cultural experience was very different between the Future Fund and T Corp, because the Future Fund was founded on a total portfolio approach, it was incepted with that mindset and that approach. So when I joined, that was already the case. That's not to say there aren't always tensions. I think in any organisation with really motivated individuals trying to achieve something, there'll always be some competitive, creative tension. But it's a very different mindset, thinking about what you're doing and how you're using that capital to bring the best outcome at the total portfolio level. For T Corp, it was a journey of change, one where not only were three different investment teams being amalgamated, but that amalgamation then progressed into a complete change in the way money was managed, and in how the clients' objectives were thought about and articulated. So there's no doubt the change at T Corp has been profound, holistic, and complete. There isn't an element of what T Corp now does that hasn't been touched by that change, beyond the amalgamation, the underlying change in the investment model and mindset.

Wouter Klijn

How do you describe the difference in the total portfolio approach?

Tanya Branwhite

Well, first of all, I think the other way we've been disciplined in our total portfolio approach mindset is that we say risk is at the heart of what we do, founded on the belief that we can only control and manage risk, outcomes are a result of that risk. So perhaps there's a nuance there: it's not only a total portfolio approach, but it's risk-based, and we think about the underlying risks that drive asset classes. Our risk exposures transcend the definition of asset classes, so when we're thinking about different asset classes, we think about the small group of similar risks we may actually be exposing the portfolio to, and that may take the form of, for example, infrastructure, or it could take quite a different form. The asset class definition isn't really the basis on which you think about constructing a portfolio.

Wouter Klijn 17:41

Right, and I believe central to this model is equity risk, which is the measure against which you measure other investments and how it all fits together. Can you tell us a little more about that?

Tanya Branwhite 17:54

Yes, you're right. Our view, reflected in our beliefs, is that we need to take risk in order to generate return. The risk factor, as we'd call it, that you're effectively awarded for taking, and that's likely to deliver the highest level of return for the highest level of risk, is equity risk. So the way we engage with our clients, across the 14 portfolios we manage, is to think very clearly about the risk budget, and then translate that risk budget into how much equity risk is likely to be required for the client's objective to be met. Now, equity risk isn't the only critical risk we think about. We have four primary risk factors. Equity risk is the most important, because without taking equity risk we know we're not really going to be able to, over the long run, have any real prospect of achieving the client's return objective. Most of our client objectives are CPI-plus type objectives, so we have to generate a real rate of return. The other three risk factors inherent in the opportunity set, in an investment market context, are term risk, credit risk, and, interestingly enough from an Australian perspective, FX risk. Our analysis suggests those four risk factors account for about 95 to 96% of total portfolio risk behaviour, and the risk premia associated with them account for a similar amount of the expected return. So equity is very much the defining risk factor, but we do think about it within that broad primary risk factor framework.

Wouter Klijn 19:55

So I assume credit and term risk relate mostly to fixed income type investments. Looking at the environment we've just come out of, a period of very low rates, how do you diversify away from equity risk, because that seems to be the only risk significantly driving the portfolio?

Tanya Branwhite 20:19

Yes. As we should all be well schooled, the only free lunch in investing is diversification, and equity risk diversification is at the heart of what we seek to do. But you're right, Wouter, to call out that those other risk factors are diversifying, but not always, and there is a risk, pardon the pun, at the moment, that there may be a secular change in the relationship between equity risk and term risk in particular. We've gone from more of a negative correlation to more of a positive correlation, so that correlation change is also something we need to think about. It's the interrelationship of these risk factors that you're calling out. But I think the total portfolio approach, and the idea of diversification, is that idiosyncratic, or differentiated, types of risk really do have a disproportionate benefit to your portfolio. If you can identify investment opportunities that bring a different set of risks to the portfolio, still a set of risks, but different, particularly from those primary factors, then that's very valuable and hugely beneficial, particularly in periods of dislocation. Most clients with capital invested for some sort of real return are comfortable when things are going well, it's the left tail that matters. So what we focus on is how, in stressed market environments, those differentiated or idiosyncratic risks can further diversify away from those primary risk factors, and hopefully reduce the volatility of the portfolio's behaviour as it moves through different investment environments.

Wouter Klijn 22:24

So where do you find this idiosyncratic risk? Is it mainly in equities active management, or also in the unlisted market?

Tanya Branwhite 22:33

Yes, very good question. Active management is certainly an idiosyncratic risk. It's generally seen, and our analysis and work reflect this, we construct portfolios on the basis that it should be highly uncorrelated to our primary risk factors, because it's a reflection of skill. So it's valuable, but beyond active risk there are other things in the idiosyncratic space that can be beneficial. A good example, and you're right to point to the illiquid space, not just unlisted assets but illiquid assets, is an investment we hold in the portfolio: a series of hydroelectric dams in Canada. We were fortunate to be able to purchase, under a bilateral arrangement, a half share of that set of investments from a Canadian investor looking to reduce their exposure. That has its own series of risks, but primarily it's a hydrology risk. They're set up to sell electricity into the Ontario grid, so if there's no water in the dams, that's clearly a risk, but it's a different risk. It's generally not correlated to economic risk, and that's an example of a part of our portfolio that has provided us with a high degree of resilience through the last few years.

Wouter Klijn 24:09

Yeah, and that's probably also a regulated asset, so there's some certainty around return and yield.

Tanya Branwhite 24:16

It has a degree of regulation, there's no doubt about that, but if you stand back, a collection of hydro dams in the current environment is, I'd argue, quite a unique and difficult asset to replicate. So there's a barrier to entry that adds to the benefit of the asset, and it also has a sustainability element, because it's valuable to any electricity grid, being green energy.

Wouter Klijn 24:48

Yeah, so it plays a role in the energy transition.

Tanya Branwhite 24:52

Correct. So it has characteristics that are positive for the sustainability solution.

Wouter Klijn 24:58

Yeah. So we're now in a higher interest rate environment, and there's still a lot of risk with higher inflation. You mentioned the positive correlation between debt and equity. Does the higher interest rate environment give you more levers to play with from a risk perspective? I can imagine bonds will probably have more of a role to play than, say, five years ago.

Tanya Branwhite 25:22

Yeah, we'd think about it more in terms of term risk, which is effectively the sensitivity of the portfolio to interest rate changes. Does it give us more levers? To the extent that the nominal return on cash, and the yield you may be generating from your term risk premia, is there, but I'd highlight that in a real-return environment the real-return hurdle has increased substantially. So in nominal terms you might say there are some other assets that at least provide a higher nominal return than in the past, that's true, but the real-return hurdle has also gone up, so I'd actually argue the challenge is probably even higher than before. What other levers does it give us? I think it suggests we need to hunt more deeply and take a much broader perspective on what is differentiating. I think the real lesson for everybody in investment markets last year was the behaviour of term and equity risk. Equity risk behaved in a fairly typical fashion for what you'd call an economic shock, but if you look at term risk behaviour and its return, it was really a three-standard-deviation event. It was almost as if bonds, and their associated term risk, had their own global financial crisis last year. So the focus now isn't so much on equity risk, which we're looking to further defray, it's about finding proxies for term risk that aren't so directly linked to term. In other words, they still diversify equity risk, but aren't necessarily highly correlated to term risk, and that's a real challenge. If you look across the spectrum of assets, some toll roads, for example, or unlisted assets, will often have CPI kickers as their underlying revenue drivers, some sort of revenue reset tied to a level of CPI or a minimum change. Those are the sort of underlying cash flow drivers that are very beneficial to a portfolio, and they come in all sorts of different wrappers from an unlisted assets perspective.

Wouter Klijn 27:49

With inflation at around 8%, real returns are really problematic.

Tanya Branwhite 27:54

Yes,

Wouter Klijn 27:55

But over the longer term I think the general expectation is that inflation might come down to maybe 3 to 4%, not quite the RBA's 2% target, but maybe 3 to 4%. Does that mean you're looking at taking on longer-duration investments in anticipation of inflation coming down?

Tanya Branwhite 28:16

I'll certainly offer the mantra we have at T Corp, which is one of great humility: we prepare but can't predict. My own personal view, having observed many commentators in markets over a long period of time, is that it's very hard to predict short-term outcomes, and when you have very large institutional portfolios, you can't position them on that basis. I think it's very risky and challenging to position large institutional portfolios on a shorter-term view. The way we approach portfolio construction is very much around a longer horizon. Most of our portfolios have a long horizon, some a little shorter, but generally speaking we think about portfolio construction with that long-term perspective. We're focused on a stream of work at the moment which we're calling "journey risk management," thinking about how the portfolio moves through time and through different market environments, and again using the risk lens to think about where the level of risk presented by a particular opportunity or asset class isn't being rewarded, either because return expectations in the shorter term are too low, or because return expectations are much higher and the market isn't appreciating that. But we're very humble in saying that will be a modest part of our portfolio and how we manage it. In some cases what we're trying to manage isn't picking a path, but being aware of the path dependencies of a portfolio in the environment we're in, making sure the portfolio, particularly around diversification, can reduce some of that path dependency. So it's trying to narrow the expected volatility of a portfolio, but let's be open and transparent, this is a very challenging environment in which to be confident about how you do that.

Wouter Klijn 30:28

Yeah, that long-term focus reminds me, a couple of weeks ago I interviewed Ken Marshman. Looking back at his career, he's more or less retired now, he's well known from his time at JANA and, later in his career, as chair of Rest. At one point he lamented that the investment focus has become shorter and shorter term, to the point that people are looking too much at short-term price changes rather than the underlying fundamental drivers behind businesses or other investments. T Corp also has a long-term focus. Do you recognise some of his comments, in terms of the changes you've seen compared to when you started out?

Tanya Branwhite 31:19

Yes. I think there's always the temptation and pressure to think short term, and certainly, given we have a very broad range of asset managers who are closer to the market, they may be aware of opportunities that present themselves, from a risk or return perspective, to take advantage of. So the question is where you seek to have that shorter-term perspective reflected in your portfolio. Some might argue that shorter-term perspective, at the manager or asset-class level, is the skill, that's the skill base of an asset manager, so that's really where active management should be delivering your return. I think moving your portfolio construction building blocks to think in a short-term context is certainly not the most effective way to deliver the returns for the risk your clients are seeking. One of the things we also do, which I think is important to your question, is that if you feel you have to be short term, it may be because you don't have the kind of relationship with your clients where you've really articulated what the journey of a portfolio may feel like in the worst times, not the best times. So we have a very deep engagement with our clients around establishing their risk appetite, what sort of risk they can stomach at different points in the portfolio's journey. Over a short horizon, can they tolerate being down 8%, down 10%? If you've had those conversations, then the pressure to move things on a shorter-term basis tends to go away. That said, there are strategies we may have in place, for example, we run a risk overlay, particularly around equity risk, through options, where we're looking to mitigate deep left-tail drawdowns in equity markets, and in that case you have to be willing to act within the moment of a short-term market move. We learnt that during the COVID drawdown, the benefit of being disciplined about saying "this is a short-term opportunity" and how we wanted to manage the portfolio of options we held, in particular for one of our clients.

Wouter Klijn 33:47

Yeah, talking about that COVID period, one of the things that came out of it was the stark difference between listed and unlisted assets, and I think the regulator has been thinking more about how often unlisted assets should be valued. Did you draw any lessons from that period, where you thought maybe we should look at this a little differently?

Tanya Branwhite 34:12

Yes. I think it comes down to the fact that illiquid assets do require an illiquidity premium because of the constraints they place on your portfolio construction, but it's naive to think that because the valuation mark on an unlisted asset happens once a year, the valuation volatility only reflects that one-year mark. I'd argue we should have learnt that from the global financial crisis, because property, in particular in this country, had some fairly significant challenges, and some assets through COVID were at risk of potentially needing cash injections. The listed market does this through capital raising, but in the unlisted space, the risk of needing additional cash from shareholders is perhaps not thought about as much. We try to desmooth the way we understand the behaviour of unlisted assets, and there's a whole range of quantitative and technical techniques you can apply, so we do think about that, and there are some benchmarks that are helpful in giving a better understanding. The other interesting observation was that some of our clients, given they're very aware of their fiduciary obligations around money that may be transacting through that period, actually asked for valuations of unlisted assets to be done more regularly, in some cases quarterly. So it's interesting to observe that unlisted assets aren't as stable in pricing terms as the regularity of the valuation mark might suggest.

Wouter Klijn 35:58

So how do you approach liquidity from a portfolio construction point of view? Can you manage that at the TPA level, the total portfolio approach, or does it really differ from client to client? I think T Corp has quite a wide variety of clients, some with more of an insurance element. How do you manage that liquidity?

Tanya Branwhite 36:17

Yeah, so to be clear, we apply TPA to each individual portfolio, so each portfolio has its own TPA focus. Again, in our engagement with clients, understanding the various natures of the funds, liquidity is a very critical part of our consideration. We have a number of funds where we have quite clear expectations of regular cash outflows. We also have a number of funds funding various New South Wales government projects, particularly in infrastructure, so we have a very clear understanding of the expected cash flows, although those cash flows do change through time. We need to be mindful of aligning the portfolio construction to the liquidity requirements of each fund, and the illiquidity we build into the fund needs to be able to cope with some uncertainty around that liquidity requirement. So yes, it's an inherent part of each of our individual portfolio construction reviews.

Wouter Klijn 37:31

So what's on your agenda for the next couple of months? Are there any big asset class reviews coming up?

Tanya Branwhite 37:37

We undertake an asset class review for all asset classes each year. T Corp is probably in the first 12 months where a lot of the restructuring, the change, the rethinking of how we approach investment opportunities and put them together, has happened. We're now much more in a phase of review: how do we utilise the structures, and what we call access points, to different investment opportunities? How do we make sure we're getting the most value out of those? How can we improve them? How can we bring further diversification? So if there's a project, it's not an asset class project, it's much more about intensifying our diversification. That's probably the best way to describe the project in front of us at the moment, and again, from a longer-term perspective, really trying to find that space that isn't easily defined by asset class terms but that might be beneficial to longer-term portfolio outcomes.

Wouter Klijn 38:43

So are there any innovative new asset classes you're looking at?

Tanya Branwhite 38:48

It's not so much asset classes, but different ways of thinking about comparative advantage. We've certainly been looking at natural capital in a way that has a sustainability lens to it as well, which is very beneficial. I think there's increasing acknowledgement of investments in that space that could be quite different, diversifying, and still have sustainability benefits. We're also looking at what I'd call not necessarily fully illiquid investments, but within that spectrum, having some illiquidity, and in a more volatile market environment there can be different pricing opportunities that present themselves. These are more in the space where drawdowns cause some friction, and that friction may require an investor to have some liquidity to hold through to maturity. We're calling that "opportunistic liquidity," so we're looking at some investment opportunities there as well, and really scouring across the investment space to see if there are things we're not currently exposed to that might be valuable.

Wouter Klijn 40:03

Yeah, I think as part of the changes, T Corp has also been reducing the number of external managers it uses, to build more meaningful partnerships. Has that finished, or is there still some way to go?

Tanya Branwhite 40:18

I think it's a constant. It's a constant set of reviews. We're always looking at our portfolio, always testing ourselves, asking, is there a better way to implement this? Are we ensuring there isn't duplication? If we have active management, is it delivering to the portfolio as we've set the expectation for it to play that role? So I don't think you can ever say never, but a very large part of the initial phase of review and change is complete. We're always reviewing the active element of our portfolio, and in fact there's been a fairly important, and I think ultimately very valuable, project on how we think about active risk allocation, where it's actively allocated across our total portfolio, thinking of an active risk budget as a total portfolio risk budget rather than a single asset class risk budget. That's certainly brought some insights that I think will be valuable for the next 12 months.

Wouter Klijn 41:24

Now, T Corp isn't subject to the Your Future, Your Super environment, which I'm sure you're glad about.

Tanya Branwhite 41:32

Yes.

Wouter Klijn 41:32

But I think one of the interesting things to come out of the focus on those benchmarks is that super funds are much more aware of how they implement their investments, because every basis point saved is almost outperformance. How do you think about implementation? Because in the context of this dynamic with external managers, of course they need to deliver, but switching in and out, terminating managers, reallocating capital, also comes with a cost that adds up at the total level. How do you think about implementation in that way?

Tanya Branwhite 42:10

You're absolutely right, implementation certainly involves complexity, cost, and dislocation, as well as the time and effort it takes for an investment team to make changes to how it implements things. Without doubt, you have to be very careful, and considered, in the way you approach both your implementation and any changes to it. I think it's important to stand back and ask, if we're looking at a particular opportunity, what is the complexity of that implementation? Sometimes that complexity, and the cost to the team of managing, overseeing, and understanding it, isn't as deeply considered as it should be. But there are times where that implementation complexity is valuable because it brings a certain type of outcome or characteristic to the portfolio. So it's a deep consideration. In the listed market you have to think about to what degree you're looking to replicate what we call the betas, to what degree you want active risk as an element, and to what degree there's more of a quantitative or factor-based approach. So you need to think, in each asset class, about what implementations are available, and what opportunities and costs they bring. At the total portfolio level, if you've got complex and very diverse implementations across your whole portfolio, and that's probably where T Corp was when I first joined, we had a lot of different asset classes that had gone down quite complex and detailed implementation paths, what you actually got was a very large amount of complexity, significant challenge for the team to oversee, and, ultimately, over-diversification. So yes, implementation is a critical element of what we do.

Wouter Klijn 44:24

Yeah, and it comes back to that total portfolio approach. Does all that complexity add up to extra return, in the end?

Tanya Branwhite 44:33

Correct.

Wouter Klijn 44:34

Well, Tanya, thank you very much for your time. This was a great discussion, and thanks for coming to our office.

Tanya Branwhite 44:38

Thank you. It was fun, I enjoyed it. Thanks, Wouter.

__________

[i3] Insights is the official educational bulletin of the Investment Innovation Institute [i3]. It covers major trends and innovations in institutional investing, providing independent and thought-provoking content about pension funds, insurance companies and sovereign wealth funds across the globe. The [i3] podcast is available on iTunes, Google Podcast, Spotify, Amazon Music, Stitcher or your favourite podcast platform.

In episode 142, we take a look at AI disruption among listed Australian companies and their response to the risks arising from this new technology. Fidelity International surveyed 31 ASX-listed companies during the 2025 AGM season to find out how boards are really handling artificial intelligence, beyond the headlines. Portfolio Manager Sam Heithersay and Associate Director Sue Lyn Stubbs of Fidelity join host Wouter Klijn to unpack what they found and discuss several red flags, including CEOs and chairs talking past each other and a lack of focus leading to 100s of AI projects running simultaneously. From "shadow AI" and workforce polarisation to the case for a corporate AI "kill switch," this conversation digs deep into how companies set guardrails around AI's biggest risks.

Fidelity International Research Paper: Governing in the age of AI: How ASX boards are navigating a fast-moving frontier | Investment Insights | Fidelity Australia

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Overview of Episode 142

00:40 – Origins of the survey: understanding how ASX boards are actually governing AI, beyond the hype 02:03 – Overall sentiment: comfort with AI varies widely between "leader" and "laggard" boards 03:56 – AI is mostly framed as a cost/efficiency play, not yet a revenue driver; ROI still hard to pin down 05:35 – Red flag #1: misalignment between CEO and board on AI risk and opportunity 08:22 – Red flag #2: disagreement on workforce impact, discussed against the backdrop of CBA's AI-related redundancies 09:52 – "AI washing" — redundancies mislabelled as AI-driven; most surveyed companies are actually still hiring AI talent 12:14 – The J-curve: near-term costs (e.g., running parallel legacy/AI systems) before efficiency gains show up 15:19 – Red flag #3: scattergun AI project lists (e.g., "300 use cases") signal a lack of strategic focus 16:19 – How boards are handling AI risk oversight, and the rise of "shadow AI" / BYOAI 19:12 – Finding the balance between enabling experimentation and controlling shadow AI use 21:18 – Why "human in the loop" is a weaker safeguard than it sounds 23:27 – Cognitive offloading and skill decline — an airline-industry/autopilot parallel 27:27 – "Super users" and the risk of AI widening productivity gaps within workforces 31:39 – Looking ahead: token cost management as a board-level issue 33:15 – The missing piece: few boards have defined guardrails, no-go zones, or a "kill switch" for AI 35:01 – A recent AI incident is raised as a case for why kill-switch thinking matters 36:17 – The regulatory divide between the US and Europe, and what it means for multinational AI rollouts 37:16 – Existential disruption risk: Fidelity's 11-factor framework, and the Kodak vs. Fujifilm lesson for adapting vs. defending 40:23 – What's next for the survey: cost metrics, guardrails, and expanding coverage across the ASX 200 43:18 – Closing: Sam and Sue Lyn on how they personally use AI

Full Transcript of Episode 142

Wouter Klijn 00:00 Welcome to the [i3] podcast. I'm here today with Sam Heithersay, Portfolio Manager Australian Equities, and Sue Lyn Stubbs, Associate Director Sustainable Investing of Fidelity International. And today we're going to talk about artificial intelligence and disruption at listed companies in Australia. Sue Lyn, Sam, welcome to the show.

Sam Heithersay 00:21 Thank you for having us.

Sue Lyn Stubbs 00:22 Thanks for having us.

Wouter Klijn 00:24 Fidelity International conducted a survey of 31 ASX-listed companies during the 2025 AGM season in Australia. Can you tell me a little bit about the survey? What was the catalyst? What started it? And what were you trying to find out?

Sam Heithersay 00:40 Well, the main reason for the survey was to understand how boards were handling AI in practice. Through reporting season last year, we heard a lot of rhetoric on the broad thematic of AI and the opportunities that it presented, but we didn't hear much on the risks, the governance oversight it demanded, or how companies were thinking about the workforce impact, so we used our access to company management, to boards, to conduct a more bottom-up systematic survey to really tell whether the strategy was aligned with governance. And we conducted the survey last year, but as the AI sell-off really gathered pace, it threw up a lot of great opportunities for investing, and so we combined it with an AI framework that our analyst team did from the bottom up, assessing each company and its risk of AI disruption, and we ended up using this governance analysis as a bit of a leading indicator of the AI maturity of a company, and gave us a lot of confidence when a company was thinking more deeply about these issues, that they're more likely to adapt their business model, not just defend against AI disruption, and we think ultimately that might make for a better, longer-term investment. So, I think the use case evolved from just trying to cut through to noise to to setting a baseline for how we can track the AI maturities of the of the companies we invest in.

Wouter Klijn 02:03 Yeah, and so before we delve into sort of the details of the survey and the answers, at sort of a very high level, did you get a sense that boards and companies were comfortable with the topic, or did you get a sense of uneasiness about not knowing quite where this all is going?

Sue Lyn Stubbs 02:18 So across the survey, we really asked a broad spectrum of companies, both from small cap to large cap, across multiple sectors, financial resources, healthcare. We didn't want to just focus on technology because we felt like a lot of the rhetoric and a lot of the focus was in you know the SaaS space in technology, and so we wanted to really understand across the broader Australian economy what was happening? How were boards thinking about this? How were management teams thinking about this? So, I would say it depended. Some boards were very comfortable speaking to it, and you can see that in kind of our leaders who are really driving, you know, transformation and adoption of AI, versus quite a few of our companies were in that really early stage. Having said that, most boards were comfortable speaking to it to some degree, but really, when we were pressing more around questions of you know strategic value creation or risk and controls, that's when we saw some of the answers start to be more conservative, maybe starting to show signs of laggards or are not at that maturity level. So I think most boards were comfortable, but I think you could easily see the bifurcation of where we saw some who were very comfortable, who are leading on AI implementation, and and who were coming up the curve, and I think that really showcases how our access to companies and boards allows us to kind of really see that that that differentiation: who's really leading the charge, who's mature on AI implementation, and who is is coming up that curve.

Wouter Klijn 03:41 Yeah, I mean, there's many different angles to AI, but I think the survey still found that AI is primarily framed as sort of an efficiency lever. Were there any conversations that were more looking at innovation and the other part?

Sue Lyn Stubbs 03:56 It was very early days. Probably around 20 per cent of our companies started talking about revenue generation, strategic value creation, customer kind of developments, and what it meant for, you know, really driving revenue. Having said that, though, across the board, it's really in that productivity kind of cost perspective, and you know what we've been really focused on is trying to uncover what is the ROI, what is the investment case, how are they thinking about capex of AI and capital allocation to AI, and unfortunately, it was challenging to kind of get a clear answer from our boards. That was an area where it was a little bit more opaque. Some sort of reference that it's in our BAU, particularly the tech sector, the the ones that we're leading. They were saying it's in our classic R&D and our BAU capital allocation strategies, but that was an area I think we didn't get great answers on. I think going forward we will get better answers. Definitely looking to the reporting season and seeing how that answer matures through time.

Sam Heithersay 04:51 Yeah, definitely. I think we'd expect the conversation to move away from just pilot studies and broader kind of opera. Operationalization to more of a transformation, more adoption, and ideally more upside cases than just cost out, where they might where a company might be able to change the the value proposition for a customer, but the survey itself was still very early in in the maturity of a lot of these companies and the way they were thinking about AI, so we didn't necessarily expect a lot, and we're grateful that we now have this baseline to be able to measure companies as they adapt and evolve their AI proposition. Because you're right, it was much more about cost out and less so about the revenue generation opportunities.

Wouter Klijn 05:35 And it's no doubt that AI is quite a revolutionary technology. There's of course lots of opportunities with it, but what I found quite interesting as well in the survey is that you mentioned a number of red flags, and I was sort of testing this with a couple of the funds out here where they thought of it, and one of them stood out in particular where you sort of identify that the position of the CEO is different than the board, or they have a different view on AI that could potentially lead to some trouble. Can you tell me about that?

Sam Heithersay 06:06 Yes, there were definitely some instances where we interviewed the CEO and the board, and they were misaligned in the way that they were discussing AI, not just from the opportunities, but also from the risks that it might involve, and that was clearly a signal. I think of you know poorer governance around AI. It's a great leading indicator for us in terms of AI maturity. Ideally, they would all be on the same page, and we did see that inconsistency internally. And for us, we were able to gauge that, having interviewed CEO and boards, gaining access to both, not just through our company one-on-one meetings, but also through the AGM season, where we tend to interact more with at the board level, and it allowed us to move just beyond that kind of polished AI narrative that a lot of companies have to really understanding that internal inconsistency within the company, and we think that's ultimately going to play a part in how these companies can adapt to AI. If the board and management are different in the way they might assess cost or risk appetite, then it's unlikely they're going to be able to succeed rolling out a broader, more cohesive AI strategy. And that's exactly what this survey was designed to try and pick up where the governance didn't quite match with the strategy.

Sue Lyn Stubbs 07:24 Yeah, I mean we were seeing some CEOs uber bullish. Like we have 300 use cases, we have 100 page you know a 300 page deck of all our AI opportunities, revenue generation opportunities, and then you speak to the chair and they're very conservative. Oh, we're only rolling it out in these certain aspects, only doing these pilot studies, so that's where we started to get concerned. One from a prioritisation point of view, whether it's actually going, you know, the spend is actually going to the right products or projects or to the right products for value creation, and then I think the other thing was really around that risk mitigation piece. So it was both a strategic what capital they're spending, and then how much oversight is there from the management team versus the board as well?

Wouter Klijn 08:07 Yeah, isn't it the job of the CEO to be super bullish on everything?

Sue Lyn Stubbs 08:10 True, definitely. I think so. I think it was just how far you know across the spectrum, the CEO versus the chair. I think that's what surprised us, kind of the reaction of AI and what the opportunities were for the for the business?

Wouter Klijn 08:22 Yeah, were there any areas that stood out more than others in terms of disagreements? I mean, disagreements can be small and large, but you know what you mentioned. If the CEO talks about hundreds of projects and the chair is not quite convinced that that's all happening, that's obviously a key concern. But were there any other sort of tensions that stood out?

Sue Lyn Stubbs 08:40 I think from our point of view was also around workforce disruption, and I think not saying that management teams were talking about you know massive layoffs or anything, but I think there was more of a cost consciousness from the management team, what it meant from kind of productivity, etc. But then when we were speaking to boards, they were more conservative. Only around 40 per cent or over 40 per cent reported minimal impact over the next 12 to 24 months from a workforce perspective. I do have to caveat this: this was when CBA came out with their 45 AI-related redundancies, and they got a lot of pushbacks from you know union associations and and that impact. And then they rehired those 45 workers. So, I think we do have to caveat the answers by saying that that was the environment we were asking the boards, and I do think some of their answers were more conservative. Having said that, we haven't seen much impact in the workforce from a data perspective, at least from what we're seeing in in workforce surveys. So, I think overall that was a little bit of a difference from that productivity cost savings versus a board talking about the workforce shape over the next 12 to 24 months. So that was another area where there was a bit of differentiation.

Wouter Klijn 09:52 Yeah, let's go into that a little bit because I'm not sure if the survey was before or after Atlassian also made a lot of people redundant and. Even though they denied it was AI, there was clearly there was an angle there. But basically, it does seem that we're still early in the cycle here, so the impact is not quite as clear yet. To what degree do you think that this was a reaction to sort of that environment where it was just not very good strategy to say you were going to fire lots of people because of AI?

Sam Heithersay 10:20 Yeah, we were very conscious, certainly in the redundancies that were announced afterwards and blamed on AI. We were very conscious of this phenomenon of AI washing, where they were mislabelled as AI redundancies, but in reality, they might have been driven by other factors. And so the survey was very very helpful in in understanding where a company was adapting and could point to AI as a driver of redundancies and where they perhaps couldn't. Nearly half of the companies, you know, we had surveyed, they were in fact hiring talent. So what we actually found were most of the companies we were speaking to were still very much in that capability building phase. They were they were trying to align their data sets. They were hiring a lot of people to to ensure that was the case. And only now we're starting to hear more nuanced conversations around the headcount and the token cost that might come with that headcount and where they should be rationalising, you know, token cost as well. But so I think this is very much an early phase of AI adoption where you see this this capability build out. You see some early movers, perhaps mislabeling redundancies as AI. What we're really looking forward to is is using this as a baseline to be able to assess where we can attribute AI maturity in the way that these companies are thinking about their cost base and where they can't and so yeah we think that this reporting season in particular we'll hear a lot more rhetoric we'll hear a lot of cost out discussion but we're hoping for a more nuanced conversation about the counterbalancing cost of tokens, and really get a bit of a read on who's AI mature and deploying it as such, and who's just using as an excuse.

Wouter Klijn 12:14 I think when you look back in history, you also see that often with the adoption of new technologies, there's initially a bit of a hiring phase to plug that gaps in skills that companies might have, and you sort of see that in the survey as well. There's, I think, 45 per cent of companies added AI talent in the last 12 to 24 months at that time. Maybe we're just too early for redundancies yet. Are we just seeing a lagged effect, or is that still ahead of us? Do you have any sense of what that might look like?

Sue Lyn Stubbs 12:42 Well, we've talked about this, how it's a bit of a J-curve, right? And we're not going to see that cost efficiency and productivity come through so obviously in the beginning because of this impact. And I think one of the key insights that I got from one of the boards that we spoke to was the fact that also it's customer appetite for AI, and so one of the companies we were speaking to in the financial sector was highlighting the fact that they actually have to run dual systems-one very much a traditional kind of paper-based, maybe more analogue versus an AI-enabled one, because there was some customer appetite differences, right? So while they are seeing efficiencies and gains from that AI platform, they still have to run the traditional platform. So in the meantime, in the short term, they're actually having additional costs, almost potentially doubling the costs. Right. So, in some ways, I think it's going to be a bumpy ride from some capex, from cost savings, productivity gains in the short term. But I think, like we see with the J-curve, you'll start to see that come through, and that's probably what we'll start to see reflected in workforce shapes and outcomes going forward. So I just think it's hard to draw early conclusions, and I think, like you said, it's something we'll start to see over the next six months, 12 months.

Wouter Klijn 13:52 That's interesting that you mentioned sort of the difference in preferences because you can see that obviously on the client side, but I think also when using AI, in my own experience, you sometimes go in and out with using different type of systems and applications. I mean, when it first came out, there was a lot of applications on the back end of our website, and they were pretty much all useless. So we sort of played around with a few, and now we pretty much don't use any of them. But in other aspects, in research and that sort of stuff, it's really helpful. So it might also take a bit of time before we actually see where the efficiencies are and where the best applications are.

Sam Heithersay 14:27 Yeah, I definitely think so. There's just a proliferation of tools at the moment, and we certainly gauge from the companies we were talking to that they're all very enthusiastic in the initial phases about rolling out these tools, enabling their workforce. But I think you're right. Over time, we begin to understand that there should be really frameworks in place. Certainly, governance and risk frameworks that monitor the way these tools are rolled out and the risks that potentially arise if they were rolled out, you know, too broadly without much direction from management top down. So. Yeah, you're right. We definitely find there's a a wide spectrum of utilisation of these tools, and ultimately the productivity benefits that the companies talk to, and it again just signals we're still in very early phases of of this kind of AI rollout for a lot of these companies in the way that might change their business models.

Wouter Klijn 15:19 Yeah. Now one of the other red flags, Sue Lyn, that you mentioned earlier, was if a company has hundreds of projects and randomly applying AI agents, is that sort of a sign that they actually have no idea what they're doing, or is that more like over enthusiasm? And I ask this in particular because we have spoken in the past with a person called Peter Strikwerda, who was the global head of digitalization and innovation at APG Asset Management in the Netherlands, and so he's been really focused on how do you build a solid business strategy around implementing AI, and he had that same sort of argument: you shouldn't just randomly apply AI agents and have all sorts of projects. You need to have a fundamental strategic approach to it, where you embed it in the operational processes, you embed it in decision making, and so that you have a coherent approach to how you're going to integrate AI. What's your sense around that? Was there a little bit of like you know maybe these companies got too enthusiastic?

Sue Lyn Stubbs 16:19 I think that's right, and I think when we start to hear the 100 use cases, the 300 page deck of different ideas, I think that does raise a red flag in our minds around that prioritisation, around that strategic focus of the business, because clearly there are areas that it would be more impactful from a business model perspective, and I think, and it's really interesting you bring up that integration piece, because we were looking at how AI risks and how AI monitoring should be incorporated across an organisation, and listening and speaking to kind of AI risk experts, they were suggesting that there's two main forms you can look at and oversee AI risk. One was from your enterprise risk model and integrating it fully, or having a separate AI risk framework, and every single board we spoke to is integrating into their enterprise risk model, and I think that is constructive from an integration point of view. That it's, it's you know across the organisation that is embedded, and you're not creating necessarily a separate system to kind of monitor this. My only concern is that you know AI doesn't necessarily create new risks, but it definitely amplifies the risks. And so, if you are integrating it across your enterprise risk model, are you potentially not having certain oversight or amplified risk management of certain areas? And I think that is one of our concerns. So I'm not suggesting that it shouldn't be in your ERM, your enterprise risk model, but potentially there still needs to be additional guardrails or something to that effect, because our concern is that we will see different outcomes, different perception of the risk of AI, and I think that is something that we haven't really heard from boards or companies at the moment of of how they're going to navigate that risk. And I think the other one, which we kind of started to touch on, which was shadow AI, around you know employees bring their own tools, and we call it BYOAI, bring your own AI tools. That's really around you know potential IP loss, compliance risk, data leakage. So our concern is that boards are not also focused on how AI is being used, both in the organisation and outside the organisation, but how it interacts with their IP, with their data.

Wouter Klijn 18:31 Yeah, that shadow AI usage is very interesting because I've definitely seen that in the field where some funds they're very early on in their AI journey and they're a bit scared of it. That's my sense, and so they only just approved Copilot, and they maybe use it for taking notes in meetings. But in the meantime, you know, people in the investment team they're using their own laptops, their own phones because they want to get up to speed. They want to use this stuff, and so if I suppose the board doesn't give enough rope for them to experiment, then this problem becomes a lot bigger. Do you see anybody do it well? Is there sort of a you know best practice for how to tackle shadow AI?

Sam Heithersay 19:12 Yeah, I think I think that there's a balance to be struck in the way that you address a risk like AI for all the reasons you highlight on IP loss and data privacy, at that at one point you want to roll you want to roll out enough tools to enable your workforce such that they don't go home and start using all these AI tools. But on the other hand, you don't want to roll out too many tools that it becomes less productive at work and I think it's ultimately up to management and the board to make sure there are guardrails in place to be able to sit in that balance have that happy medium where the tools can engage the curiosity of the employee because we all know that that's what obviously drive what drives a lot of employees. To their own AI shadow AI tools, they think they can achieve a lot more with the tools that are unrestricted versus those in their workplace. But we also we ultimately want to embrace some of them, but make sure that they are contained and put in sufficient guardrails from management and board down to ensure that it's still productive and still safe to be used at work. There were the companies that we spoke to were probably that were more advanced were in sectors like software and were clearly some of the leaders, healthcare and financials as well. I think you have an employee base that is already you know more technologically advanced. Let's say in in just their day to day, and so they were all probably using shadow AI to begin with before some of these companies embraced some of these tools. You know, it's just amazing how much it's pervaded our everyday life. I think we are all bringing this. We're all naturally curious about this, and we all want to embrace these tools. We just want a framework from a company that allows us to do it to realise those productivity benefits. So I don't think being a bit of a luddite and preventing these tools at work is going to necessarily help most businesses. There has to be a happy medium struck, and it really has to be set from the top down.

Wouter Klijn 21:18 An interesting finding as well was that it doesn't necessarily reduce the risk if you put a human oversight on it, the human in the loop. Why is that? That seems to be like you know the answer to everything, but obviously it's not.

Sam Heithersay 21:31 No, human in the loop is it often sounds much stronger than it probably is in in reality, and it's certainly being used by some regulators as a as a principal core principle, but in our discussions with companies, it becomes very clear that the human ultimately gets lazy over time, and when they see the AI tool deliver you know accuracy of 99.9 per cent it's very hard for them to capture that that you know point 1 per cent that that actually gets through, so we would like to see more stronger second, third line controls, formal policies in in place, because ultimately the risk of the perception risk, particularly involved with AI, is much greater. By that I mean if if something goes wrong from a claims processing approval for an insurer or a loans processing for a bank. If something goes wrong and we can put it down to human error, it's much more palatable, let's say, for a broader society than if we were to say an AI agent got it wrong and pushed through this product. So there's a perception risk that the companies need to wrap their head around. It's why we shouldn't be rolling these tools out on mass, but it's also why we can't necessarily rely on human in the loop as a backstop. Because in talking to the companies, it doesn't seem to be enough.

Wouter Klijn 22:53 Yeah, it's interesting because there was recent cases at the say the large advisory firms where reports went out that that basically were AI generated and used a lot of cases that didn't exist, examples that didn't exist, and they basically had to refund them all their money for this advisory piece of work. You just mentioned people getting lazy. Is that sort of a risk as well that you that that boards identified, or are people cognizant of, you know, abusing these AI tools?

Sue Lyn Stubbs 23:27 I think at the moment we're not hearing that from boards. We're not hearing that from management teams. Again, I think it's too early days, and like Sam said, this was a bit of a baseline. So I think potentially through time we might start to hear that around, you know, cognitive decline, skill management. How do you get juniors coming into the workforce? How do you upskill them, etc. And so I think the whole skill set, expertise dynamic across an organisation will be a key focus area going forward. I think though I actually thought of an interesting parallel. If we think about the airline industry and you think about autopilot, for example, when that came in, I think there were a lot of concerns around cognitive decline, and obviously there were a few tragic incidents in the airline industry where it did happen. Right, you know, some pilots did become complacent, and there were accidents. But I think what's really constructive is the response that came out of that that approach, you know, there was more mandated hand flying hours. There were scenario training for automation failure. They had crew resource management. So I think it's a good parallel to look at what potentially AI would need to do. Obviously, probably much quicker in in the instance of AI. But I think you know no one was contemplating removing autopilot, but instead it's putting the guardrails, putting the necessary training and parameters in place in order to ensure that you don't have that complacency, that you don't have that cognitive decline that happens across a workforce. So I think what we need to be clear is what's going to happen. Where do we need to put incremental resources across a. Organisation not to lose that IP, not to lose that skill set, because of course it is a concern. We haven't seen it play out yet, but I think that will be definitely an area for conversation going forward.

Wouter Klijn 25:11 There is a lot more sort of attention for what they call cognitive offloading, where basically you know you don't think too deeply anymore about certain topics because you can let the AI do it, and you know I'm aware this this is probably something for a future survey for some of the questions that may be added on later on, but from that perspective, you can already start to see a little bit in schools and universities where this is creeping up where there was one article that that basically took it to the extreme and said we see students coming out of universities basically illiterate because they don't they don't engage with the content they very formally go through the motions of putting their submissions in and when they come out they actually haven't learned anything what do you think around that is that a key risk

Sam Heithersay 26:01 Yeah, I definitely think it's a real risk. And from a company context, what we're talking about more so is just the loss of domain expertise and trust from clients. If we're seeing that cognitive offloading of the workforce, particularly on tasks that they would they would normally go to that that particular company for, so we have to be very wary of the perception, the loss of trust, and the loss of skill that might come with overuse of these AI tools. I think we have to balance that with the idea that AI is still fantastic for taking away a lot of the drudgery, really, the kind of lower cognition tasks that and so we have to strike this balance where we do want to enable employees and we want to see our companies enable employees to embrace these tools but really draw that line between where a tool might be encroaching upon the their cognition in a way that undermines a whole company's value proposition, particularly if it's if it's service led, if it's a service led industry. So again, that that to me is just a nuanced conversation that we didn't have in this early phase of this of this survey, but we would like to have more so with companies, and we will probably judge the companies that can have a mature conversation about this potential risk, which is much more forward-facing risk, and we use that as a signal of their AI maturity for the broader business.

Wouter Klijn 27:27 Yeah, and I think there's a flip side to that conversation as well, because I think pretty much with every technology throughout history, there has been a cry that skills would be lost, even with the advent of the calculator. And from what I understand, even in old history, with writing becoming more commonplace and people wouldn't be able to remember anything, so there is a flip side to that. And one of the more interesting examples of that I thought was there might be in the workforce people that are just better able to adopt AI. They're sort of like super users, and they're just able to boost their productivity beyond what the average workforce does, and that might create sort of divisions within workforces. Do you have any thoughts around that, where you know people just are so skilled that they might be able to replace you know whole departments just by themselves?

Sue Lyn Stubbs 28:20 We haven't seen real evidence of that yet. I think we were speaking to one board where they were very conscious of where they were investing in AI, where it made sense across the business, and kind of really targeted pilots' use cases. I think maybe that was more from a cost perspective rather than a super user perspective, but I do think we potentially will start to see this bifurcation across workforces because of the cost element as well, right? Where do you actually invest in AI use cases that have the biggest bang for buck? Having said that, though, I think across Australia, there's still we actually were looking at some of the RBA surveys of appetite, trust, and kind of willingness to adopt AI. Australia is still quite low on that curve in terms of trust, particularly against other OECD countries. So I think across the board and boards, Australia is very conservative from an AI adoption perspective. So I think we may not see that super user bifurcation across the workforce come through quickly. It may take time to kind of come to fruition, and I think potentially it does create some certain workforce divides that that could be challenging for a board to navigate in the future. So definitely something we'll monitor going forward, but we haven't seen particular signs of that yet?

Sam Heithersay 29:42 Yeah, I do think it's something that's obviously always existed. This spectrum of the workforce, where some are just more productive and better than others, where we've had discussions with companies, they will highlight, say, a software engineer might be five times more productive than the top tier. Than the bottom tier, but if it's an augmentable task like software development, then what we find is an AI tool rollout might make them 10 times, 15 times better than the than the lowest tier software engineer. So it might it's always existed on a spectrum, but that that polarisation might just increase with AI tool adoption, and that will bring up cultural frictions, particularly if you start rewarding that top performer with more advanced tools and models, and the way you allocate costs. But I don't think that's necessarily completely different to what companies already manage in their top and bottom performers. It just might increase that that polarisation that we that divide that we necessarily see between the top and bottom.

Sue Lyn Stubbs 30:46 I do think though when we were speaking to our leaders in our in our survey, they were creating cultures that were leaning into AI adoption, kind of celebrating AI, putting incentivization, really championing AI as a an improvement for your productivity, improvement for the workforce, and it was very different from some of the boards that actually shared that they had a culture of fear of AI and across the workforce, and they were actually having to assure their workforce that it it would there wouldn't be redundancies, etc. So I think it was very clear that across our survey, that the boards that were able to create a culture that was positive around AI adoption were the leaders as well. So I think creating super users, creating too much divide across a workforce, could actually be detrimental to the adoption and rollout of AI as well. So boards have a hard balancing act going forward.

Wouter Klijn 31:39 Yeah, that was interesting because I think there was the example where a company had put in incentives for using AI, and then within the first sort of three months, they ran out of tokens that they had budgeted for. So we're getting into that stage where the questions change. So you have that baseline now from the 2025 survey. What are some of the areas that you look at maybe adding to the survey token usage and cost might be one of them.

Sam Heithersay 32:06 Yes, definitely token usage and the way that it might offset any potential headcount redundancies is going to be a key topic of discussion. I think it will come up in reporting season the way that companies are balancing token cost against the productivity benefits that they might be talking to, we are likely to see a lot more rhetoric on AI through this reporting season. But I think, given the expenditure that we've seen, we're probably beyond the point of just offering anecdotes on time saved on talking about the number of pilot studies. We now really need to start talking about the return on investment and you know a significant, a more mature discussion of the potential revenue upside that we're seeing. So that's where we're likely to dedicate a lot of the next round of surveys, and I think that all of this is to just gauge company maturity on AI, and in the initial phases, it was much more about experimentation and access. Now we need a real conversation on how costs might play a part in the in the rollout of AI.

Sue Lyn Stubbs 33:15 I think another area that we're focused on, and potentially I'm being a bit dramatic with this term, but what are boards thinking about a kill switch? Right, you've seen what's happening with AI deployment across organisations. What controls you have? So I'm not suggesting that some of the ASX 200 companies should have kill switches because they're not, you know, developing AI models. But having said that, one of the key surprises from the survey was the fact that there was minimal articulation of guardrails, no-go areas that the board had identified, even if it was sort of a brainstorming exercise of these are areas that we will not let AI kind of touch or or really run. So, for example, we know it's still maturing, but there are areas, several high-risk areas such as workforce surveillance, bias, customer treatment, and so I thought this would come through some of our board conversations, but unfortunately it didn't. And so I think going forward, in addition to cost, we'll be very focused on what are the guardrails, where are your no-go areas for AI implementation? Do you have the ability to have a kill switch to shut this off if it actually does run a bit rogue in those areas as you start to implement it for revenue generation, for customer-facing use cases, I think that is another key area we will really focus on. I think unfortunately at the moment we're all just sort of waiting for a high-profile incident where what we saw in cyber, we think will come over to AI and then we'll start to have regulation. Right, it was a bit of a novelty. Then we had voluntary frameworks. Then there was a high-profile incident, and then we have regulation and fines, etc. And I think, unfortunately, that might be the process for AI as well. With cyber, it took 15 years. My guess with AI, it's going to be much faster, right? So that's my concern. Obviously, that won't come through in the survey, but. That's all what we're sort of waiting for.

Wouter Klijn 35:01 Yeah, no, that's fascinating because you've seen recently already with Anthropic's Mythos 5 model that it went completely rogue and it went out in the internet. And from what I understand, it was setting up fake profiles in in order to try to get customer details and hand over passwords and that sort of information, that would be a good place to have a kill switch where once it gets into your customer base, that you can shut it down. But that seems to be already here. Do you think that that will be a key focus of potential questions in the future around how to protect your client base, your customer base, rather than just IP in the company, but potentially more the interaction with the outside world.

Sam Heithersay 35:44 Yeah, data privacy discussions are always raised in our conversations with companies and cyber security risks. What we find with AI is it just amplifies that existing risk in the system. And you're right. If you had a rogue AI agent, you know, disclosing that information, then that's an example of that amplification of what companies already manage, but need to be aware that the game has changed now in the way that these AI tools can really expose any weakness in the data security protocols that they already have in place.

Sue Lyn Stubbs 36:17 What we're also seeing is this regulatory divide, this AI divide of you know the U.S. being a lot more open and willing to kind of adopt and utilise models versus the European stance, which is far more conservative, really trying to protect customer data, etc. And so I think for some boards, one in particular I was speaking to, financials again, was describing the fact that they're finding it challenging. How do you roll out one platform, one product when you're trying to navigate this divide of different regulations, different requirements? It's actually creating real hurdles for multinational companies. Of what cost do you put here? Do you roll out that model there? Do you actually put that new project or new product there? So it's a it's a new minefield of of AI regs, AI requirements, and I think that's going to introduce new costs as well and new challenges for businesses that I think obviously were there. Obviously, there's always different regulation across the world, but I think it's amplified with AI rollout.

Wouter Klijn 37:16 Yeah, did you get a sense from speaking to the boards that I think about that potentially existential level of threat where certain business models might become irrelevant. I mean, software has obviously been an example that has been heavily impacted, but you could see potentially legal firms, advisory firms. I mean, we have listed legal firms. So, you know, do boards ask themselves to the question.

Sam Heithersay 37:41 Yeah, well, it's incumbent upon us as investors to ask the question first. And so, in addition to this survey work we did, we also went through all the companies that we own and brought a ASX 200 index with a large team of analysts from a using a bottom-up framework of AI disruption risk, we had an 11 characteristics to judge each company. Whether it's defensive moats, like do they have a safety criticality that might prevent an AI native startup from challenging them? A proprietary data moat, regulatory moat. Is there adoption friction in the way that they can roll out their own AI? Whether it's workforce unionisation, and through that process, we were able to understand where companies might be able to defend themselves against this existential threat that you highlight of AI disruption. But I think what we've also paired, what we've also realised, particularly being longer term investors and having the history of looking at previous examples of disruptive technologies is that it's very hard to actually understand in the moment who can not just defend their existing business model but adapt to change because this this AI is clearly a transformational technology that will force companies to change in order to survive and we've had examples of this previously. One we drew on was digital photography in the early '90s with Kodak and Fujifilm. And if you had run a framework using a backward-looking defensive moat framework like we've done, you might come to the conclusion that they were both losers in the way that they couldn't defend their print photography business against a digital photography business. But if you were to understand which company was more mature in the way they were able to adapt, then you might be able to pick that Fujifilm quickly adapted. It diversified its portfolio. It wasn't concerned about necessarily cannibalising its print business. It survived where Kodak failed, and I think the parallel example here is true too. We will see all companies are talking about how they're going to defend their business model at the moment. But what we're probably more interested in for as longer term investors are those companies that recognise this might be an existential threat and are mature enough in their thinking around AI to adapt their business model and. Perhaps change it entirely, and the best leading indicator we have in this very early stage is governance. We feel like that's the way that we can assess where a company is thinking very deeply about this risk, and who is more likely to adapt in order to survive. Because you're right, it will be an existential threat for some companies, and it's up to us to pick which ones we think can adapt rather than just defend.

Wouter Klijn 40:23 Yeah, and going forward, do you have an idea of what areas might be coming up in the next survey where you're going to have an extra close look at?

Sue Lyn Stubbs 40:32 Cost is definitely that one of the key ones. As we mentioned, I think you know we've already heard from one board how they were looking at revenue per FT. If this was a tech company. They were looking at revenue per FTE, and they were changing their board metrics to better understand cost and AI capex. And so now they're looking at revenue plus capex per FTE. So that's a clear signal that boards are already trying to get a better handle on what the investment is, how effective it is, how efficient it is. So I think cost is very much one of them, and I think the other area is really that those guardrails, that risk mitigation piece. If human the loop fails, what are your next defence lines, etc. I don't have good examples for those. I think it looks different for different organisations, but I think that those are the areas where we're really wanting to see more information, much more concrete answers to those questions.

Sam Heithersay 41:24 Yeah, as I said, I think we have to move beyond the anecdotes now, and we have to move beyond the just repeating the number of pilots that they might have. We want to see progress return on the capital that's invested, and we do probably want to see companies moving beyond just thinking about this, as 70 per cent of them did from just an operational efficiency gain. I think the next stage is is augmentation, so not just where you can replace tasks, but where you can enable your existing employees to be more productive. I think after that, that we have to look at more transformation of of end-to-end processes, and really that the final stage in my mind is this complete reinvention that might be required for certain companies if they conclude that AI is enough of a disruptive threat that they have to do, you know, a Fujifilm style diversification. So, we'd like to see more understanding of a better understanding of the potential threat and how companies are going to adapt because the operational cost efficiency answer is probably not going to be enough in the next iteration of this survey.

Sue Lyn Stubbs 42:28 So our goal with the survey is really one to be able to see the companies that we surveyed. What is the progress? You know, a year on, how have they maybe matured in certain areas? What areas have they improved on, etc. But then I think we also want to expand. We want to cover more of the ASX 200. Unfortunately, it would be it would be lovely if we could do it across the ASX 200. But it is more of a detailed company engagement, speaking to the board. So quite manual and labour intensive. But I think as we look, there might be more proxies or data around AI that we can kind of use as to enhance and and complement our survey as well. So that's something we'll be looking at. But I think it'll be great to do a time series and understand how our companies have improved, what are the differences, and then also expand that across more sectors and across more companies as well.

Wouter Klijn 43:18 Yeah, maybe final question to end up with: Are you using AI yourself?

Sam Heithersay 43:23 Yes, definitely. I use it. I use it for work. I use I use it at home. Yeah, using it for parenting hacks. So there's no part of my life it probably doesn't touch. And yeah, I think it's I think it's very much in the camp that it can. It's a fantastic, you know, tool. It's a fantastic technology that we should be embracing. But I guess yeah, doing this this this work highlights that it does come with risks, both personally in repeating my parenting hacks to my wife and professionally at work.

Wouter Klijn 44:00 Fair enough. Sue Lyn?

Sue Lyn Stubbs 44:01 Also using AI a lot and have multiple tools as well. I think it's such a useful tool. It can be so effective and helpful, but obviously with the right guardrails, with the right risk considerations as well, and just being very clear of what it can and can't do. Right? What are the limitations of it? But yeah, I love it, and we'll continue to use it, and it will be very much part of my day-to-day activities all around.

Wouter Klijn 44:27 Excellent. Well, thank you very much for this conversation, and thanks for coming to the offices. It was great to have you. Thank you.

Sue Lyn Stubbs 44:32 Super. Thank you so much.

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[i3] Insights is the official educational bulletin of the Investment Innovation Institute [i3]. It covers major trends and innovations in institutional investing, providing independent and thought-provoking content about pension funds, insurance companies and sovereign wealth funds across the globe. The [i3] podcast is available on iTunes, Google Podcast, Spotify, Amazon Music, Stitcher or your favourite podcast platform.

In this interview from November 2023, we speak with Matt Whineray, then CEO of New Zealand Super, to celebrate the fund's 20th anniversary. Established in 2003, with an initial contribution of NZ$2.4 billion, the fund has achieved an impressive average annual return of 9.5 per cent over this 20-year period, adding NZ$40 billion in value. We delve deep into the fund's strategic tilting program, which has been a significant contributor to its success, and this interview contains the startling admission that NZ Super once held a short position in the NZ dollar that grew to 40 per cent of the net asset value of the fund.

Overview of Podcast with Matt Whineray

01:00 NZ Super started investing in September 2003 and now has a 20-year track record 03:00 One of the key starting points was to get the risk position right and get the board to understand this position 04:30 The 20 year track record: the country is about $40 billion better off as a result of the creation of the fund 07:00 The fund invested in private equity only two years after the beginning. 8:30 The strategic tilting program; the philosophy behind it and the early days 14:00 There are times when you get tested and 2013 was one of those times 15:30 I borrowed this one from [AQR's] Cliff Asness: 'Don't size a strategy so that when it goes wrong you are dead'. 18:30 The amount of risk that we allocate to our strategic tilting process is definitely the highest of all of our internal strategies 20:30 The strategic tilting program has evolved from trading once a month to trading every day, sometimes multiple times a day 22:00 Introducing the reference portfolio; the beauty about the reference portfolio is that there is real clarity about the decisions that are being made 26:00 Since inception the decision was made that we always hedge the reference portfolio 100 per cent back to NZ dollars, and that is one that is always debated at reference portfolio reviews 28:00 Managing NZ equities in-house 31:00 What else do we do internally? Portfolio completion credit strategies, direct investment and strategic tilting 33:00 Embracing responsible investing 36:00 There is no downside to us helping our friends in the region 37:00 Preparing for the drawdown period 41:00 New Zealand Super has been experimenting with an AI portfolio. What is this? 44:00 Leaving the fund after 15 years and Matt's favourite moments with the fund 45:30 Early 2020, I had a radio interview where I was telling the interviewer that we just went from $48 to $35 billion. The fact I could say that is a testament to our stakeholder management and the education we've done along the way

Full Transcription of Episode 141

Wouter Klijn 00:11

Welcome to the [i3] Podcast. I'm here today with Matt Whineray, who is the Chief Executive Officer of New Zealand Super, and today we're celebrating 20 years of the fund. Matt, congratulations on this milestone!

Matt Whineray 01:26

Oh, thank you very much, and thanks for having me.

Wouter Klijn 01:29

Excellent. So there's a couple of dates that we can take for these 20 years. I think the New Zealand Super Innovation and Retirement Income Act was passed in 2001, and that set up the structure of what is now New Zealand Super. But it wasn't until 2003 that the fund received its first contribution, which I thought was 2.4 billion New Zealand dollars, and started investing later that year. So it's actually in I think October this year that we have a 20-year track record of the fund is that right? And can you share some of the learnings from that period?

Matt Whineray 02:08

That is right. Yes. So it took a bit of work between the passing of the legislation and 2001, and and kicking off. So getting a team, getting the team together, and those those board and those first few people that were were involved. That's right. We got the money on 30 September 2003. I understand it actually. We we invested almost straight away, some of it anyway, and had got set up to to be ready to do that. So yeah, it's been a big a big moment for us taking over 20 years and an opportunity at that point to sort of reflect on on how we've changed since then, and we've changed quite significantly, but also what we've learned. So, from a from a lesson perspective, I guess probably the most important ones are get the get the long term risk setting right, understand how you think that might perform along the way, and then spend as much time as possible making sure that stakeholders understand that. And so, how it might, how it, why you've done that, and and how it might operate. As as an investor, we think about our as a long horizon investor, we think about our our key risks as being two big ones: liquidity. So running out of liquidity is pretty terminal, and stakeholder support. And so we spend a lot of time thinking about how we manage those in order to be able to get to the long term. Because if you're a long horizon investor, you care about what the return is over the long term, but if you cannot survive the journey, the destination doesn't matter. So, so we think hard about those. And the other one of the other critical foundational things that we've done is is being really clear about what our advantages are as an investor. So we call these endowments. We don't have a lot of advantages, but they are important. So things like long horizon, our operational independence, our governance, our strong governance model, and our sovereign status are all critical. And aligning our investment strategy with those endowments and with really clear investment beliefs is really important as well. So those those are sort of the big things that we've we've learned along the way. We didn't. We certainly didn't know them all at the start, and we found out as as we've gone along.

Wouter Klijn 04:27

New Zealand Super always has a strong focus on on governance, but of course we also would like to know the numbers. Have you crunched the numbers for the 20 year track record?

Matt Whineray 04:35

Yeah, we're about 9.5 per cent per annum over that over that 20 years, and I guess most critically, from a from a national perspective, the the country is more than $40 billion better off as a result of the creation of of the super fund. So, if you think about the alternative use of our of the contributions we have received, would have been to pay down government debt. We have we. Beaten that benchmark by more than $40 billion, and within that 40 billion, we've also added about $16 billion of value over our risk equivalent benchmark, our reference portfolio, which we'll get onto later on. But yeah, so we've we're very happy with how those how those numbers have turned out.

Wouter Klijn 05:17

Excellent. Of course, governance is really important, but when we look at sort of the investment approach, can you tell us a little bit about, you know, the early days in terms of the asset classes that the fund started with and how that has evolved over time?

Matt Whineray 05:32

Sure. So in our in our right at the outset, we were a pretty traditional SAA approach. We had in that global equities, New Zealand equities as a separate asset class, and global was both developed and emerging markets, global fixed income, and then we we also had a reasonable, reasonably significant allocation to private market assets. So those were in those days, private equity, timber, infrastructure, property. When I turned up in 2008, we had this other category that was called other private markets, which was kind of whatever else we found that was kind of interesting. And so we had a pretty big allocation to that to that private markets in that early SAA. But I think right from the outset, we've had a pretty growth-oriented portfolio. So it might have started at about sort of 7030, moved to 8020, and then our reference portfolio has been 8020 since since we implemented that, which was about seven years into our into our operation. So we've always we've always sought to take advantage of our long horizon and our relative lower need for liquidity, and allocated across those broad range of asset classes.

Wouter Klijn 06:49

Yeah, is is that why the fund started relatively early investing in private equity? Because I think I looked it up, and it was only two years after the fund started investing that the first private equity investment was was already made.

Matt Whineray 07:03

Yes, so we had some small private equity funder funds earlier on, and some secondary secondary fund and a more traditional GP commitment. That was part of that that SAA allocation. So we, as a result of that that original construct of the SAA, the team was focused on on private markets. That that allocation to private markets was about 35 per cent in the in the early versions of the SAA. So a pretty chunky one. And so the team the team got on with with thinking about how we could how we could gain that exposure.

Wouter Klijn 07:37

So what was the inspiration for that? Was that sort of you know, a lot of the the Australian funds look at the Canadian peers, and they obviously have a very heavy allocation to private assets. Or was it more that long term investment

Matt Whineray 07:51

horizon? Well, it was definitely a long term investment horizon. But I think early on, the some of the the people in the or investment people in the organisation certainly also looked at not just the Canadian peers, but also some of the U.S. endowment models as well, which had significant significant exposure to private equity in particular. And I think right at the outset as well, we were we were almost we were entirely outsourced. You know, when we kicked off, we're obviously using external managers, and that was the approach that that was taken to get exposure to some of those different asset classes that were included in the SAA.

Wouter Klijn 08:27

I think one of the things that really sets New Zealand Super apart is the strategic tilting programme. That is not not not something that you see, especially not at the scale that I think New Zealand Super has implemented it. Can you tell me a little bit about you know the philosophy behind it and why it was chosen to implement that? Because I think it it first started in 2009, so about six years after the fund first started investing, which was relatively quick.

Matt Whineray 08:55

Yes,

Wouter Klijn 08:56

tell me a little bit about the philosophy.

Matt Whineray 08:58

Sure. So the strategic tilting came out of a lot of work done by our asset allocation team under the leadership of Neil Williams. So Neil had been in in the asset allocation team at UBS Asset Management and worked with a couple of other guys, guy called Brian Singer and Renato Staub there, and he had brought with him this this thinking around a dynamic asset allocation approach, and the idea of it for us was was to take advantage of our belief that we can have a a more constant relative risk aversion than the market. So as the market gets excited, or the market gets depressed, and we have a if we have a long run view of the equilibrium value of a particular asset class. Then, as it gets depressed, we can we can add exposure, or as it gets excited, we can we can reduce exposure and do that in a systematic way. So, what we're trying to do is remove our own behavioural biases by creating a systematic, dynamic asset allocation approach. So. The team did a lot of work on on setting that up, thinking about what the governance of it ought to be. How do we make it efficient? How do we remove our personal biases as markets get really you know volatile and overcome that to be to be systematic in that? So it's not about waiting for a market to get to an extreme, and then putting a position on it's saying, "Hey, if the market's gone down and it's and there's a gap between what we think value is and prices, then we will add exposure and we'll we'll be systematic about how we size that. Then if it goes down the following day, then we'll add some more. If it goes down the next day, then we'll add some more. But what's happened in that moment is that the last two days are now worth less. So we've got a we've got a mark to market P&L loss. So it took quite a bit of of work with the investment committee and also with the board to approve that strategy because you know the darkest hour and that one is right before the dawn. As you get further and further away from fair value, and you've increased your position either in a long way or in a in a short way. Your mark-to-market loss will be at its peak at the moment. That at the moment where you forward-looking have the have the highest expectation in terms of return. So it takes a lot of work to be able to hold on to that. You have to size it right to start with, so that you don't get you avoid two things. There's two really important things with tilting strategy. One is you don't you don't lose your bottle at the wrong time, and that's really critical because as soon as you you've stopped out, you've lost that, and there's no hope of getting it back. The other is getting your sizing right so that you've got a reasonable allocation of risk through the through the sort of different VP gaps, and because the worst thing is to have used all your risk while the market is just being volatile beyond where you where you got your positions on. So that that took quite a bit of work to get all that done, but we kicked that off in March 2009, and frankly, that was a good time to do it because if you draw the graph, that is the low point of the equity market. So we were we were very fortunate in terms of kicking it off there. It was interesting because we had said to the board, "Look, you know, we may be out of the money for a long period of time here, and we'll all have to you know hold hands and make sure that works, and then what happened was we put some positions on, and the market immediately went off. And the board said, "Oh, that was easy. Why don't you do some more?

Wouter Klijn 12:30

Yeah, and and from memory, I think one of the ways to sort of get the board along with this programme was that you you had specific people on the board that were sort of selected to go in in sort of a deep dive into this programme, so that they almost became spokespeople for this programme on the board itself. How has that developed over over the years? Did it once you had that initial success, did they immediately became much more comfortable with it, or have questions been raised during the years whether we should continue this.

Matt Whineray 13:02

Yeah, look, I I think it's you know as boards change in terms of personnel, it's always important to keep them up to date with what the genesis of a particular strategy was and what the basis for it is and how it connects with our endowments or our investment beliefs. It certainly has taken a lot of time for us, you know, keeping the board refreshed on how the thing works and how we expect it to work, and why, why in a model where once a when a when a market hits a particular level, we buy some exposure and then it goes down and then it goes down and then it starts coming back up. We will we will demonstrate that over time that should generate us a return, and so we've we've done a lot of work with the board on that. But absolutely, there are times when that will be tested. So if you fast forward to 2013, we had a time when the the Kiwi dollar was very strong against, in particular the U.S. but other currencies as well. And what happened was, in those days, we had a our tilting programme was really the Kiwi against like the world basket of currencies, and and so what happened was we slope we increased the short position in the Kiwi, and it got very large, like up to nearly 40 per cent of the NAV of the fund, and that starts to create nervousness because to get to that short position as the Kiwi continues to go up, we're losing money each day on what we had put on yesterday, and so that that really focused the mind of the board and of the investment committee and of the tilting team and everybody on on that position. But we saw in the end that that you know the the Kiwi reverted, so it is a this is ultimately a mean reversion strategy. We we expect things to revert to that that long run equilibrium at some point. There'll obviously always be volatility, but it did, and so we got through that. But that that was a a real moment of tension, and. One that required, you know, careful understanding of the basis for for the strategy. Step away from the positions and the P and L and all that sort of stuff. Go back and say, well, has the has the basis for the strategy is that still exists? Do we still believe in some long run value? Do we still believe in mean reversion? And then, if we've sized it correctly, then then we can we can survive it. So that's the key with these types of things. Is over time we have increased the active risk allocated to that. We we doubled it a couple of times from the from the outset. But you always need to make sure that you size a strategy. I I pinch this one from Cliff Asness. Don't size a strategy so that if it goes wrong, you're dead because you know that's pretty fundamental. And so that's that's how we've thought about that. Get this, get the sizing of the active risk budget right.

Wouter Klijn 15:52

Yeah, yeah, for sure. Because I think we we spoke in 2019, just after Willis Towers Watson did a review of the fund, and and they brought this up. They basically said the tilting programme is quite unique, and perhaps the board should look at it and reconfirm whether they're comfortable with the amount of risk budget it takes up. And I think New Zealand super did that, and they said yes, we are comfortable with that. Did that sort of 2013 experience help with formulating the thoughts around that query of Will Stars Watson, where you basically because you went through that exercise and got into a situation where it was quite uncomfortable, I suppose, to hold that position. That it was then easier to state that you were comfortable with it a number of years later.

Matt Whineray 16:43

Yeah. So a few things that happened. The team continues to develop that tilting strategy, and and some things that happened. So very early on, if you go right back to the start of it, we just had sort of two levers. One was equities versus bonds, and we tilt that, and Kiwi versus you know all the other currencies, the trade-weighted index, and and so it was a pretty narrow strategy. And what the team always had intended to have happen was to increase the breadth of that strategy. So, particularly in the currency side of things, we went from that Kiwi versus the basket to nine different currencies that we could tilt against each other, and so that was a really important change in the in the breadth of the strategy. Now that helped us a lot because then you reduce the amount of risk you've got on sort of one particular view of the equilibrium view of the current of two currencies of a pair of currencies, and so so yes. So I think all of that work helped when we came to that conversation with the with the board following the Willis Towers Watson report to be able to say, well, this is how we think about this. Because at the same time as doing that, we'd expanded the equity bond one to be. I think we've got nine markets in both of those now, and and we tilt equities versus cash and bonds versus cash and and bonds versus equity. So there's a there's a bit more breadth than that as well, and that gave us a bit more comfort. So and funnily enough, what that meant is that our our actual risk budget went down a little bit because because we ended up with a few more positions that were not perfectly correlated with each other, so all of that helped when it came to that discussion with the board to say, are we still confident in this? Because the amount of risk that we allocate to the tilting strategy is definitely the the highest amount of any of our internal strategies, but there is a lot of breadth in there across the different types of of tilting asset class, but it also reflects our confidence in the strategy and critically, its alignment with our endowments and our beliefs. So, so that's why it gets more risk, and that risk has turned out to be rewarded for us. So we've been very pleased with that.

Wouter Klijn 18:56

Yeah, and I think in recent years it has also been expanded. I think commodities was added as one of the levers. Can you tell me a little bit about that and what is sort of the plans going forward for this programme?

Matt Whineray 19:08

Yeah, so we've got commodities in there as well as REITs. So we sort of took REITs out of out of the equities and thought about whether they might provide us with a different a different exposure or a way of expressing views in a in a way that wasn't perfectly correlated with the other markets that we're doing. So we needed commodities in a pretty small way. Commodities is a bit trickier because you've got both levels and curves, and so there's sort of more variables, if you like. So really, the addition of that is a way of us learning a bit more about those markets. It has a very small amount of active risk associated with it at the at the moment, and and the team are looking to learn a bit more about how how our models work in that situation, our confidence in our models, because in all of these different markets we have a differential level of confidence in you know our our view of equilibrium or our. Of how the how it might track over time, and as a result of that that sort of explicit level of confidence, that will affect how much risk we allocate to it. So, what the team's looking to do is thinking about: well, are there other are there other ways we could express this strategy? Are there different signals we might use? How do we think about how do we think about trading not necessarily frequency but size positions? You know, this thing has evolved in the very early days. We just did it. We traded it once a month. Now the team trades it every day and and sometimes a couple of times a day, depending on which markets are are open. So the yeah they continue. they continue the team continues to develop that to look for again more breadth and ways that we can take advantage of our endowments in terms of that long horizon and and as I say a belief in that slightly more constant relative risk aversion

Wouter Klijn 20:59

and how do you keep the costs under control if you trade multiple times a day.

Matt Whineray 21:03

Yeah, so that's a debate that the team has very every so often, which is what, how do you think about that trade-off between position sizes and transaction costs? We keep the costs under control by by executing all of the the trades ourselves. So our portfolio completion team does those does those trades? We trade predominantly in futures. Sometimes there's some swaps, but mostly it's futures. And yeah, there's an active an active discussion about how do we how do we make sure we've got the trade off right between position size change and and transaction costs.

Wouter Klijn 21:37

Now this programme was in place before New Zealand super embraced the the reference portfolio, and I think that came in in about 2010. So the fund had already been operational for, or at least investing for at least seven years. Why that switch at that time? What what was the thinking behind introducing this reference portfolio?

Matt Whineray 21:58

Yeah, so so we'd been we'd been looking at some of the work that had come out of Canada and thinking about that reference portfolio approach. And in those days, it wasn't actually I don't think it was called total portfolio approach. That's sort of been coined later. But yeah, one of our firm beliefs is that you should have some real clarity about whose decision is whose. So let's let's be clear about who's making the big decision about the risk tolerance, which is obviously the board. What the active risk budget should be in terms of the implementation of that portfolio, and then be able to you know determine how how those big decisions have panned out. One of the challenges with an SAA approach, is it's it's impossible to fully replicate the SAA. You can't you cannot ever be at the exact amount of the SAA, and so then you always have a little bit of a confusion about well, are you there because you didn't want to be, or you there because there's just not a it's not available? How do you think about those? What the the the beauty of the reference portfolio approach approach is that there is real clarity about the decisions that are being made. So you've got the big one, which is what's the composition of the reference portfolio, including the asset classes and the currency decision you're making, the Heng decision. Then then the allocation of active risks to management in order to be able to manage that, then says, okay, if we decide to invest in something, so let's buy a forest. We are going to sell some part of the reference portfolio, so we'll sell some equities and some bonds that match the risk. We can we can tell exactly how that decision panned out because we know what the what the what the funding proxy was, and we know what the what the asset return is, so it's very clear that you know when we make those decisions, we we can we can determine how they how they went. So there's this sort of that clarity of responsibility of decision and accountability for outcomes. We we thought was important, but it also helped with our team to be able to say we're not here to just if we've got 10 per cent and allocated to this private market asset class, you know, call it timber or infrastructure. We're not just here to fill that up. We we we need to we need to only put assets into that opportunity if they're actually going to improve the outcomes for the total portfolio. And so the idea of trying to get the team to think more clearly about what is it we're selling in order to buy this thing, what is the relative attractiveness of a forest versus some private equity commitment versus some property development, and how do we get them to think about that? The reference portfolio really helps with underpinning that total portfolio approach, and so that's so there was quite a lot of work went into that before we implemented it and or agreed it with the board and then implemented it in 2010.

Wouter Klijn 24:50

And I think the reference portfolio has changed over the years a couple of times. I can remember an instance where emerging markets was part of it, and then that was taken out again and. There was an argument made for a more simple reference portfolio. Can you tell me a little bit about that evolution?

Matt Whineray 25:07

Yeah, so some things have come and gone. I mean, emerging markets has always been in there, but but it's been in there. Sometimes it was broken out, so we had global developed markets and global emerging markets with with separate weights, and then we said, "Oh well, let's just take the MSCI, you know, Acwi, and that has dynamic weight, if you like, between the emerging markets and the and the and the developed markets. So, so it's always been in there, but it has been expressed differently. The other things that have been in there, so we've we've always had some New Zealand equity in there. Earlier on, we had a bigger when when the fund was smaller, we had a bigger proportion of New Zealand listed equities in the in the portfolio. That's that's now 5 per cent which is still pretty chunky for a portfolio of our size. We had some listed real estate in there for a while in the portfolio. So so still actually in our annual report, you'll see in some of the really longer term returns, you'll see a reference to to real estate in a reference portfolio calculation of performance. So that's because that was in there at at some point. So so we've stuck to the idea that it is a simple notional passive portfolio. So global equities, New Zealand equities and global fixed income, and then and then the decision on how much we hedge it. And so, the the decision since we since inception has been that we hedge the the whole portfolio 100 per cent back to New Zealand dollars, and that's a that's one that we always debate at a reference portfolio reset. Yeah,

Wouter Klijn 26:39

yeah, yeah. So, how close is the current portfolio to the reference portfolio?

Matt Whineray 26:44

Ah, it's quite it's quite different to the reference portfolio. So, there'd be 30 something percent liquids or unlisted assets in there, and various different strategies. So, yeah, a reasonable a reasonable difference from the reference portfolio. We have an active risk budget from the board of 4 per cent expressed as a tracking error at the whole fund level, and that's a reason. That's quite a bit of rope for us to sort of you know depart from the reference portfolio with the objective of beating the reference portfolio, and we have been able to do that through those various strategies, including including that strategic tilting one. So yeah, so there's a there's a reasonable difference from the from the reference portfolio, and really what the reference portfolio is doing is setting that long term risk appetite, and then giving management the the leeway to go and deliver that in a way using that active risk, which will which ought to beat that on a on a on a risk adjusted basis. So we're we're not while we're taking active risk, any position that we that we add to the portfolio, we're going to sell something that keeps the total risk constant. That's what the aim is.

Wouter Klijn 27:56

Yeah, and you mentioned you have a reasonable chunky allocation to domestic equities, New Zealand equities, and I believe you manage them in house. Is is that right? And what why was that decision made to bring that in house?

Matt Whineray 28:08

Yeah. So actually, we've just in the last few weeks we've just gone over 10 years of of doing that. So we haven't always managed them in house. Obviously, we had 10 years before we started doing that. But why do we do that? So at the moment, we we manage it in house, but we also have two external managers of New Zealand active equities. Interestingly enough, it's really the only place that we have active listed equity exposure is in relation to our New Zealand piece. We have in our global equities we we have mostly passive, but we also have some factor mandates run by external managers. But in the domestic one is where we actually have sort of stock pickers, if you like. Why do we do it? Well, from the outset, as I said, we were pretty well. We were entirely outsourced. We had a number of external New Zealand managers. We we set up the the internal New Zealand team because we need we're we're a significant presence in the New Zealand market and we needed to have a way of properly engaging with that market as opposed to just oh well we've appointed these three external managers and they're they're doing it for us so if someone came and said to us well what's your view on this stock we're like well we don't know because you know we're not managing it on an active basis, so we needed really to step up our engagement with the domestic market and make sure that we were properly participating in those capital markets. But also because we we we held the view and still do that there is a there is a positive expected alpha for the average New Zealand active manager, which maybe says more about the benchmark than it does about the managers, but you know, nevertheless, it's there. And so we we we thought that that was something that we could do in house, and and over time that has proved to be the case. So that team has has done you know really well over the 10 years it's been operating.

Wouter Klijn 30:00

Yeah, internalisation is a big point of discussion as well here in Australia, where we have a number of funds that have gone down that route. They mainly do it for sort of capacity reasons as well as cost savings. From your perspective, you say you wanted to have a say in the market, have a former view. Does that mean that this will be the only asset class that will be internalised, or are there plans to do that with other asset classes as well?

Matt Whineray 30:28

So yeah, so there are a few reasons. There was there was that that reason to be able to engage. It was never really a cost one for us, but we did. It is a space that we thought that we could get the capability internally, and that's one of the big challenges with, you know, internalisation. Is the assumption is that you will be able to get the people internally that you need to do it as as effectively as those external managers that you might otherwise use. This is a place where we thought we would be able to do that. Capacity is an important one though too, because we had seen some change in our external managers in New Zealand over time, and so we ran a little bit of a risk that if we if if we lost one of them or if they fell below a conviction threshold for us and we took the mandate back, that it would be hard to replace that. So so having an internal team was able to we're able to you know, have a bit of flex and and how we manage those external mandates in terms of that internalisation. Yeah. So what else do we do? We well we have a portfolio completion team that that runs an internal credit mandate called we call it the tactical credit opportunities mandate. So that does that does things which look to take advantage again of our endowments and also the strength of our balance sheet. So that's an internal that's an internal function. We have a direct investment team where we make direct investment in unlisted unlisted assets, both in New Zealand and internationally. So that's something that we do alongside either external managers or other other asset owners as partners, we we operate obviously the tilting team internally, but we don't. We're not. We're not wholesale looking to internalise a lot of things. We've always thought about you know why why would we do something versus have somebody else do it? Yes, cost is a factor, but it's not really the key driver for us. We've thought about it as: is it a critical risk function? Is there something that we need to manage? A risk that we need to manage. So that's why we created that portfolio completion team originally. That is to manage liquidity. So at the GFC, we we needed to know what liquidity we had and how much we needed. Well, that was all being done by individual managers externally, and we didn't have really a view of it because we had no market-facing team. So we created that. That's a that's a risk management function, but has turned into a into a value adding function, or it's a place where you can't get alignment, and alignment is really what has driven tilting to be an internal strategy. It's very hard to get alignment with an external manager on that type of strategy because of the the possibility that it is out of the money for extensive period of time, and and that causes you know agency issues with your your external agents.

Wouter Klijn 33:18

Yeah. Now another topic that comes up a lot these days is decarbonisation and climate change, and if we take a bit of a broader view, it comes down on the sustainable and sort of responsible investment. Now, I think New Zealand Super already implemented a responsible investment framework in 2006. That's, I think a time when people were still looking very differently at this space. Where did that focus come from?

Matt Whineray 33:48

So in our legislation, we've got we've got three bits to our mandate: maximise return without undue risk, use best practice portfolio management, and and do it operate while avoiding prejudice to New Zealand's reputation as a responsible member of the world community, and so the original hook, if you like, for our responsible investment framework back in 2006 was that third one of you know avoid prejudice to New Zealand's reputation. What's been interesting over time as the world has evolved and the investment world has evolved is that those first two maximise return without undue risk and best practice portfolio management have both become increasingly important parts of responsible investment. We did a we did a big piece of work a couple of years ago. We called we called our resetting the RI compass, resetting the responsible investment compass, and we looked at looked at practices around the world and said, "What is best practice portfolio management these days in relation to asset owners like ourselves? And and in fact, what we discovered there is best practice is absolute integration of responsible investment considerations and investment decision making over the long term. So, so and then if you think about that, Max. Return without undue risk. That undue risk language became the the key hook for our climate change investment strategy because we thought, you know, we're not getting paid for this, we're not compensated for that risk. It's therefore undue. So, so all of those bits have been important over at different times to how we've evolved that responsible investment framework from 2006, when we created that, and we were founding signatories of UNPRI to the RI Compass work, which has led to our sustainable finance strategy and our climate change investment strategy, which has led us down the decarbonisation route in terms of the broader portfolio.

Wouter Klijn 35:39

And I think New Zealand Super has also put itself in a as a guiding light for some of the regional funds in the Pacific, and I'm thinking especially on sort of that there was a programme where you you basically invited them to co-invest with New Zealand Super in in a private equity programme. Can you tell us a little bit about how New Zealand Super looks at that position, you know, trying to help out the the funds in the region.

Matt Whineray 36:07

Yeah, so that one is sort of from an asset owner perspective. There's no there's no downside to us to helping our our friends in the region, you know, lift their capability and understanding of particular issues or strategies, and so we've been involved in the Pacific Island Investment Forum for a while. The fund that you referred to around co-investment was a was a domestic one where we're we've entered into a co-investment relationship with a a private equity fund that we helped sponsor the establishment of, which is a number of different Māori tribes, so different iwi invest in that in that vehicle, and we have co-invested with that with that vehicle and domestic transactions. We've had great benefit from knowledge sharing with our you know our big peers around the world. I think of the you know the Canadian funds and the Swedish funds and the and the Singaporean funds, GIC and Tamasic, and and they've all been very generous in in helping us. And there's a there's a really nice dynamic there where asset owners will will assist others because it it doesn't hurt them, but it helps the overall system to to lift the general capability, and so we we feel that in relation to our domestic and also our our broader Pacific cousins, and and happy to help them too.

Wouter Klijn 37:30

Yeah, if we look a little bit into the future, I think New Zealand's super at some stage will go in a drawdown mode, and I think the government has had plans to start drawing down on the fund in 2035, around that time, and that will mean that the fund will probably reach its peak size in 2070. How do you sort of prepare for that change?

Matt Whineray 37:55

Yeah. So the the way our legislation works is it's got a it's got a formula in it, which was a you know hats off to the people that drafted that because it was a fantastic bit of drafting. Anyway, that formula is is the way that it gives effect to the legislation's desire to have us smooth out the long term cost of New Zealand national superannuation and Treasury Keeper model, they they maintain the model of that formula, and they publish that on their website, so anyone can go and have a look at it. You just type in you know New Zealand Superfund model, and you can open the Excel spreadsheet. You can change the assumptions. You can you know play around with it. If you're finding it hard to go to sleep, you can do that. It's but it is very interesting, and so that will change depending on what our returns have been, what the sort of forecast view of GDP growth is, what our long run returns are, that type of thing, or what contributions are. And so at the moment, what that model is saying, and that's updated once or twice a year by Treasury, is that in about 2035 we'll go from receiving contributions, contributions decline through till then, to start paying money back to the government to to smooth out that cost. Those those withdrawals, if you like, are relatively small to start with, and then by the time you get to about 2050, they're a bit chunkier. But the way the model works is that we will continue to grow in nominal terms. Our forecast expected returns are higher than the than the than both the tax leakage and the and the withdrawals. We will peak on the current modelling at a as a percentage of GDP about 2080, but we'll continue. We should continue to grow in nominal terms beyond that. So that that's where that very long horizon comes from. So what does that mean for us? It means that there will be some change. We will start to see some liquidity draw in about 12 years' time. It won't be big to start with. And so something that we need to think about there is we as we'll have. You know, we'll have three more iterations of of reference portfolio reviews before then to think about what does that do to us in terms of our view. We'll we'll have some some liquidity requirements. We'll have to produce liquidity each year, obviously, to to make those payments, and that may change our risk profile a little bit. So, don't know what that looks like at the moment. That's going to be something for the the team to work out over the next 12 years as we as we go through that. So we've got a a 2025 reference portfolio review, then another one in 2030, and then you know another one, and based on the current scheduling. Anyway, we do that roughly every five years.

Wouter Klijn 40:39

Yeah,

Matt Whineray 40:39

yeah, it'll be interesting to see how that that changes our our tolerance.

Wouter Klijn 40:43

Now, another part of sort of looking into the future is there's a lot of talk these days about artificial intelligence with ChatGPT, and I was interested to see that in the annual report that came out over last year, there's a paragraph in there that New Zealand Super has been experimenting with sort of an AI portfolio. Can you can you tell us a little bit about that, or is that still in early stages?

Matt Whineray 41:08

No, I can talk about that. So it's it's more of a sort of machine learning portfolio. So where we're what what that portfolio is, it's a New Zealand equities portfolio, and we've the one of the team has been has built a model to to effectively construct a portfolio of New Zealand equities that maximises factors that that we believe will be rewarded over you know subsequent periods, and then and then you know rerun that model on a regular basis and do the trades based on on what the model is telling us. It's pretty small at the moment, so we've just got a we've got I think the number at the moment is about 30 or $40 million allocated to that. But we are actually running the portfolio. It's a it's different from you know running a notional one where you're actually saying oh well what what what's the impact of transaction costs? What's the impact of market spreads? The actual impact of running this, and and and we're watching it as it goes, and we're learning from that as we go. So it's quite a it's quite a neat little project that quite a few people have been involved in internally, and it's giving us a an alternative, if you like, an alternative access point for the New Zealand market. So we've got obviously our internal active. We've got this small machine learning portfolio, and then we've got a couple of external. So we've got we've we've got different ways to access that that local market, and and also, but just to learn along the way. That's really what it's doing for

Wouter Klijn 42:37

Yeah. So do you think that will become over time a substantial part of the portfolio, or is it more an experiment still?

Matt Whineray 42:45

Oh, it's still an experiment at the moment. But I, but I expect if you know if you get some comfort around how how it operates, yes, that will be. I expect that probably even in some of the other work that we do around around our currency hedging or our completion of the portfolio using derivatives, we might we might see some some use of of AI techniques and those as well from an optimization perspective.

Wouter Klijn 43:11

Yeah, yeah. So the fund has had a good experience in the last 20 years. It's in a good position to tackle the next 20 years, but I believe that you're gonna leave the position at the end of the year to have somebody else take it over after nearly 15 years with the fund. What's in store for you?

Matt Whineray 43:32

Well, I'm planning to go to the beach at the end of the year and stay there for a while. That's my plan. I haven't. I haven't got anything. I'm not going to a role at the moment, so yeah, I'm really just looking forward to spending a bit of time on the beach and getting an opportunity to think about what might what might come next after after as you say, 15 years here and five years in the in the CEO role. But I'll be I'll be very interested in how the how the fund how the fund goes.

Wouter Klijn 43:59

Yeah, do you have any sort of favourite memories of that time?

Matt Whineray 44:04

Yeah, look, I well, I arrived in May 2008, and so the world at that point that was after Bear Stearns but before Lehman, and I was looking after private markets, and so that was a really interesting position to be in to watch the you know sort of observe the what was then the credit crunch turn into the GFC and the and the carnage that ensued. And being in the private markets was a little bit, you know, private markets just smoother as a result of you only measuring them once a year. So it was a little bit less of a of a crisis than what was going on in public. But that was a great opportunity for me to learn. And then, so so right out of the blocks, I got I got some pretty good lessons and and how to think about portfolio construction. We had a 10 year anniversary. We created a super fund ukulele orchestra that was pretty awesome. That was 2013, 2016. We hosted the inter. International Forum of Sovereign Wealth Funds here, and the most memorable bit about that is that the final dinner was was the night when the presidential election was being reported, and so that had quite a big impact on that dinner. In fact, almost everyone at at the International Forum of Sovereign Wealth Funds can remember that particular meeting in Auckland because of that of that moment, and then look, I think the the last few years have been interesting. That you know, early 2020, I had a radio interview where I was telling the the interviewer that we'd just gone from 48 billion to 35 billion, and as a result of that big drawdown in in fair March 2020, and actually actually the ability to say that without the sky completely falling in was a testament to the work that we've done about that sort of stakeholder management. I talked about right at the start, educating people why we took the risk and what could happen along the way. Since since then, obviously the market rebounded, which was which was great. We're up to 65 billion. We've got a about 200 people. When I started, we had 40, but there are still quite a few people from when I started who are still here, which is a which is a testament to what a great place to work here is. And then most recently, the fund got named best performing sovereign wealth fund in the world for For the last 10 years, so that was you know that was very exciting and a and a great recognition of the of the awesome work that the the people here do.

Wouter Klijn 46:30

Yeah, for sure. Yeah, I remember doing an interview a while ago with Bob Maynard, who was the CIO of a state pension fund in the U.S. the Idaho pension fund, and I asked him a question around, you know, which other funds do you look at? And he said at that time, "Ah, New Zealand Super, their returns are just magical. Yeah, I think it's a testament to the great work you guys have done. So congratulations again on 20 years, it was great having a bit of a historical view on it and the development. So, thank you very much for your time and all the best in whatever new role you might end up in.

Matt Whineray 47:12

Well, thank you very much. We've we've appreciated our relationship over the years with I three. You've had you've had a lot of contact with the team here, and been it's been a very helpful forum for us again to to share the knowledge because I think that is one of the one of the great things about about asset owners is this this willingness to share and I've been a great beneficiary of that and so you know long may that continue.

Wouter Klijn 47:39

Thank you very much.

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[i3] Insights is the official educational bulletin of the Investment Innovation Institute [i3]. It covers major trends and innovations in institutional investing, providing independent and thought-provoking content about pension funds, insurance companies and sovereign wealth funds across the globe. The [i3] podcast is available on iTunes, Google Podcast, Spotify, Amazon Music, Stitcher or your favourite podcast platform.

In episode 140 of the [i3] Podcast, Conversations with Institutional Investors, we speak with Charles Wu, Director of Investment, and Elie Saikaly, Head of Liability-driven and Government Investors at Frontier Advisors about the recently launched Independent CIO service, not to be confused with outsourced CIO services. We delve into the background of establishing the new service, the backing by State Super, the potential market size and why this services is needed now. Enjoy the show!

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Frontier Advisors: ICIO Podcast – Overview

[00:15] Introduction – Wouter Klijn frames the episode around Independent CIO (ICIO) services vs. outsourced CIO (OCIO), with guests Charles Wu (Director of Investment, Frontier Advisors, formerly State Super) and Elie Saikaly (Head of Liability-driven and Government Investors, Frontier Advisors).

[02:00–06:37] Origins of the deal – Charles explains that State Super's investment team joined Frontier in a "win-win-win" arrangement: State Super de-risks by handing over portfolio management while retaining continuity; Frontier gains institutional-grade implementation capability and people. He details why State Super's situation is complex – a 100+ year-old scheme in decumulation, with average actuarial cash outflows around 7 per cent annually, creating major liquidity forecasting demands.

[06:45–10:34] Frontier's motivation and custody issues – Elie discusses Frontier's 31-year history adapting to client needs, and why smaller asset owners struggle with key-person risk, operational risk, and custody access (partly due to the closure of NAB Custody Services), creating an opening for Frontier's expanded service.

[10:34–13:35] Defining ICIO vs OCIO – Charlie distinguishes ICIO by its independence and non-conflicted, tailored approach (no predefined product suite), contrasted with more standardized outsourced models. Governance benefits like stock lending and balance sheet management are passed to clients.

[13:35–16:43] Service integration and structure – Elie describes the combined offering (strategy through implementation) and lessons learned from merging Charlie's tactical asset allocation process with Frontier's advisory teams. They discuss the managed discretionary account structure and the governance partnership with Ironbark, including an investment management committee.

[17:19–20:09] Target market – Referencing KPMG research showing a fragmented market (no player over ~10 per cent share), Elie outlines target clients: insurers, universities, charities, endowments, small-to-medium super funds, and family offices – emphasizing deeper transparency on reporting and costs as a differentiator.

[20:09–22:45] Japan expansion – Charlie discusses a recent trip to Japan, Frontier's local office (established ~4 years ago) and partnership with Mitsubishi UFJ Asset Management and interest in partnership models rather than full portfolio outsourcing. Expansion plans remain APAC-focused rather than global.

[22:45–24:35] Current status – State Super is confirmed as the first client, with regulatory steps nearly complete and significant inbound interest from prospects citing key-person risk, operational risk, and performance/custody concerns.

[24:35–27:26] Scope of services – Charlie explains services extend beyond portfolio construction to strategic guidance (e.g., specialist help building hedge fund or real estate platforms), tailored case-by-case to each client's governance maturity.

[27:26–28:11] AI capabilities – Charlie confirms new clients can request an AI roadmap/governance framework, drawing on State Super's earlier AI work.

[28:11–29:23] Sydney office – Charlie discusses the new Sydney office (with room to grow) supporting Sydney-based clients, plus light banter about Melbourne/Sydney rivalry.

[29:23–31:17] Next steps – Elie outlines finalizing regulatory approval, change management efforts (a December immersion day, training sessions, governance/risk work groups) ahead of official launch.

[31:17–33:25] Insurance sector potential – Elie notes insurers are a strong candidate client base, particularly those without the resources or desire to fully in-source investment management risk.

[33:25–35:00] Addressing suboptimal portfolios – Charlie acknowledges it's a widespread issue that off-the-shelf products don't suit varying risk appetites, and notes Frontier is investing in internal technology to balance scalability with tailored service.

Full Transcript of Episode 140:

Wouter Klijn 00:15

Welcome to the [i3] Podcast. Today, we're going to talk about Independent CIO services as opposed to the outsourced CIO services, and we'll go into this distinction later. But I'm here today with Charlie Wu, who is the Director of Investment for Frontier Advisors. So Charlie leads the former State Super investment team that joined Frontier Advisors at the end of last year, and established the ICIO office. We also have Elie Saikaly, who is Head of Liability-driven and Government Investors at Frontier Advisors. Charlie, Elie, welcome to the show.

Charles Wu 01:57

Happy to be here.

Elie Saikaly 01:58

Great to be here.

Wouter Klijn 02:00

Excellent. So, Charlie, maybe we start with you. From what I understand, the conversation about this started a few years ago, and and we're partly tied to sort of you know projections about the future of State Super. State Super is in runoff. Obviously, over time, this this will pose some issues. Can you walk us a little bit through why State Super was interested in this partnership?

Charles Wu 02:24

Yeah, sure. Well, maybe let me put that in a bit of the context. I think if you look at State Super, it is not unusual. State Super actually has a really long history of coming up with innovative structure. So all the way back in the 1980s 1990s we're talking about Stay Super being one of the in in house investors. The funds manager like DB Reeve and Axiom is all coming out from State Super. So this is, I guess, the most recent iterations of the the innovation that has been in STC's portfolios for a very long time. And just to again set that context correct, so the way to look at this is State Super effectively has exchanged the investment team and I to Frontier or an equity stake. Subsequently, hire Frontier to manage Stay Super's DC portfolio, and this is really a rare win-win-win situation. And what I mean by that is, in many ways, State Super wins by de-risking the portfolio management activity by appointing Frontier, and you get that continuity of services. Frontier wins because this acquisition brings on board an institutional grade implementation and operational capability, and the people for the people that's involved is actually really the core component that the discussion that we're talking about. We win because we get we now get to expose either in my term horizontally, like the breadth, such as like me being exposed to different client segments, or vertically going all the way from the formulation of investment strategy down to the implementation, and those are all group potential. So the outcome of this is, like you said, ICIO offers that provides a non-conflicted service offering. There's a strong synergy between the two different investment teams, which we're in the part of bringing them together and the growth potential for everybody.

Wouter Klijn 04:25

So, at the announcement of this transaction, I spoke with John Livanas, the CEO of State Super, and he told me a little bit about the importance of sort of retaining access to adequate resources from an investment perspective, and he partly related this back to the fact that State Super is in runoff, but it has quite a complex sort of structure in place that you know you can't just have like one or two guys looking after it and take care of it until it's completely run off. Why is that? What what's sort of the complication there?

Charles Wu 04:59

Yeah. So for most people that don't know, State Super, State Super is one of the oldest schemes in New South Wales state government. I think the inception. I still use the word "we" every now and then. Like you know, the inception for State Super is back in the early 1900s and so it's more than 100 years old. The scheme was closed in the later end of the 1990s, and so what that created is a very aged member demographics. It has a very complex scheme dynamic. We're talking about various conditions, including reverse due spouse and so on and so forth. But the key thing from an investment perspective is it created a portfolio that is the in decumulation mode, and I'm not just talking about you know one or 2 per cent that you that that's in line with the the state the spending policy of an endowment. We're talking about on average, it's a 7 per cent actuarial projected cash outflow every year, and depends on where you draw that line because, like I said, we have age member demographics, so depends on where you draw that line. That instantaneous liquidity shock can be quite high, and so it's not a simple. By no, I mean it's not a simple investment, but in this particular case, because it is unique, we have to pay a lot more attention in terms of ensuring that the liquidity there, like we we do forecasts not just the member in our flow, so to speak. We're also talking about how do we ensure that we have enough liquidity to pay the member benefit payments. We have sufficient liquidity to meet the investment drawdown, so on and so forth. And all of those isn't as straightforward.

Wouter Klijn 06:37

Yeah, yeah, for sure. So Elie, State Super obviously had some incentive to look at this deal. What's in it for Frontier?

Elie Saikaly 06:45

Yeah, great question, Wouter. So, Frontier and State Super have known each other for a very long time. There's a lot of comfort between the two organisations, so that's important to to bear in mind here. Also, as our clients have evolved, our services have evolved with them, and in Frontier's 30-one year history, we'd like to think we've adapted to the changing needs of that client base. And as you'll also know, our clients range from large, complex super funds all the way through to much smaller asset owners such as charities and foundations. And over the course of that journey, Frontier has wanted to be alongside those asset owners who are looking for services outside of just advice, and in an environment where it is becoming more challenging to invest portfolios, and the burden of investing those portfolios from a compliance and regulatory point of view is ever increasing. Frontier understands better than most that those those demands on those organisations is is becoming a challenge for them, and that if Frontier can step in and provide additional services over and above advice, then we remain a very relevant partner for those organisations, and I'll give you some examples which are relevant to us today, and also based on market feedback, we we understand that key person risk is a challenge for a number of smaller asset owners that are struggling with retaining an investment team. That is particularly relevant outside of the large capital cities like Melbourne and Sydney.

Wouter Klijn 08:25

Yeah,

Elie Saikaly 08:26

the operational risk burden is also one that is challenging for organisations, and that sits alongside the custody challenge, where smaller asset owners are struggling to retain custody, and we observe these trends in the industry. And Frontier wants to be a consultant that sits alongside our clients and helps them solve those challenges. Yeah. So all in all, there's a there's a range of events that have taken place in the industry in Australia, where Frontier feels like it can provide a solution, and bringing the best of what we do today in the advice space, and what Charlie and his team does today in the portfolio management implementation space, gives us an interesting proposition for the industry.

Wouter Klijn 09:20

So you briefly mentioned there custody as well, and from what I understand is that it was important to get support from a large custodian to sort of get this deal offline. Why is that so important? Do they just not want to deal with the smaller clients anymore?

Elie Saikaly 09:36

The challenge that that we observe, Wouter, is that smaller asset owners, and particularly outside the superannuation space, don't offer those larger global custodians scale, and also are going to struggle offering those services at a reasonable price, given the sizes of those portfolios, and. This is not just an Australian phenomenon; it's one that's also happening globally, but one that really was seeded by the closure of NCS (NAB Custody Services) a number of years ago, and that had a cascading effect on the rest of the industry. And as some of the global firms are looking for much larger minimum sizes, it does leave a gap in the market for asset owners who want to retain an advisor on an independent basis, but also are struggling with the back end of their investment programs.

Wouter Klijn 10:34

We got a little bit ahead of ourselves, but you know, I opened up this podcast with the comment that independent CIO is not the same as outsourced CIO services. Can you tell me a little bit about you know the difference and why it's important to make that distinction? Yeah, maybe Charlie, maybe you can give that a go. Do we need another acronym in the industry?

Charles Wu 10:55

We're always short of acronyms, right?

Wouter Klijn 10:56

Exactly.

Charles Wu 10:57

Yeah, like this. This topic is actually really interesting because before this, I'm probably quite oblivious in terms of the different operating model that they are to provide such a service, and we've just done a trip, really leveraging our connections to assess the different operating model across different outsourced CIO service provider. So let me touch on that, and then we'll come back to the ICIL, and it's not just a play on words. There are there really many different models that we're talking about, and they really range from your standardise everything for all the way to the other end of the spectrum that would be spoke everything. And this shouldn't be a surprise, but you really should look at all these operating model from the lens of organisational strength, the governance strength, the investment sophistication, and so on and so forth. And so this is how we look at that operating model and pick what is right for Frontier. Now to bring it back to what Frontier has decided to offer to our clients is the whole independence, and that's the I in the ICIL. We're not just talking about our source. We're not talking about you giving us the whole lots of the portfolio. We're talking about independent, unconflicted. We don't we we don't have a predefined product to put you into our product suite. We provide tailor-made solution flexibility and that tail to clients, and that's quite important. And Elie, by all means, jump in as you see fit. And this is important because as we see the increasing, I guess, requirements from regulatories and not regulatory, but client preferences such as responsible investment need. We see all those things are just if you provide a predefined product structure, it's just not going to be enough. And in addition to that, we're also talking about governance, governance and organisational strength. So we also bring on board the strength of so for example managing the balance sheet, stake lending. We do believe that those benefits are the one that we should pass on to the clients and not retain within us. And so that again is where the term independent independence come in.

Elie Saikaly 13:12

Yeah, yeah, that's right. And in addition to that, it's clear from the clients that we talk to and other asset owners in the industry that the the independence angle is critical for them, and in some cases, they feel they don't have a choice in the in the offering that's out there in the market today. And Frontier is determined to remain the leading independent advisor.

Wouter Klijn 13:35

So, can you tell me a little bit, Elie, about where they sit within the existing services? Because I remember I spoke to Andrew Paulson a while ago and he said we used to have like 60 odd deals that we were looking at and we couldn't really implement it because that was not really part of our service offering and now with this ICIO office we should be able to do that.

Elie Saikaly 13:57

Yeah, absolutely. The reality here is that the team that comes across to Frontier is complementary to what we do today, and so that allows us to provide the full set of services within an investment program that asset owners may require, and that starts with policy and investment strategy advice all the way through to portfolio construction, it might be DAA or TAA manager selection, and then operational efficiency and excellence to really drive better outcomes for those portfolios. So even the coming together of two teams has taught us a lot.

Wouter Klijn 14:40

Can you give an example of one of those lessons?

Elie Saikaly 14:43

Yeah, absolutely. So, for example, Charlie's team runs a process around asset allocation that might be more tactical than what some of our clients might be used to, and that informs us. The consulting teams of the opportunities that potentially lie in front of us in terms of providing advice from a strategic perspective, a dynamic perspective, and also a more tactical perspective. So there's a lot of work that's commenced and also continues to determine how best we can bring all these capabilities together, and most importantly, what are the needs of asset owners going forward? What would they expect from an organisation like Frontier, and what adds true value at the end of the day? And that's that's really important to us, and that's a process we're still going through as we speak,

Wouter Klijn 15:41

yeah, and I think as part of the setup, you have explored sort of the model of the managed discretionary account structure. I believe there's a partnership with Ironbark as a management around that. Why have you chosen that structure?

Elie Saikaly 15:54

Well, that structure, Wouter, gives us the flexibility to tailor portfolios for clients. It gives us the framework and infrastructure to implement the advice that we provide those clients, and working with a partner like Ironbart gives us great breadth. It gives us again complementary skill sets, but in essence oversees the delivery of the service and aims to ensure that what clients receive from us and the outcomes clients expect is exactly what they they have signed up for. And I embark so far have been a great partner, and they've supported our our ICIO capability so far. And we look forward to how that partnership grows in the future,

Charles Wu 16:43

And to this last point on the partners Ironbark being the partner, just to be very clear, like you know, take a more tangible example, like on the governance structures, we set up this investment management committee which oversees the portfolio activities, and Ironbark representative will be sitting on that committee to give that additional governance support, and they also holding us account very accountable to the investment due diligence and operational due diligence as we do something. And all of those should be taken as a strengthening of the governance requirement in order to provide this this service offering.

Wouter Klijn 17:19

Yeah. So let's talk a little bit about the potential market. I understand that Frontier has done some work with KPGM on on what potential the market is for independent CIO services. I think one of the learnings from that exercise was it's a very fragmented market. There's no single player with more than sort of 10 per cent of of that market, can you describe a little bit in who you see as the key sort of client for for this service? Is it family offices? Is it private wealth? Charities? Who are you targeting?

Elie Saikaly 17:56

As it stands today, the the market is fragmented. You are correct. There is also wide scope for opportunity, not just in Australia, but also in New Zealand, in the Pacific, and as we expand our reach into the region and utilise our presence in Japan, we would expect that those conversations will also take place outside of the domestic market, but in essence, the the clients who have shown the most interest in this service are those that are looking for an organisation like Frontier to manage their investment programme, and they could be insurers, they could be universities, charities, endowments, they could be small to medium super funds, all the way through to private wealth and family offices. The types of asset owners you would expect that would use a consultant's capability. However, the reality here is that given that those asset owners still need to retain responsibility for investment policy and strategy, that those asset owners that we would look to service and would be comfortable with a partner like Frontier taking care of manager selection, portfolio construction, rebalancing portfolios, helping them around activities such as proxy voting, building mandates to account for RI exclusions, for example, and that's the focus for us: is what are the activities and needs of those asset owners, regardless of who they are, and whether Frontier can provide the support that those asset owners expect. And one of the key points of difference for us here is that we are offering a much deeper level of transparency than the industry is used to, and that's very much around reporting. It's very much around costs, and it's very much around what's in the portfolio driving returns, driving risk to those assets. Have a reasonable amount, if if not a sufficient amount of comfort around the activities in those investment programmes.

Wouter Klijn 20:09

Charlie, I just mentioned Japan. I think you've been reasonably on a trip to Japan. Did you go there for the for these services, or did you go for investment research?

Charles Wu 20:20

Well, well, how did you know that?

Wouter Klijn 20:22

I'm well informed.

Charles Wu 20:25

I was definitely there to to see some prospects, and I guess Japan is one of those. If you speak to any funds management business person, they'll tell you that Japan is a market that will take easily four or five years to crack, and I think we so Frontier established established a Japan office about four years ago, and and we're definitely working closely with our strategic partner, Mitsubishi UFJ Asset Management. We're growing the revenue there steady and stable, and we're seeing a bit of the crack. And so this trip in many ways is to bring the ICIO capability to to the prospect to see if they're interested, and and and ICIO is one of those very interesting, I guess, service in the sense that we're not talking about just coming in to do the whole lots of the portfolio. Like after dealing with some of the prospects in Japan, we also find that sometimes they just want us to come in and manage a sleeve of the portfolio, and that's easily something that the team can do. So yeah, no, we're seeing opportunity there.

Wouter Klijn 21:33

So a sleeve of the portfolio is that sort of like the Texas Teachers' model, like the partnership model.

Charles Wu 21:38

It is a partnership model, and normally, as you can probably imagine, that in Japan, a lot some of the clients I can't say a lot of clients, some of the clients, some of the prospect, they like our research in the real asset segment, for example. And so the natural question there is, well, I can manage my own bonds and equities portfolios, but you have a lot more experience in real asset,

Wouter Klijn 22:01

so Japan is a natural second sort of market. Is it the intention to make this sort of a global service? Are you looking at other countries?

Charles Wu 22:11

At this stage? No, primarily is still in Japan, Japan and domestic domestically in Australia. Now I can say in due course that's probably more an APAC initiative rather than a global initiative. At the end of the day, there's a very very well developed US markets and very well developed European markets already. Yeah, this initiative was announced last year. I think there were some regulatory hoops to jump through before you sort of could open for business, how's it going? Do you have any clients?

Elie Saikaly 22:45

Absolutely, our first client is State Super New South Wales, and and so the focus the focus at the moment is completing the project and making sure we jump those hurdles, and that's imminent. And then it is about ensuring that those existing clients and prospective clients understand the offering. So we have had significant amount of inbound interest in this service, particularly around solving the challenges that I mentioned around key person risk, operational risk, performance reporting, custody. They are the the real drivers of concern for asset owners interested in a service like this, and we cannot underestimate the challenges around performance in today's market, particularly given the outcomes of active management, in particular asset classes, the desire for asset owners to look into private markets as well and access opportunities offshore. So there's some significant drivers ensuring that asset owners are revisiting their current arrangements, and that Frontier has benefited from those inbound queries. And we we would expect to be in a very good position to bring on additional clients in the imminent future, and that's going to have cascading effects on not only State Super but our whole business in terms of building scale, making sure that our clients benefit from that scale, but but also giving our staff different career paths, making our work more interesting, and also connecting us much closer to the end portfolio or the end client. And I think there's real value in that type of work. And we look forward to the next steps of of this service.

Wouter Klijn 24:35

And will the services focus predominantly on sort of the portfolio construction piece, asset allocation piece, or are you also looking at more strategic type of questions like, should an organisation do TPA, or maybe these organisations are too small for it, but it's a lively debate. Charlie, do you have any views on that?

Charles Wu 24:56

Yeah, yeah. I was thinking where TPA is going. Come up in this conversation. No, no. We can talk about TPA in a in a slightly separate context. But in this particular case, I think it has a lot more to do with what we can offer. And if you look at this in from a business perspective, we're talking about a slightly smaller asset owners and in a challenging environment, not just regulatory, but also the market dynamic that is going. So naturally, you cannot you can see that, for example, if an organisation that wants to establish hedge fund platforms, hedge fund portfolios, or real estate portfolio, the specialist services that need in order to build out that portfolio is quite meaningful, and not everybody has the the budget to develop their internal team, let alone talking about data modelling, so on and so forth. And so those are things where we stepped in in terms of helping them to develop their services. And for some, that is of different path maturity of the organisational maturity, we also we can also be there to help them to guide them through the setting of the policy. If if they want to grow the internal team, then we're there to help them to grow that internal team. They all those are all on the table for people to consider. And I think as as we kind of heading into a more complex environment, every organisation. every smaller SEO owner has the right to to get that type of services, and that's why we're here to to develop. In terms of more just portfolio construction, now I do think we we offer a lot more than just portfolio construction because at the end of the day, and from my perspective, while there is an end-to-end investment process, and we can range from let's call that the SAA down to put the dollars on on the on the road, so to speak, every organisational has a different organisational strength, has a very different governance setup, and some are better and well positioned to play all parts of them. Some are less so. So it's not as straightforward to say, "Yep, let's just go do a TPA or go do a SAI or let's focus on manager selections. It all it's it's all quite independent case by case, in my opinion, and that's something that we can bring as a holistic assessment of that process, and then we focus on the where we can have value.

Wouter Klijn 27:26

So, Charlie, we we've spoken in the past a little bit about artificial intelligence, and you've done quite a bit with that at State Super. Are you bringing some of those learnings now to new clients coming on board? Can they ask for a AI roadmap for their organisation.

Charles Wu 27:43

Ah, they definitely can. They can ask AI roadmap. They can ask AI governance. But what are they like? We started this conversation eight years ago, and back then no one was doing AI or machine learning. Nowadays, if you don't do, if you don't use AI, you're falling behind. So I think the world is in a slightly different place, as you you will know that we're always open to compare nodes and helping people. We're definitely bringing our capability to frontier and assist the clients.

Wouter Klijn 28:11

Yeah, yeah, Charlie, you didn't have to go all the way to Melbourne to to make this work. There's now a Sydney office. What are the plans for that office? And I don't know if you can answer this as well. I understand there's a few spare seats as well, so you can have some growth there in the office.

Charles Wu 28:27

Yeah, yeah. Well, let's start with the senior office. We definitely have few spare seats, and we will grow the the senior office, senior presence. Sydney is really important for for us for Frontier in many ways, we do have many clients that is Sydney based, and so instead of flying everybody from Melbourne to Sydney, which we still do, but now that they have a permanent location, where say Ela, when he comes to Sydney, there's an open arm, a nice cup of tea, you know, being made ready for him to to step in, and he has an office to work on, so all that is good. Now that being said, we still like to maintain like a you know let's let's call that friendly rivalry between our Sydney and Melbourne office.

Elie Saikaly 29:10

I mean, the reality is, Charlie, that that AFL is the permanent football code, so there's probably no argument there. And I'll let you have the benefit of better weather as well, being in Sydney.

Charles Wu 29:21

No comment on that one.

Wouter Klijn 29:23

Fair enough. So, what's what's ahead in the next couple of months? What's on your agenda? Do you need to, you know, are you developing more portfolios that you prepare for future clients, or what's going on?

Elie Saikaly 29:36

We are essentially finalising the regulatory process, and we are not far away from official launch, which which we're really excited about. In the meantime, we are ensuring that we continue with our change management programme, making sure our whole team, our whole business, is on the journey with us and understands how this service fits in with. What Frontier has historically provided to clients, and we've held a number of company-wide initiatives and activities to make that happen. So in December we held an immersion day where everyone joined us in the Melbourne office, and there was a lot of rivalry between Melbourne and Sydney. But at the end of the day, we all came together, and and it was it was a very it was a very energising event for the whole organisation, and we've conducted a number of training sessions across the business around education, and and under and and getting together a real understanding of what this service means and how we deliver that service into the future, as well as a number of work groups which have sought to make some important strategic decisions around our governance framework, as Charlie mentioned earlier, our risk framework, ensuring that our service remains independent. We offer the transparency that asset owners are looking for as well. So there's there's a lot to be done, and and we've made a lot of progress so far. But we are really looking forward to to the official launch of this service for client two and beyond.

Wouter Klijn 31:17

Yeah. Now, Elie, you've built up quite a practice amongst the insurance companies for for Frontier and your title. Are they also potential clients for this service? Is that suitable for an insurance environment?

Elie Saikaly 31:34

Absolutely, it is. There are a number of insurers who have internal teams with fantastic capability and have a long history of adding value for shareholders and policyholders. I'd imagine those insurers will continue to do that internally, and run their own investment programmes. But there is a significant number of insurers who are looking for support around managing an investment programme, and really that comes down to the fact that an insurance company, just like a university and just like other asset owners, have a core business to run. And typically, managing the investment portfolio is not part of their core business. It could be a secondary or tertiary activity, and they may not want to in-source some of the risks that we spoke about earlier. It could be operational risk, could be key personal risk, and so Frontier is in a good position to provide those services. And it's experience working with the boards of insurance companies and its stakeholders that gives it an understanding of the the solutions that they are looking for and the problems that we have identified or the challenges that we have identified that are all part of this service and and essentially a part of our value proposition.

Wouter Klijn 32:59

I think when I was speaking to Andrew last year. He sort of indicated that he's seen some smaller clients, not frontier clients, but people out in the market with portfolios that use off-the-shelf products, where he thought, well, these portfolios are not as well run as they could be. Is that sort of a widespread problem, or how do you think about that? Because that's a potential client base, I suppose.

Charles Wu 33:25

Yeah, sure. It is a widespread problem, and when we're looking at the portfolio, and this comes back to well, again, how do we how do we ensure that we do the right thing by the clients and by providing that flexibility? So again, you can probably get the sense from the way I talk. I come back to a lot about the organisational risk appetites. Like they all have different things. This this is this is not standardised. While this may not be their day job, but I'm pretty sure that they have different type of risk appetite for different company, be insurance or charities. They have they in different parts of their potentially their journey as as they establish their different sophistication, different level of commitments. Then all of those triggers one way or the other about how you can manage that portfolio for more, I guess, sophisticated, higher risk appetite clients, the ability to withhold drawdown is would be a lot larger than you know someone that just started this journey, and so by just applying the same type of portfolio to every single client in that, it just doesn't make a lot of sense to me. Now I'm I'm not going to shy away from saying that. Yes, we do need to address the the problem between scalability and efficiencies, and I'm very aware of that. And that's why we're spending a lot of time to develop internal technology to enable how we can approach this problem in a more, I guess, disciplined and consistent manner.

Wouter Klijn 35:00

Fair enough. All right, excellent. Well, thank you very much for that. Thanks, Charlie, and thanks, Elie, for this conversation and for making the time.

Charles Wu 35:08

Thank you. Appreciate that.

Elie Saikaly 35:09

My pleasure.

In this episode of the [i3] Podcast, Conversations with Institutional Investors, we speak with Steve Meier, who is the Vice Chairman of Neuberger's Institutional Client Group. Before joining Neuberger, Steve was the Chief Investment Officer for the New York City Retirement Systems, the third largest public pension plan in the US, consisting of five different plans. There, he implemented the total portfolio approach (TPA). Steve recently published a paper about the lessons he learned from implementing TPA at the fund, titled 'Case Study: Implementing Total Portfolio Thinking at NYC Retirement Systems', which we will explore in this conversation.

Follow the Investment Innovation Institute [i3] on Linkedin Subscribe to our Newsletter Explore our library of insights from leading institutional investors at [i3] Insights

Overview of podcast with Steve Meier of Neuberger

03:00 I knew we were heading in the direction of TPA but I didn't want to freak people out with a certain nomenclature

06:00 I think an SAA is compatible with a total portfolio approach

07:00 There has been a lot of work done by CalPERS CEO Marcie Frost to get support from the board for TPA

09:00 My experience is that an SAA is more granular than a reference portfolio

17:30 We hired external managers that could be tactical on our behalf. With a US$300bn portfolio it is hard to be tactical at scale

21:00 We didn't have an incentive compensation pool at NYC, so that wasn't one of the levers that I could pull

25:30 We had five plans that each had their own consultant. The firefighter plan had a funding ratio of only in the 80s, and that was largely because of 9/11. We lost 346 firefighters that day.

28:00 At the heart of TPA, there is an element of being very factor aware

31:30 We put together the BAM university so trustees could learn about how we made better decisions and we had a thought leader speaker series where I interviewed senior figures in the industry, including voting members of the Fed.

43:00 The case of Irene Triplett, the last remaining survivor of a Civil War pension plan. That is 155 years later and the plan is still paying out a benefit. We are long-term investors.

46:30 I do believe we are seeing a convergence of public and private markets

Full Transcription of Episode 139

Wouter Klijn (00:00): Welcome to the i3 podcast. I'm here today with Steve Meier, who is the Vice Chairman of Neuberger's Institutional Client Group, and who was previously the Chief Investment Officer for the New York City Retirement Systems, the third largest public pension plan in the US, consisting of five different plans. Today we're going to talk about the Total Portfolio Approach (TPA), and in particular, the NYC Retirement Systems' version of it. Steve recently wrote a paper titled "Case Study: Implementing Total Portfolio Thinking at NYC Retirement Systems." So, let's talk about that. Welcome to the show, Steve.

Steve Meier (00:42): Great, Wouter. Thank you for having me. It's a pleasure to be here.

Wouter Klijn (00:45): So, when you were at NYC Retirement Systems, you didn't quite call it TPA—that seems to be a bit of a later name or interpretation. Can you tell me a little bit about your thinking around this system and how you referred to it?

Steve Meier (01:01): Sure, absolutely. When I first joined the New York City Retirement Systems—and just to be clear, there are five separate and unique investment plans with five boards of trustees totalling 68 trustees, five separate investment policy statements, five separate general consultants, and a matrix of nine specialty consultants. There's a level of complexity just in terms of the organisational structure around managing the public pension plans for the city of New York. We had about 800,000 beneficiaries and participants, so it was a real honour to actually work in and lead that organisation for a little under four years.

When I first joined, my first observation was that there was not an appropriate amount of collaboration across the teams. I tried to implement more of a non-siloed mindset to get people to work together, integrate the teams, and flatten the organisational structure. I wanted to give everyone a voice and open up the investment committee. Prior to my joining, the only participants in the investment committee discussions were the asset class heads. I opened it up to the entire 130-person organisation to really get more brains in the game and use it as a developmental tool. I did a number of things organisationally to force the integration of the teams, get the very best out of our tremendous individual talent, and challenge people to think more holistically about the portfolios and exposures. I wanted them to think: if they were the CIO, how would they want to see the portfolios positioned and presented? More importantly, for each incremental investment we put into the portfolio, how would that impact our overall exposure?

Wouter Klijn (02:56): Yeah, so in hindsight, when did you start to realise that this is pretty similar to what is now called the Total Portfolio Approach?

Steve Meier (03:04): Well, I suspect that all along we were moving on that path. I didn't want to freak people out by giving it a certain nomenclature or name. For us, it was really a journey and evolution of our thinking and capabilities. What I truly focused on when I first joined is the Japanese concept of Kaizen, which means a focus on continuous improvement with the ultimate goal being excellence—which you never really reach. But as fiduciaries, I tried to challenge my teammates into thinking we have an affirmative obligation to eke out every last quarter of a basis point in terms of performance. At every turn, there's a way we can improve how we interact, how we think, how we behave, and ultimately how we invest. Listen, the markets are dynamic, things are constantly evolving, and technologies change. We're certainly in the midst of reincorporating a revolutionary, transformational technology into our thinking and practices, but it was really a recognition that we could always do better as a starting point.

Wouter Klijn (04:11): Now, I think your case study is quite interesting because there are a lot of similarities with Australian pension funds here. They have different investment options that they more or less have to stay true to, so a lot of funds here can't get rid of a Strategic Asset Allocation (SAA). Getting rid of the SAA is a model implemented by sovereign wealth funds that embrace TPA, but you can't really do that in a pension plan. I think you had a similar situation where you still had to have an SAA. Can you tell me a little bit about your thinking around that, and how you went about implementing TPA with an SAA still in place?

Steve Meier (04:56): Yeah, absolutely. As an American, I'm a bit embarrassed to admit that America seems to think they come up with all the good ideas, but the Total Portfolio Approach—or total portfolio thinking—has been around for decades and has been widely and successfully adopted abroad. For the US, it's more along the lines of an evolution and an awareness that there's a better way to do things. As I said, part of it is artificial intelligence supporting more analytical rigour and quantitative tools. I think about framing decisions analytically versus using an inherited narrative. First principles thinking asks: what can we know that's objectively true about the portfolio? What can we state as a fact, and how can we use that as a building block for constructing and managing portfolios differently?

Wouter Klijn (05:54): And in your experience, looking at implementing that in an SAA environment, are there any lessons learned or quick wins that you can share?

Steve Meier (06:04): To answer your question more directly, I actually believe that a Strategic Asset Allocation can be, and is, compatible with the Total Portfolio Approach. There's a full spectrum and a bunch of different flavours of TPA that any institutional investor can implement. What's really interesting right now in the United States is the largest public pension plan, CalPERS—which is about a $640 billion plan. They've moved down a path where they are adopting, I believe at the beginning of July, a more full-blown, pure form of TPA. They have a very talented Chief Investment Officer named Steve Gilmore, who has been successful in implementing TPA at the New Zealand Sovereign Wealth Fund and, before that, the Australian Future Fund. There's also been a lot of work done behind the scenes by their Executive Director, Marcie Frost, to win the trust of the boards, secure a high degree of delegated authority, and ensure the right infrastructure is in place to bring in good talent and incentivise them to perform. A lot of eyes are on that, because not only is CalPERS the largest public pension plan in the US, but it also has a great history of being innovative. A lot of folks, myself included, are watching CalPERS implement that pure form of TPA, and to be honest, I'm rooting for them. I believe TPA is the best operating model for institutional investors today for many reasons. Because it's happening in a very visible way with the largest public pension fund in the States, many are watching to see if they're successful and if it can be replicated in different degrees by other US institutional investors.

Wouter Klijn (08:12): That's an interesting example, because Stephen Gilmore has been in organisations that have all embraced TPA over the last couple of years. I think one element of the version of TPA he's bringing to CalPERS is that they are looking at a reference portfolio, and we just had a discussion about SAA. The reference portfolio is a big part of the New Zealand Super model. What is your thinking around that? Can you still do TPA without having a reference portfolio in place? That reference portfolio is sort of your base case; it illustrates what you should achieve if you had no skill or talent whatsoever, and challenges you to do better. That's a fundamental approach to investing, so what are your thoughts?

Steve Meier (09:04): Wouter, my experience is that Strategic Asset Allocation tends to be more granular. For example, you look at your equity beta exposure, private equity, public equity, and your allocation to large-cap, mid-cap, and small-cap in US developed markets, ex-US markets, and emerging markets. Conversely, a reference portfolio in a pure form of TPA might just be a 75/25 split: 75% exposure to equity and 25% to fixed income. From there, you look at underlying factors like duration, liquidity, and equity beta exposure, and you get very granular in how you view the portfolio.

I believe that an SAA is a good starting point. It's something our trustees understand significantly, and it's something we're used to working on with our outside general consultants. It's easy to understand, but it does have deficiencies. The capital market assumptions that go into SAA decisions are typically backward-looking. If you look back 25 years, it takes you back to the dot-com bubble blow-up, the Global Financial Crisis, the European sovereign debt crisis, and the COVID situation. One thing we know with certainty is that the next 25 years are going to be very different than the last 25 years. We also know that SAA tends to be very static in a world that is very dynamic. So, I recognise there are pros and cons associated with SAA. It acts as an anchor and a starting point for decision-making, but hopefully not a constraint when it comes to smartly positioning the portfolio to take advantage of shifting risk and return dynamics.

Wouter Klijn (11:13): So what do you see as the key benefits of TPA? You mentioned earlier that there are some really distinctive benefits. What are they?

Steve Meier (11:22): Thinking holistically, I'll give you a couple of examples. When we started analysing New York City's portfolio at a very detailed and granular level, we discovered that out of our private real estate portfolio, we had a 12% exposure to real estate debt. Our infrastructure equity portfolio had a 5% exposure to debt. Take infrastructure, for example—one of my favourite asset classes. It's no longer just toll roads, airports, and utilities; it has evolved into data centres, fibre networks, cell towers, battery storage, and renewable power. That asset class has expanded to include elements of real estate and growth equity. It has long-duration assets similar to bonds and offers inflation protection dynamics. The factors and exposures infrastructure brings are very blurred now compared to what they used to be, and I think that will continue as the market evolves.

This also recognises the convergence between private and public assets. We're seeing that to a great degree in the US, particularly in fixed income, where managing public and private mandates together makes a lot of sense. I travelled to California last week to meet with some wonderful clients, and two of those large institutions have actually integrated their public and private fixed income groups into one credit group. I think that's the right way to think about portfolios: evaluating duration, liquidity, and credit spread widening exposure irrespective of whether an asset is public or private. Irrespective of an asset's public or private status, it will respond to the same underlying economic drivers over time: growth, inflation, productivity, government spending, and private capital flows. Those are the real drivers of economic outcomes, and they'll impact your portfolio, perhaps with some delays. The value creation mechanism for PE and private assets tends to be longer, but there is a high correlation between what goes on in the real economy and across both public and private assets. I think the blurring and convergence of those markets strongly supports a TPA mindset.

Wouter Klijn (14:27): With that difference between public and private assets, it's sometimes said that it's harder to implement TPA in a private market environment because it is more transaction-driven. For instance, if funds here have large airport holdings and a new one comes up, are you going to say no just because it doesn't fit the TPA philosophy? Probably not. Can you give a sense of how TPA integrates with the private market aspect?

Steve Meier (14:56): The path we were going down in New York City—and the path that I think makes sense—is to implement portfolio tilts primarily in public assets. Philosophically, I don't believe private or alternative asset classes are areas you can quickly lean in and out of. You need to be more strategic because it takes longer for deals to get approved, and the value creation mechanism takes longer. There are practical aspects like finding managers, performing due diligence, getting board approval, and going through contracting. You need a five-year pacing plan for vintage diversification, or three years for private credit.

You need to be very deliberate in those areas, but you can still think about private assets in a total portfolio construct. For example, with secondaries, we were just too big and couldn't turn around continuation vehicle approvals fast enough, so we often just allocated cash. However, upon analysing our private equity holdings, we discovered an underweight to middle-market private equity. We were able to use secondary exposures in those asset classes as completion assets within the overall PE allocation. You can be somewhat tactical while remaining long-term strategic, and adjust annual pacing pipelines to reflect changes.

At New York City, we didn't have a lot of delegated authority. We had 68 trustees who were good fiduciaries but laypeople, making it harder for them to get behind dynamic asset movements and statistical risk analysis. Because of this, we hired external managers who had the capability to be more tactical. For example, nearly 50% of our private credit book was in separately managed multi-strat accounts with accordion features. With a one-time board approval, we enabled our managers to be tactical on our behalf and move in and out of asset classes based on risk-reward dynamics. In extreme sell-offs, relying on VIX volatility indicators or spread widening, they could quickly call capital and put money to work. With a $260 billion portfolio, it's hard to be tactical at scale. This isn't market timing or trading; it's tilting the portfolio where you believe you have a better risk-return outcome.

Wouter Klijn (18:30): That's very interesting, because we're starting to see that more in Australia as well, where TPA plays out not so much within individual asset classes, but at a higher level with dynamic asset allocation. People take tilts or use completion portfolios to try to eke out a little bit of alpha on top of their allocation and be responsive to the environment. Do you see that as an integral part of total portfolio thinking, or has that always been around?

Steve Meier (19:11): I definitely think it's an overlay. You have your SAA, and then you have a TPA approach in terms of tilting the portfolio. I've had the privilege of spending time in Australia, and now in my role at Neuberger, I see that your superannuation business model for retirement planning is far superior to anything we have in the States. As the US moved from defined benefit to defined contribution, many people haven't been vigilant in saving. Your compulsory system produces great outcomes and creates a tremendous pool of capital that influences global flows. Hats off to the Australians; you've set a great example. As baby boomers in the US reach retirement age—many unprepared financially—we are going to face real challenges that are much better handled by the Australian superannuation construct.

Wouter Klijn (20:31): When you first came to NYC Retirement Systems, you tried to implement TPA by breaking down the asset class silos. What were some of the first things you did? There can be quite a different mindset between asset classes. Was it a matter of basing remuneration on the total outcome, or how did you effect cultural change?

Steve Meier (21:05): From an incentive compensation standpoint, focusing on the total outcome is exactly how you do it, but we didn't have an incentive compensation pool at New York City, so that wasn't a lever I could use. Instead, I tried to win the hearts and minds of individuals by providing an educational backdrop and a sophisticated understanding of why we make collaborative decisions. Winning over teammates who had decades of experience in their siloed asset classes was challenging at first. But as we developed analytical rigour that provided insight into overlapping or cancelling active bets, they recognised things about our portfolio that we hadn't fully intended or appreciated.

I give the team a lot of credit for coming around, but it was an almost four-year exercise to clean up our data, build out an analytical framework, implement quantitative tools, and train people on risk management statistics. Then, we had to turn those complex concepts into an understandable narrative for lay-trustee boards focused on their fiduciary responsibilities. Translating these complex ideas into a format people could easily understand was a constant work in process.

Wouter Klijn (23:09): I think the other complication is that the pension plan consists of five individual plans. By analogy, we have TCorp here in New South Wales, which manages multiple plans using TPA, and they apply it over each portfolio. Is that how you went about it? Did you have five TPA models, or could you draw it at a higher level?

Steve Meier (23:38): If we had gone all the way down that path, we probably would have ended up with degrees of variation across the five plans. In New York City, the Bureau of Asset Management (BAM) reports to the Comptroller, an elected official. Each of the five plans had its own general consultant responsible for their SAA, capital assumptions, and return expectations. We were prepared to be very respectful of those relationships, recognising that no single consultant will be entirely correct because the future will be vastly different than the past 25 years.

Because they were different, I suspect we would have had an 80% commonality with perhaps 20% variation at the margin. That also speaks to the fact that one of the five plans had a funded ratio over 100%, three were in the low 90s, and the Fire Department pension plan was in the mid-80s. A lot of the Fire Department's funding ratio challenges stemmed from 9/11, where we lost 346 firefighters in one day, and many more subsequently from related illnesses. That plan had long-lived liabilities turn into shorter liabilities, heavily impacting its funding ratio—at its worst, dropping to around 47% or 49%. It has bounced back to about 85% or 86% now due to increased city contributions and a more aggressive investment policy that bore fruit.

Wouter Klijn (26:16): You have to have a bit of both: more contributions, but probably also a more aggressive investment target. Does that just mean more equities and private equity?

Steve Meier (26:30): Yeah, a little bit more private assets. The one fund that is funded at 102% actually de-risked by taking some chips off the table, reducing exposure to alternative or illiquid assets, and pulling back slightly on non-US assets as a dollar-based investor. That was only for the one fund, which happened to be the smallest of the five, but they are all highly consequential and we care greatly about the outcomes for all the beneficiaries.

Wouter Klijn (27:01): It's always the smallest fund that does the best, isn't it? I want to talk about the role of technology within TPA. There's emphasis on knowing what tilts you have at the total portfolio level, but your paper also references the importance of deep analytical skills. Can you explain why that is, and what you expect to see regarding artificial intelligence providing deeper analysis?

Steve Meier (27:45): At the heart of TPA, you must be factor-aware and risk-aware, tilting your portfolio where you get the best return for the risks you're taking. Instead of asking "what asset classes do I own," you ask "what risks do I own?" This requires an in-depth analytical framework. For example, many worry about private equity's exposure to software companies given concerns about AI. You need to look top-down and aggregate your total software and AI exposure, regardless of whether it's public or private.

Embracing TPA requires market professionals to be more quantitative. In 1983, I actually took a 50% pay cut as a computer engineer to go through a Wall Street training programme. I've always been curious about analytics, being a Certified Financial Risk Manager and a CFA. When I got to New York, my Chief Risk Officer, Ed Berman, built fantastic analytics off the MSCI Barra One system using Python applications we developed. We repurposed positions to hire data analysts with hedge fund and python programming backgrounds to deeply analyse risk.

We also heavily focused on supporting and servicing the trustees. We put together a "BAM University"—a two-day annual event to educate trustees on how we made decisions. I also hosted a Friday morning Thought Leadership Speaker Series over Zoom, where I interviewed major CEOs, CIOs, former US Treasury Secretaries, and Fed officials. This mechanism showcased my team's talent through smart questioning, but the huge benefit was educating the trustees. Once they interacted with senior leadership and understood the value creation mechanisms, it was much easier for them to approve deals. Rather than taking an arrogant view of knowing better than the lay-trustees, we collaborated and used our resources to help them make better decisions.

Wouter Klijn (33:55): That dynamic between the investment team and the board is interesting. I recall someone who implemented TPA looking at a well-structured bottom-up portfolio and realising it was incredibly hard to explain to a board because it wasn't designed from the top down. It's an interesting problem when you yourself wonder why certain tilts exist as the result of siloed teams doing their own thing.

Steve Meier (34:43): Those are unintentional bets. For example, we made the cardinal error of diversifying active managers with other active managers. Individually, they performed strongly relative to benchmarks, but in a portfolio construct, their bets cancelled each other out. We realised you need to be deliberate and partner with the right managers in concentrated positions to avoid cancelling out bets. As we developed our analytical framework, we learned things that might not have been great for outcomes previously, but it wasn't about apportioning blame. It was about understanding what we can prove about the portfolio now and adjusting our holdings to have better outcomes.

Wouter Klijn (35:57): How does implementing shorter-term tactical tilts interact with longer-term investment objectives, especially when short-term and long-term goals can sometimes oppose each other?

Steve Meier (36:24): Strategic asset allocation assumes markets are efficient, and we know they're not. Markets become euphoric or overly pessimistic, creating opportunities. You want to have the benefits of being a long-term investor while being slightly tactical at the margin to seize opportunities. We're not talking about trading or market timing; we're talking about an elegant framework that tilts the portfolio where you are compensated more generously for risk. It's hard to do, but you can implement it through dynamic asset allocation, overlays, or by hiring flexible external managers to execute mandates meaningfully when opportunities present themselves.

Wouter Klijn (38:01): In your paper, you mentioned a rotation programme where investment specialists would sit in other asset class teams. Equity and fixed income people have very different mindsets—how did that work?

Steve Meier (38:21): Absolutely. As a former fixed income person, you tend to be more sceptical, while equity folks are more optimistic about growth. The pilot rotational programme applied to junior folks to give them an opportunity to stretch and grow. Working for the city provides great experience but the pay isn't great, so providing a voice, training, and growth opportunities was our value proposition to incentivise talent. We actually moved a senior investment officer from public equity into private equity; he brought a different perspective that became infectious.

In my 43 years of experience—including acting as CIO at State Street Global Advisors for 18 years and interim CIO for Connecticut—I thought I had all the answers. But meeting with 200 institutional clients over the last six months at Neuberger has shown me that everyone has something new to teach you. To foster this at BAM, we opened up investment committee meetings so junior staff could learn from the discussions and understand how every new investment impacted the overall portfolio. While we met some initial resistance from industry veterans, a quantitative, data-backed approach usually brought people around.

Wouter Klijn (41:44): You finished your paper by saying that despite the changes at New York, it remained a work in progress. What challenges regarding liquidity management, remuneration, or data integration were still outstanding?

Steve Meier (42:09): Everything. As senior investment professionals, our job is to move the ball forward and leave the portfolio, the team, and the trustees in a better place. I used to tell the trustees about Irene Triplet from a 2020 Wall Street Journal article. She was the last surviving beneficiary of a Civil War pension plan; her 83-year-old veteran father had her in 1930. Even 155 years after the Civil War ended, the plan was still paying out a monthly benefit to his disabled child. It's an incredible reminder that these are long-term, generational liabilities and promises. With that long-term mindset, everything can always be better. We were still building the analytical framework, educating trustees, and integrating teams. It is always a work in process, but we made great strides toward a TPA mindset, and now it's up to the next CIOs to advance the ball.

Wouter Klijn (44:36): In your current role speaking to institutional investors, can you give an example of something you've recently picked up from the TPA discussion that stood out?

Steve Meier (44:51): Spending time with Steve Gilmore and Marcie Frost at CalPERS has been exciting. I'm rooting for them because I truly believe risk awareness and factor tilting is the best operating model. I also believe artificial intelligence is accelerating our access to a richer data set for decision-making. It requires us to be fluent in quantitative analysis and risk management. Even at 65 years old, I believe I will see much more convergence between public and private assets in my lifetime, heavily supported by TPA and better analytics.

Wouter Klijn (46:32): If AI provides deeper analysis and access to large data sets, will differences in organisational objectives become the primary factor in how people invest, rather than access to information?

Steve Meier (47:00): I think so. Information moves incredibly fast now. AI accelerates our access to data and allows us to build powerful tools like Python scripts off of risk management systems. We're in a transformational period in financial history. For example, alternative assets were rare in the 80s and 90s, but now they often dominate portfolio positioning conversations.

Wouter Klijn (48:12): And adjusting to these changing markets is aided by total portfolio thinking, especially since post-COVID assets don't fall neatly into traditional buckets anymore, correct?

Steve Meier (48:37): Yes, it's the blurring of asset classes. Infrastructure now looks like real estate, long-duration bonds, inflation hedges, and growth equity. Private credit often has equity kickers. As assets blur together, it requires discipline around factor exposure. Utilising technology and sophisticated analytics enables more deliberate portfolio positioning that drives long-term performance. You still need scale to resource all this technology and analytics, but it's essential.

Wouter Klijn (49:54): Yeah, you need some scale to have the resources to implement all this technology and analytics. Well, Steve, thank you very much for your time. That was a fascinating discussion, much appreciated.

Steve Meier (50:09): Thank you very much, Wouter. I really enjoyed the conversation. I'm incredibly excited about where the industry is going. Hopefully, we'll have a chance to do it again down the road.

Wouter Klijn (50:31): For sure. Thank you very much.

NYC Retirement Systems (NYCRS) is a current client of Neuberger. Any reference to NYCRS is not an endorsement by them of Neuberger or any of Neuberger's advisory or other services. NYCRS has not approved or disapproved of the @i3 Investment Innovation Institute podcast. None of the information in the podcast is representative of any particular client's experience. No one should assume they will have a similar investment experience of any previous or existing client of Neuberger. Any information provided in the podcast is not indicative of the past or future performance of any Neuberger product or service. Mr. Meier's style, philosophy and process is subject to change without notice. His views may differ from those of other portfolio managers as well as the views of the firm. Neuberger paid a fee to participate in the podcast.

The podcast provided is for informational purposes only and nothing therein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. The information in the podcast is general in nature and is not directed to any category of investors and should not be regarded as individualized, a recommendation, investment advice or a suggestion to engage in or refrain from any investment-related course of action. Neuberger is not providing the podcast in a fiduciary capacity and has a financial interest in the sale of its products and services. Investment decisions and the appropriateness of the information provided should be made based on an investor's individual objectives and circumstances and in consultation with their advisors. Information is obtained from sources deemed reliable, but there is no representation or warranty as to its accuracy, completeness or reliability. All information is current as of the date of the podcast and is subject to change without notice. Any views or opinions expressed may not reflect those of the firm as a whole. Neuberger products and services may not be available in all jurisdictions or to all client types. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results.

Neuberger Berman Investment Advisers LLC is a registered investment adviser. The "Neuberger" name and logo are registered service marks of Neuberger Berman Group LLC.

In this episode, we're revisiting a conversation originally published on 6 March 2019, with John Coombe, one of the true veterans of investment consulting in Australia.

John joined John A. Nolan and Associates – now known as JANA Investment Advisors – back in 1988, as the firm's very first employee. Over three decades, he helped grow JANA from a single client into a business advising on hundreds of billions of dollars for institutional investors across the country.

Investment specialist Daniel Grioli sits down with John to talk about the early days of investment consulting, the art of backing fund managers before anyone else will, the biggest asset allocation calls of John's career, and what really separates a good fund manager from a great one.

It's a conversation full of hard-won lessons from someone who's seen more than one market cycle up close.

Follow the Investment Innovation Institute [i3] on Linkedin Subscribe to our Newsletter Explore our library of insights from leading institutional investors at [i3] Insights

Overview of Podcast with John Coombe

Overview John Coombe Podcast

3:20 Got a job in superannuation, because I was the only one who knew how to use a PC 4:30 Spent most of my early days selling equities, because the market was so rampant. 6:30 Meeting some of the great investors two days after the '87 crash 9:00 Backing start-up fund managers 10:30 What went wrong with those managers that didn't make it? 17:00 The biggest asset allocation call in the firm's history 18:40 Shifting 15 per cent out of equities into property 21:23 Allocating nothing to US equities 29:00 If 95 per cent of risk is due to asset allocation, then why do we spend so much time on manager selection? 32:00 Never bet against the central banks 36:00 Do consultants add value? 40:00 Regulatory scrutiny of consultants; "throw them in the Thames and let them all drown" 45:00 Consulting is about making educated guesses. 49:00 Consulting is relationship management; don't kill it with being dogmatic 53:30 90 per cent of returns are driven by a manager's investment philosophy 58:30 There was a ton of money in hedge fund land being run on quant 1:01:00 Do performance fee ever make sense? 1:03:45 Tips for fund managers in dealing with consultants 1:08:00 Discussing the different consultant models. 1:12:00 Is consultancy getting too concentrated in Australia? 1:13:00 John's tips for institutional investors 1:14:00 Are CPI targets set today achievable? 1:17:00 The biggest challenges for instos today 1:18:00 A word of warning

Full Transcript of Episode 138

Daniel Grioli 01:12

Welcome to the i3 Insights podcast. My name is Daniel Grioli, and today I am joined by John Coombe. We first met back in 2011, when I interviewed for a job with John at JANA. Fate intervened, and it wasn't to be. My first impression of John was that he's more than happy to call a spade a spade, so I'm really looking forward to this chat. For listeners in Australia, John probably needs no introduction, but for the rest of you, here's a brief intro. John is a 30-year veteran of the investment consulting business. He joined John A. Nolan and Associates – now more commonly known as JANA Investment Advisors – back in 1988, as John Nolan's first employee. JANA has grown from a single client to around 100 institutional clients, with over $350 billion in client funds under advice. The firm also oversees a further $90 billion in implemented consulting portfolios for its clients. We cover so many interesting topics in this conversation, including what investment consulting was like in the early days, the traits the best fund managers share, whether asset allocation is an art or a science, and much, much more. So, without further ado, I'd like to welcome John to the podcast. John, thanks for joining us today.

John Coombe 03:14

Thank you, Daniel. How are you?

Daniel Grioli 03:16

I'm great, I'm great. So, we usually get started by asking our guests about their background and how they got into their career. How did you get started as an investment consultant?

John Coombe 03:28

Well, I started as an accountant at the SEC (State Electricity Commission in Victoria), and I was very fortunate that a good friend of mine, Terry McCreadon – who I think you know, who's now on the board of MLC Super but was also CEO of Telstra Super and UniSuper – phoned me up one day. I'd worked with Terry in the Treasury Department, and he said, "Coombsy, come and have some fun in the superannuation fund," because he was CEO of the SEC Superannuation Fund, which at that time was, I think, something like the fourth- or fifth-largest super fund in Australia. So I joined the superannuation fund, not knowing anything about investments but knowing a lot about a thing called a personal computer. The SEC ran everything off a big mainframe, but the superannuation fund had just bought a new investment management system that required a personal computer, and as I was the only person at the SEC who knew how to use one, Terry thought I'd be ideal for the job. So I started working with Steve Thompson, who's now at Cooper Investors and is a terrific equity investor. Steve taught me a lot about equities, and I used to do some of the bond investing too.

Daniel Grioli 04:57

Do you remember what that first piece of software was?

John Coombe 05:00

I can't, but it's the one all the custodians used for a very long time as their bolt-on to do Australia, because it had a tax module on the side. I honestly can't remember the name of it, but it was a very interesting time to be in the markets. I joined in '85 or '86, and we were selling equities all the time because the market was so buoyant, trading at all-time highs. I still remember Steve and I used to get told off – we'd go to an investment committee, and John Niland was the chair. John would say, "I told you guys to sell X percent of the share portfolio," and we'd say, "We did, but the market had recovered, and we're back at the same level as before." I think I spent the first two or three years just selling shares all the time. We had a big portfolio, and we got involved in things like the takeover of Fosters by Elders, and all the corporate shenanigans that went on in the late '80s. It was actually quite insightful as a young man doing that.

Daniel Grioli 06:27

So you clearly weren't working in a fund that delegated investment management out. Sounds like you were doing everything in-house.

John Coombe 06:33

That's the start of – oh, John A. Nolan and Associates. John left the SEC – he was head of finance – and started up John Anthony Nolan and Associates, or JANA, in 1987. It started the day after the crash, and I was fortunate: two days after the crash, John and I went up to Sydney to interview managers, because the SEC had decided to outsource part of their Aussie equities to external managers. I met Rob Maple-Brown two days after the crash, and I met some of the great names of the time – Sedgman and a few others. Two days after the crash, and a 40 per cent drop in the market in one day – we've not seen it again, thank goodness. I can assure you it wasn't much fun that day.

Daniel Grioli 07:42

Do you remember what you were talking about at the time? Was it just the crash, or–

John Coombe 07:46

No. We talked about philosophy a lot, and John, as you know, has a strong belief that corporate culture and corporate structure matter a lot in investment management – he learned that from Budge Collins in the United States. So when JANA started, we had two relationships: one with Intersec in Connecticut, who were the first to do global surveys of equity managers, and the other with Budge Collins and Associates out of Newport Beach. Budge ended up becoming PIMCO – well, Collins Associates ended up becoming PIMCO – and essentially they used to fund up start-up managers. They always said that was where all the return was, and they'd fund a lot of young start-ups, which eventually led into the hedge fund world for them, though not for JANA. But that's how their business evolved.

Daniel Grioli 08:55

Okay, so you mentioned backing start-ups early – that was going to be one of my questions later on, but you raised it, so let's cover it now. John's been quite active over the years in identifying managers early. Do you think that's been a big part of your success?

John Coombe 09:14

Without a shadow of a doubt. I think we've helped a lot of managers get started – they've done fantastic jobs for our clients and the members who benefit from that – and it's been really interesting to see the growth in the market, in guys (and ladies, sorry) willing to back themselves and have a go. It started very slowly. Andrew Sisson was one of the first, at BT – well, I suppose Robert Maple-Brown really was the first, wasn't he? Initially we had money with Maple-Brown Abbott. As I say, I think I'm the only consultant who's sacked them twice – there's a long story behind that, we won't go into it – but it has been a big part of our success. Budge was right: if you can get good talent early, when they don't have much money, they make a substantial amount for your clients in the early days.

Daniel Grioli 10:28

One of the criticisms often levelled at consultants is that they're afraid to back managers early, because they're putting their reputation on the line when they take an idea to a client, and also that they want managers with a lot of capacity, because they need to get 20 consultants into a manager to get scale on their research. What is it about JANA that allowed you to do something other consultants were afraid to do?

John Coombe 10:57

John's very entrepreneurial himself – remember, he started JANA with a little bit of backing from Bruce Cook. John is a starter of small businesses, and he understands that. I think the most important thing from our perspective is that we try to make managers profitable, because the last thing you want – and it happened to me once, won't happen again – is to back a manager who isn't profitable. That's a disaster reputationally, because they end up shutting down, and you end up having to find another manager and lose some credibility with clients. Look, we haven't got every start-up manager right – I'll confess to that – but the hit rate's pretty high. It's not 100 per cent, though I'd like to lie and say it was.

Daniel Grioli 11:57

I'm sure there are some stories there – maybe you'd feel comfortable telling us about some of the ones that didn't go so well. You don't have to mention them by name, but what went wrong?

John Coombe 12:09

Generally, the one common trait among the ones that haven't worked was the backing and the capital structure of the organisation. It wasn't that the people were poor investors – quite the opposite – it's just that they didn't have the corporate backing, the corporate structure, to get them through that start-up period before they became profitable, and that put too much pressure on them.

Speaker 3 12:44

[inaudible]

John Coombe 12:45

And then, if you've got a team of four or five, not everyone's got the same financial backing. If you have a person who's, say, got a couple of kids in private schools, etc., they can last for a while off their savings, but after a while the missus is in their ear, asking when they're going to get a real job and start bringing in money to pay the bills. So that's generally the pressure point in that start-up phase – that first year or two.

Daniel Grioli 13:21

Okay, so coming back to the early days at JANA – you'd joined John at JANA. What did you do? What did you start out doing?

John Coombe 13:31

I did everything. There were only two of us.

Daniel Grioli 13:36

But what was consulting like back then? What sort of questions were you helping clients with?

John Coombe 13:40

We were trying to convince clients to get out of balanced funds and into sector specialists. I'll give credit where it's due – John basically started the trend of telling clients that managers aren't good at everything: pick them for what they're good at, give them money in that asset class, and build a portfolio from the best managers in each asset class. We were pretty radical early on – well, it was the way the SEC was run; we had a team running fixed interest, a team running equities, a team running property, etc. So it wasn't foreign to us – it was how we ran money at the SEC. In fact, if you went into the bigger balanced shops back then – BT, AMP, Colonial here in Melbourne, National Mutual – they were all run on the same lines, all with specialised sector teams, but the product sold to the marketplace was a balanced fund. Most people had three balanced funds. MLC's whole premise in the corporate super world was, "We will be the median fund in the surveys, and then you can put your hot-shots wherever – but we'll always give you a median return in the survey." It was a very successful campaign; they had a third of all corporate super. So we came in with the idea that you could pick specialist managers and get a better outcome.

Daniel Grioli 15:27

Okay, so what was the reception to that idea in the early days? Did people think you were crazy, or did a particular event change minds?

John Coombe 15:36

I think we got a bit lucky with the property boom and bust at the end of the 1990s. John had formed a view – and he was right – that property was overvalued, partly because the SEC was a big property owner. The SEC Super Fund owned properties down St Kilda Road, and we'd been selling them to anyone who wanted to buy, but there was all this new property going up on Collins Street – 333 Collins and so on – being built at the time, cranes everywhere. Finance was super competitive, and the banks were lending like crazy. So we told our clients not to own any property. The first three clients we had – if they had property, we sold it; if they were in a balanced fund that held property, we got out of it. They literally ended up with no property. We also started working for Australian Super – or ARF, as it was then – and for REST, and it was a beautiful place to start, because they had all their money in either AMP Capital Guaranteed or National Mutual Capital Guaranteed. We took those portfolios, and all the new cash flow, and put it into asset classes we thought would do okay. The asset class we thought would do terribly was property, so we stayed right out of it. Those clients had a fantastic run through the early 1990s because they didn't own any property. We were probably the first consultant ever to take the National Mutual and AMP property unit prices, graph them, and use that as our proxy for the Australian property market. AMP had dropped their property unit price by something like 20 per cent, and National Mutual had dropped theirs by 5 per cent – there was something wrong at National Mutual in Melbourne, which subsequently there was. So we said, "There's an anomaly here – these property prices are starting to look reasonably cheap relative to the share market." We made the biggest asset allocation call, I think, in the firm's history, with Western Mining, which had no property. Don Morley was the chief financial officer. John went on holidays in mid-January to go fly-fishing, because that's what he loves to do, and I was left with instructions that if the stock market kept rising to a particular level, I was to call Don, and we'd switch 10 per cent out of equities and into AMP property, all in one day. The stock market hit that high – I think it was the 18th of February, I'm not 100 per cent certain of the day – but it was up 73 per cent in twelve months. I think that's historically the highest one-year rolling 12-month return. Anyway, it was up 73 per cent, and I phoned Don. I still remember the call – Don said, "Are you certain, John?" and I said, "Yes, Don," with all the conviction I could muster.

Daniel Grioli 19:30

You were on a rocket ship – about to go to the moon.

John Coombe 19:34

I suppose we were lucky, because the '87 crash was still fresh in people's minds, so it wasn't that hard a sell, though it wasn't an easy one either. We shifted something like 15 per cent in the end, out of equities and into property, and to be blunt, it was timing from heaven, because – I don't know whether you remember – in 1994 Alan Greenspan started raising interest rates.

Daniel Grioli 20:07

I was in primary school.

John Coombe 20:09

You were in primary school. But he started raising interest rates, and that was the only year the bond market had ever lost money – ever, in history, because we'd reconstructed all the index history back over time. So it was fortuitous: here we were in property, which had been hammered, and out of equities, which were getting absolutely slaughtered as bond rates rose. It was a lovely call.

Daniel Grioli 20:43

I had the pleasure of interviewing Jeremy Grantham in his office back in February, and one of the things we spoke about was his early career and some of the early calls he got right.

Speaker 3 20:54

Yeah.

Daniel Grioli 20:54

In that conversation, we discussed the importance of getting a big call right early. Do you think that's been a big part of JANA's success? Would JANA be JANA if you hadn't?

John Coombe 21:08

If we'd seriously got that wrong... it's hard to say, in hindsight, but at the time it was – the stock market's up 73 per cent, everything looks rosy, interest rates falling – none of it felt like a big call. I think the next biggest asset allocation call we made was coming into 2000, in the tech boom. We were working for Wesfarmers, and one of the premises we had from Michael Chaney – he was CFO at the time, before he moved into the CEO role – was a mandate to maintain their surplus for as long as possible. They were our first client, back in 1988, and we'd kept the surplus. Coming up towards the tech boom, we convinced Michael that he should have virtually no US equities – none whatsoever. The market was frothy, but that was a year and a half before it peaked. You were probably still at school then.

Daniel Grioli 22:48

I'm starting to remember this period.

John Coombe 22:50

The peak happened in March 2000.

Daniel Grioli 22:55

So what was that year and a half like?

John Coombe 22:58

It was painful. At REST we'd gone down to 10 per cent in global equities, the lowest they could go, and I remember saying to John, "We can't go any lower in global equities, so let's be smart about it – why don't we hire a value manager, because they've cleaned up and aren't buying any of this rubbish?" We went to the REST board and said we were going to hire a global value manager – the best of the worst, because the value managers were all terrible, underperforming the index by 10–15 per cent. We hired the best of the worst, which was Brandes in those days. The following year, the US stock market was down something like 35 per cent, and that portfolio was up – it was magic. About 65 per cent of stocks hadn't risen in the dot-com rally, but the following year that 65 per cent rallied, while the other 35 per cent, trading on enormous valuations, plummeted – some of them ceased to exist. So the market was down a lot overall, but by number of stocks, 65 per cent actually rose the following year. As long as you were in the value manager, you did okay. That was really interesting. I remember going along to events – I'd shifted up to Sydney by then – and we'd put together 20 pages of presentations for clients to prove why all this technology stuff was just smoke and mirrors, and that it would always end in tears. I'd go along to present at BT, and they were buying everything we were saying was rubbish. I remember a conversation at an AMP function with Jeff Rogers – you know Jeff – who was firmly in the camp of "you should be in global, you should be in tech." I said, "Jeff, so you're willing to give up franking credits and tax benefits" – because the full franking regime was in vogue then – "just to go and buy something that has no earnings?" It was quite a funny little exchange at that meeting, and I remember Michael Lillicrap from REST sitting next to me. I don't know who won, but at least the point was well made – it was entertaining.

Daniel Grioli 25:54

I can't help thinking, as you talk about these shifts – and the question of peer risk comes to mind – were institutional investors far less concerned about what other funds were doing back then, when making those sorts of shifts?

John Coombe 26:10

Yeah, a lot less, but the biggest change in super came when the Coalition came to power and introduced choice. Choice, by its very nature, takes the asset allocation decision away from trustees and puts it onto the individual investor. That, in my opinion, was the biggest change in the super industry, because prior to that, everyone just ran their own balanced fund based on the membership profile – and in a lot of cases, defined benefit liabilities, etc. By the end of the 1990s, choice had been introduced, and by its very nature, once you introduce four or five different options, you've narrowed the range within which you can move the asset allocation – because a balanced option can't look like a growth option, and it can't look like a capital-stable option either. You've really narrowed the range, and I always said to anyone who'd listen that this stymied asset allocation. Ray King and I used to talk about how everything in a fund's outcome came out of its asset allocation. I said that's history now, because once you've introduced choice and narrowed the range, the amount you can get out of asset allocation, in terms of its impact on your portfolio, is also narrowed. So choice was the biggest change.

Daniel Grioli 28:02

Did choice also have an impact on the way trustees approached their roles?

John Coombe 28:09

Yeah, because they also introduced licensing of trustees, which is partly why JANA sold the business to MLC/NAB in 2000. We were about 80 per cent corporate funds back then, and all of them were talking about moving into a master fund, or getting out of super altogether. No corporate fund we worked for wanted their executives doing 30 hours of training to keep a licence – they just wanted to offload it, which was a real shame.

Daniel Grioli 28:54

Well, it sounds like it was quite an interesting and dynamic industry before everybody decided to give it away.

John Coombe 29:03

Yeah, it was, and there were lots of funds. APRA probably didn't like the fact that there were so many corporate funds, but back in those days, super was part of the whole package you offered employees. Government funds offered higher contribution rates in some cases; there'd be a staff superannuation fund where staff were given bonuses and additional contributions into their super, and then the wages employees were in a separate scheme, and so on. It was really seen as part of the HR benefits regime – much less so today.

Daniel Grioli 29:53

You touched on the topic of asset allocation, and it's something I've always wanted to ask about. There have been various studies, and the number varies from study to study – some say it's 50 per cent, others 75 per cent, 90 per cent, or 95 per cent (usually it's risk, but sometimes return) that's determined by asset allocation. If that's the case, and you look at what a typical institution spends on trying to find active managers to pick stocks, the fee budget is probably somewhere between 20 and 50 times what they spend on consultant advice for asset allocation, depending on the size of the fund. So I've always wondered: if asset allocation is the most important part of the investment decision, why are you paying 20 to 50 times more for the other stuff?

John Coombe 30:49

Because history tells us it's the hardest game in town – and Jeremy Grantham would have touched on this.

Daniel Grioli 30:57

Absolutely.

John Coombe 30:58

Mean reversion works, but sometimes it takes a long time, and sometimes you get regime changes. I don't know whether you talked to Jeremy about the profit-share component.

Daniel Grioli 31:16

We did, but–

John Coombe 31:17

GMO always argued that the stock market was over-earning, because the share going to shareholders was higher than historical norms – and that hasn't come down. Whether that's a permanent shift, I actually do think it is. A lot more people are remunerated nowadays through share ownership – if you work for a bank, part of your bonus is in shares that get issued. So there's a higher percentage of people whose remuneration is linked to the stock of the company they work for. But with asset allocation, there are a lot of times when you shouldn't do anything. Sometimes I go along to clients and think, "What am I going to tell them?" because markets are a little expensive at the moment. In the longer term, whether you look at EPS, PEs, or free cash flow – none of the metrics look cheap. No market does, but then it becomes a relative game. Am I going to take my money out of the stock market and put it in cash at zero – or, if I'm overseas, negative, paying for my cash to sit in the bank? How crazy is that? Or put it into a bond market and get negative real yields after inflation? Or stay in the stock market and earn a yield, even though I know there's going to be volatility around that capital? Well, I've learned one thing in 30 years of consulting.

Daniel Grioli 33:07

Just one?

John Coombe 33:08

There's one lesson you should learn, Daniel. It's a very simple lesson.

Daniel Grioli 33:12

Please, enlighten us.

John Coombe 33:13

Never bet against the central banks – you can go out of business. I learned that from Tim Hughes. He bet against the RBA back in the 1990s, running bond portfolios in his own little business. He bet that inflation was going to get high and that the Reserve Bank of Australia wouldn't control it. He put duration positions on for that outcome. Three or four years later, he was out of business – his clients had given up on him, and he was never right. The Reserve Bank has kept inflation in its target range pretty much ever since it got that mandate. So if central banks are pump-priming the world, or their own economies, you don't want to go short equities. You seriously don't want to be short equities. You might take a little off the top – be one or two percent underweight because valuations are high – but you wouldn't punt ten. Did you ever consider repeating–

Daniel Grioli 34:22

–your trick from the tech bubble, maybe hiring a value manager here or there to fade the valuations?

John Coombe 34:30

Yeah, obviously, if one part of the market is doing things that you hope are smart – so if part of the market's trading at a 25 per cent discount to the rest, what do you do? You should go and have a real, hard look at it. There might be a structural reason you shouldn't be there, but if there's no structural reason, you probably should buy it. So you should be looking within asset classes for the cheapest, least risky way to invest – but at the broad asset allocation level, you'd be a very brave person to bet against the central banks. I love risk models, but everyone knows 90 per cent of all risk comes from the equity market, so it doesn't matter – as soon as I own one equity, I'm in strife from a risk perspective. It's a matter of looking even within equities: is there somewhere in the market that looks much more attractive than somewhere else?

Daniel Grioli 35:34

I'd be interested – because you obviously deal with more trustees than I have – but in my experience, I've found it much harder to convince trustees to make shifts within asset classes than between them. It always seemed easier to say "we're taking money from equities into bonds" rather than "we're shifting between investment grade and high yield," or "between emerging markets and developed markets," or something like that.

John Coombe 36:00

Well, I think–

Daniel Grioli 36:03

–I've never understood why.

John Coombe 36:06

I think our trustees are getting more sophisticated, and the fact that they've got internal teams means they look to them, and if their internal team agrees, that reinforces the decision – it's not so much them making the call as backing their team. It's about the meeting of the minds between your internal team and your consultant; there'd have to be a very big differential between those for trouble to start, because no trustee wants to see their consultant fighting with their internal team.

Daniel Grioli 36:47

Well, there goes their legal protection, if that happens – what do they tell the judge?

John Coombe 36:52

Don't know.

Daniel Grioli 36:53

So, I'm going to put you in the hot seat now. There have been a lot of studies – I saw one recently that came out of Oxford Business School–

Speaker 3 37:01

Yep.

Daniel Grioli 37:02

–calling into question the value investment consultants add by picking managers.

John Coombe 37:07

Yep, I read the article.

Daniel Grioli 37:09

I'd love to hear your take on it.

John Coombe 37:11

Maybe they're right? I look at our results across our client base, and we do have mixed results, but in general, in Aussie equities, our managers have added value. In global, they have too, but it's been less consistent – more about style, and us calling different parts of the market, like emerging markets. When we've called EM right, our clients have really benefited, but we've probably stayed in too long, if I'm honest, and that's dragged returns down. Value has been very difficult over the last five years in global in particular, and since we have a value-oriented philosophy, that's been hard, though we've still done relatively well compared to others. My criticism of that particular study is that it looked like they were looking at retail returns, not wholesale returns. If you look at retail products, some managers have six or seven different products in them, ranging from growth to value to core–

Daniel Grioli 38:40

–different share classes, and–

John Coombe 38:42

–all that sort of stuff. So I worry about that. They haven't narrowed the field to one manager, one product – you know what I mean – they're comparing apples and oranges. Some of those funds have a million dollars in them, and some have billions. I know which one matters most for the outcome of most investors, so I read it with a lot of interest, but I struggle with academics looking through performance tables and coming up with conclusions – they might well be right, but the article also highlighted that the really big international consulting firms have a process where they rank managers, and if you're a client, you're meant to end up with the top three or four. If you're one of those big firms, advising, say, $500 billion or a trillion dollars worth of assets, and you're trying to put it all into the same manager configuration, you're going to cause massive issues. We don't do that.

Daniel Grioli 40:06

Well, you'd give up the edge we spoke about earlier – backing interesting managers early. You pretty much rule that out.

John Coombe 40:14

We'd never do that anyway. We don't believe four managers should always make up the lineup, because it doesn't take into account the client's risk profile, etc. Some of our clients couldn't stand having some of the small-cap managers we use, where, yes, they add value over time, but they can be five or six percent under benchmark in a given year. Or really aggressive, high-octane, concentrated portfolios, down five percent in a quarter but up ten over the year – wonderful when they're up ten over the year, terrible when they're down five in a quarter. So you've got to have managers that fit the client's profile as well.

Daniel Grioli 41:02

So you've mentioned you're not entirely convinced by academics looking into investment consulting – what about regulators? Consultants have received a lot of scrutiny in the UK.

John Coombe 41:13

Yep, and probably justifiably so. I actually made a comment after the 2000 tech bubble that I'd throw all the UK consultants in the Thames and let them drown. I think they did an appalling job – the average UK pension fund had something like 85 per cent in equities, global and domestic. The interesting thing was, having had Wesfarmers with no US equities, we'd actually have been better off with no UK equities and no German equities either, because those two markets performed even worse than the US, since the big telecom companies in both went to extraordinary valuations.

Daniel Grioli 42:09

Vodafone – a huge part of the UK market.

John Coombe 42:12

I think it was 15 per cent. And News Corp.

Daniel Grioli 42:15

And Nokia as well, in Finland.

John Coombe 42:18

So you would have been better off getting out of the European markets entirely. Anyway.

Daniel Grioli 42:26

Well, that moves me on nicely to my next question. How is consulting different in Australia compared with other countries?

John Coombe 42:35

Well, having never consulted in another country – other than New Zealand. Does that count?

Daniel Grioli 42:42

It counts. We'll say it counts for the New Zealand contingent.

John Coombe 42:44

It is completely different, let me tell you. They're much more internationally oriented and focused on absolute return in the way they think about markets, which is quite refreshing. There are no surveys over there – they don't care.

Daniel Grioli 42:59

Would you end the surveys tomorrow if you could? Do you think they help?

John Coombe 43:03

They don't help.

Daniel Grioli 43:04

I don't think members ever read them.

John Coombe 43:06

Members never look at them.

Speaker 3 43:07

Yeah.

John Coombe 43:07

The only people who look at them are trustees and consultants.

Daniel Grioli 43:11

Where I get really scared is when I see people's variable compensation linked to a survey – I've seen that a couple of times. There are some large funds that do that, and I think it's a real issue.

John Coombe 43:23

Yeah, but I do think it's an issue – though you could argue the survey is the collective wisdom of all participants in the super industry at a point in time. I'm not 100 per cent certain about that, but it could well be. I had a colleague, Rob Clark, who was CIO at Rothschild, where their asset allocation for their balanced fund was set to be the average of all the other funds in the surveys. He and I had wonderful debates over glasses of red wine about how stupid that was, in my view, and how correct it was from a business perspective, in his. So it depends whether you're running it as a business – if you are, you do have to be aware of where your competitors sit, because you don't want to be out on a limb for too long and have it cost you the business.

Daniel Grioli 44:34

What qualities make a good investment consultant?

John Coombe 44:39

A questioning mind, willing to ask really stupid questions at times.

Daniel Grioli 44:46

What's the dumbest question you've asked? I can remember starting out not knowing what tracking error was – that was probably my dumbest moment, trying to figure out tracking error. I still don't know that the answer is particularly useful, but–

John Coombe 45:05

I asked a bond manager about convexity once – clearly didn't know what I was talking about, even though I'd managed bonds myself, which is funny in hindsight. But no, I just think a consultant should have a view, while realising their view isn't necessarily right – it's just a view. There's nothing right or wrong in investments, really; you've got a view, someone else has a view, and you can use that to question them and gauge the strength of their conviction and knowledge. I used to ask people about Wesfarmers all the time – they were our first client, and I got to know them really well. I even bought shares in it, because I thought they were the smartest people around. I'd go along to fund managers and ask them about Wesfarmers, and it was clear I knew more about the company than the people I was paying to manage the money, because they clearly had no idea what management was doing inside it. That, to me, was a real knowledge point. We also worked for Mayne Nickless, and I remember the company secretary at the time – I won't name him – telling me something that made it clear the company was in trouble. I'd go and talk to friends in the funds management world, and they'd say, "Oh, it's a wonderful company, going fantastically." Three months later, it profit-warned, but everyone still loved them. So sometimes you get insight through your contacts – you can't obviously go and share that, but you can use it to test people's knowledge about things.

Daniel Grioli 47:01

Okay, talking about fund managers – do ex-fund managers make good consultants, or is it a different skill set?

John Coombe 47:10

Consulting is a really funny art, because you come up with ideas, you listen to a whole lot of people, then you have to put it into two words on a piece of paper, hand it to somebody else, and debate whether you're right or wrong about the future.

Daniel Grioli 47:30

Because you're not really doing anything other than offering opinions, are you?

John Coombe 47:33

Correct, at the end of the day. That's why I worry about people who are so sure of themselves that they think they actually know what's going to happen. We're in the game of looking into the future and making educated guesses about what might happen, then building portfolios that can hopefully survive through those scenarios – but you really don't know which scenario will play out, you have no idea. I can paint you a picture of doom and gloom, and I can paint you a picture of rosiness – it's all in the delivery.

Daniel Grioli 48:16

I think that's a really important point about making educated guesses – you see it in lots of different ways in investing. A stock manager might get less than half their picks right and still make a lot of money, because the ones they got right, they backed heavily.

John Coombe 48:35

Sure. There's a value manager I asked this question of: their hit rate on the first dollar they put into a position was less than 50 per cent. Their hit rate on the second dollar was 52 per cent. Their hit rate on the third dollar – in other words, when they were doubling down – was 75 per cent. So you think you got it right when you put your first dollar in, you still think you're right when you add to it, but you only get really brave on the third dollar, when you're more confident. Generally, if you're right, that's the position you make the most out of. Really interesting studies.

Daniel Grioli 49:19

Yeah, I've seen similar dynamics with growth managers. There's a tiger cub I'm thinking of whose hit rate on stocks is less than 40 per cent, and yet the alpha has been phenomenal, because where he's backed something with a larger position, his hit rate has been much higher.

John Coombe 49:39

I'd bet he starts slow, and as his conviction builds, he puts more and more in.

Daniel Grioli 49:47

You're probably right. So my question is: if so much of investing is about testing educated guesses, how do you make that easier to do in a highly regulated, bureaucratic, committee-based, consensus-driven environment like super? To me, all of those things almost get in the way of forming and testing hypotheses. So how do you manage the tension between the two?

John Coombe 50:17

By admitting that you don't know everything – and I learned this from John early on – sometimes you give way on the little things that really don't matter. It's like, "They might be right, I might be right, I'm not going to fight over this – you can have that one." But, a bit like Jeremy and his – what does he call them – his points–

Daniel Grioli 50:53

His blue chips.

John Coombe 50:55

It's like career points. You don't want to throw them all on the line – keep a little bit back for the big day, when you really want to take a big swing and convince people to buy the best manager in the worst part of the market, because that's when you'll make a lot of money. But you're going to need career points to get there, so give up on the things that don't make any difference at the end of the day – the 1 per cent manager that doesn't change anything – but on the big one, be ready to stand up and fight hard.

Daniel Grioli 51:39

Okay, so those moments only come along–

John Coombe 51:42

–every now and again.

Daniel Grioli 51:44

So it's a bit like Warren Buffett's punch card – you've got about ten career calls, and if you thought of it that way, you'd be much more careful about making sure that you–

John Coombe 51:55

Well, it's like today – at JANA, we probably haven't changed our asset allocation views for nearly three years, and you could say, "Aren't you being weak?" But the reality is we've been in this hiatus of easy money for nearly ten or fifteen years, and basically you're punting against the Reserve Banks of the world. The regime's starting to change, but it's still easy money wherever you look. So it's right to be cautious about taking big asset allocation calls – sometimes. Other times, no – you've got to stand up for your convictions and hit the table – but that's not very often.

Daniel Grioli 52:44

So how do you learn when to play it safe and when to swing the bat? Is that just experience – getting belted up a few times?

John Coombe 52:54

Having a few chairmen phone you up and say, "John, that didn't go so well today." Look, it's an art – it's relationship management, and you have to be careful not to kill the relationship by being dogmatic about something where you might have a nine-out-of-ten chance of being right, but you might still be wrong. So, humility.

Daniel Grioli 53:31

I think there's some great advice there. So, you've been privileged to meet some of the best fund managers around the world.

John Coombe 53:41

Yep – one of the great highlights of my life, actually.

Daniel Grioli 53:45

I'm glad to hear you say that. So you're the perfect person to ask: what makes a good fund manager? What are the common traits, and on the flip side, what are the red flags that mean you're out of there as soon as you see them?

John Coombe 54:04

It isn't humility, interestingly enough. The really great fund managers I've come across have an investment philosophy they truly believe in, live by, and are 100 per cent wedded to. It can be growth, value, or quality – but they have a philosophy. At the end of the day – my colleagues hate me saying this – I think 90 per cent of returns are driven by a fund manager's investment philosophy, and about 10 per cent comes from their skill at picking the better stocks within that philosophy.

Daniel Grioli 54:52

I agree – it's markets that pick managers, not the other way around.

John Coombe 54:56

Yeah, but it's the conviction in the manager to stay the course. The other thing is they've generally been successful somewhere before – school, sport, or otherwise – and have this desire to win. They know what winning feels like, and they want to have that high again. A bit like a runner who keeps running marathons for the adrenaline – they know what winning is like, they like it, and they keep wanting more of it.

Daniel Grioli 55:30

Okay, and on the negative side?

John Coombe 55:32

This is probably one of the reasons Australian fund managers aren't too bad against the rest of the world – Australians are actually very competitive. But I'll be honest: the worst ones I've come across have come out of broking. They know how to sell a story, but they're not investors in any real sense – they moved to the buy side because they got sick of the sell side, but they listen too much, and they're not great investors. The other red flag is a bit of hubris. I remember walking out of one fund manager meeting – he'd told me he and his team were the smartest people in the world and worked the hardest, and I said, "How do you know that? I've been a consultant for 20 years – tell me how you know you work the hardest." You should have seen him trying to bluster his way around it. We see straight through that now – they have no idea.

Daniel Grioli 56:45

It's funny you say that – it never ceases to surprise me how little fund managers really know about their competition.

John Coombe 56:55

No, I was–

Daniel Grioli 56:56

–constantly amazed at that, and it's worse–

John Coombe 56:58

–when you go into the big financial centres, like New York and London. I'm amazed in London – it's not that big an area, let's be honest.

Daniel Grioli 57:10

A square mile, or thereabouts.

John Coombe 57:11

Yeah, but it's pretty concentrated. You go and ask a fund manager in London who their competitor is, and they don't know.

Daniel Grioli 57:24

You'd think they'd be running into them–

John Coombe 57:25

–around the corner.

Daniel Grioli 57:26

Oh, you'd think they'd be running into them at AGMs, seeing each other on the register, or at least looking at who else is on it.

John Coombe 57:32

No, it's funny – they just don't care, and they focus on their own business.

Speaker 3 57:37

Which is–

John Coombe 57:38

–I don't really understand that.

Daniel Grioli 57:40

It's the ultimate irony – their business is to be students of business, and if they're not applying their skills to their own business, in their own industry, what are they doing? I do laugh–

John Coombe 57:51

–at fund managers who tell me how they've advised company management on how to run their businesses, and I'm thinking, "Boys, you don't know how to run your own business – telling someone else how to run theirs, I'd have a little more humility." But honestly, fund managers generally aren't great at running their own businesses. I quite like the ones who know that and hire a business manager, or have an equity partner who handles all of that, because most of them are good at the investing side.

Daniel Grioli 58:26

That's an interesting observation. So, in terms of funds management, it seems to be becoming more and more quantitative. Do you think that's a good or a bad thing?

John Coombe 58:42

I actually think it's been this way for a long time, and a lot of people haven't noticed – screening by style and other quantitative techniques have been going on for at least 20-odd years, so the fact that it's now gone the whole hog and taken analysts out of the loop doesn't mean it's any bigger overall. Ian Patrick was the one who pointed this out to me, and I should have listened to him harder: around 2007–2008, there was a hell of a lot of money in hedge fund land being run on simple quant strategies, particularly in Asia. It had all built up over the prior three or four years – long-short, Asian equities, Aussie equities, a bit of global – and the number of people doing it had exploded, as had the dollars behind it. Even the internal prop desks were running quantitative processes. So I'd argue it was bigger then than today. The biggest phenomenon today is passive–

Daniel Grioli 1:00:37

–smart beta as well?

John Coombe 1:00:39

Well, not really–

Daniel Grioli 1:00:42

–not big by size, but it's growing.

John Coombe 1:00:44

Yeah, and there are a lot of techniques being used – long-short, alt-beta, and so on. Don't get me wrong, but I don't think it's as big, in aggregate, as it probably was back in '07/'08. We actually took our medicine and got out of nearly all our quant exposure around 2008/2009, because I felt the regime was wrong for quantitative techniques at that point – too much volatility in style rotation. We didn't really get back into quant until 2011. So quant isn't a process that works all the time, in my view – it works most of the time, but it can get crowded, and value signals are classic signals; if value's getting hurt, your quant strategies will get hurt too, because–

Daniel Grioli 1:01:52

–the Fed has its hand on the scale?

John Coombe 1:01:54

Well, quant always gets hurt when value and quality get hurt, because that's the backbone of probably half the strategies out there.

Daniel Grioli 1:02:07

Do performance fees ever make sense for clients? They're great for managers, but–

John Coombe 1:02:19

I've worked with a fund that wouldn't hire a manager unless they had a performance fee – at one stage, 80 per cent of all their equity and bond managers were on performance fees. They thought it incentivised better outcomes. I don't think it changed the outcome at all – I don't think a manager tries harder just because of a performance fee than they would running a standard fee structure. That's talking about long-only managers. In the hedge fund world, I think performance fees drive everything, but I think they're structured wrong – performance fees calculated off a cash benchmark just–

Daniel Grioli 1:03:14

–are totally wrong, because it's a benchmark that doesn't reflect the risk.

John Coombe 1:03:18

It just feels wrong – it feels like a transfer of wealth that, in hindsight, history will look back on as one of the greatest transfers of wealth from the people who had it to the people who wanted it, without giving much back in return. I'm not talking about performance fees for a private equity manager doing returns in the high teens or low twenties – that feels fair. I remember at the SEC, when I first started in super, we hired some of those "baby tiger" managers you mentioned earlier, because Collins had introduced us. I remember – and this is my memory – back in 1986, we wrote out a $21 million cheque to one of those tiger managers, and the trustee board hated it so much that we sacked the manager the following year. It's terrible, but–

Daniel Grioli 1:04:24

–it stuck in their throat?

John Coombe 1:04:24

It stuck in their throat – they couldn't stomach it. I think it was a 20 per cent take, so he'd made $120 million for us and we paid $20 million in fees, but they couldn't stomach paying the 20. It's funny, isn't it?

Daniel Grioli 1:04:41

It's a very behavioural thing. Some of our listeners are fund managers – what tips can you give them before they talk to you again?

Speaker 3 1:04:51

I don't know.

Daniel Grioli 1:04:53

I would–

John Coombe 1:04:54

–come with a good business case. Don't walk in with a wish list – you need to know certain things before you present how you're going to operate. What does my capital structure look like? What's my investment philosophy? In which markets am I going to make money, and in which am I going to struggle? How much do I need to break even? What does my team look like if I'm successful? You'd be surprised how many people, when you ask that question, have no idea. You might operate in the early days on the smell of an oily rag, but if you're successful as a fund management business, you're going to need more people, and that should be built into your plan. How long can I last before it really hurts, if I'm funding it myself? How long is my funding partner going to stay with me? Those fundamental questions have to be answerable – maybe not in the first meeting, but definitely by the second. The first time, you might ask me a few questions about what you should do. The second time, you'd better have answered those questions and come in with a business plan, because you can't walk into Ian Patrick at Sunsuper and say, "Look, Ian, back me – I've got no backers, I don't really know what I'm doing, I just want to do this." You've got to go into a big fund like Sunsuper, or REST, or anyone like that, with a plan for how you're going to make their members better off. You've got to have a value proposition.

Daniel Grioli 1:06:47

How often would you see managers come in with a half-baked business plan?

John Coombe 1:06:51

It depends whether it's the first meeting or the second. Usually, by the second, they've got it worked out – the first might be a bit iffy. We're in a privileged position, because, as you mentioned earlier, we've backed a number of firms over the years, and a lot of young people who want to start up come and ask for a bit of advice. I give it for free these days, so they don't have to buy me a coffee anymore, which is good – I'll let them off the hook. But yes, you've got to understand what the business will look like in its growth phase and its mature phase. It's interesting – people generally know what the growth phase looks like and how hard it might be, but they haven't necessarily worked out the economics of the mature phase. The backers of boutiques are sometimes in a similar boat. Some have got it right now, but in the old days, the backer would take a cut all the way through, and when the manager becomes really successful, that cut becomes a big number, and the people running the money don't like it.

Daniel Grioli 1:08:10

Yeah.

John Coombe 1:08:10

So there has to be a recognition of what a mature business looks like, as opposed to a growing one.

Daniel Grioli 1:08:16

That's a really good point. If things go badly, the backers have generally risked money they could afford to lose, but the person – or people – having a go have lost a lot more, because it's all tied up in their–

John Coombe 1:08:30

–career, for a very long period.

Daniel Grioli 1:08:33

So they're the ones really taking the risk. But as you say, the arguments happen when things go right, because that's when everybody's unhappy about their respective slice of the pie.

John Coombe 1:08:43

Yeah, no, it's a real issue.

Daniel Grioli 1:08:46

You touched on this early in our conversation, and I wanted to come back to it in more detail. JANA started out as a privately owned firm, then became part of a much larger public company, and now it's a private firm again.

John Coombe 1:09:01

Part-private.

Daniel Grioli 1:09:02

Part-private. So some of your competitors are divisions of public companies, and some are owned by their clients. Do you think the business model of a consultant matters?

John Coombe 1:09:15

I do, though I'll hedge my bets here. If I were running a big multinational – and we all know who those firms are – I'd want to be part of a big organisation, because I'd be going into markets where I'd need some financial backing, since I might be in those markets for three or four years not making any money – in fact, losing money, because I've hired people. I've seen my contemporaries in places like Hong Kong, Seoul, and Japan go five years without coming close to break-even. So if you're really global, you do need to be part of a big organisation with deep pockets. And let's be honest, the big firms nowadays are part-owned by insurance companies, fund managers, or life companies – those owners have deep pockets.

Daniel Grioli 1:10:30

But their consulting arm is generally a rounding error on the parent company's revenues, and not–

John Coombe 1:10:36

–necessarily, not if they're into the outsourced-CIO model. Having just–

Daniel Grioli 1:10:44

So then in the US–

John Coombe 1:10:47

If you think the UK has done it, it's nothing compared to what's happening in the US, where you've got small government funds outsourcing the CIO function, and it's not just the consulting firms – it's Vanguard, Morgan Stanley, Goldman Sachs, everyone's in the game. It's a very, very competitive space.

Daniel Grioli 1:11:11

Is that going to happen here in Australia?

John Coombe 1:11:13

No, I don't think so. Well, it sort of already has – that's what's been called the exodus of corporate super, left, right, and centre. It happened. No, I think we're in a consolidation phase here. My answer is, it depends on how big you want to be. If you want to stay in your own market and just be excellent at what you do within your own hemisphere, you can probably get away with employee ownership, and that's probably the best model, because you get buy-in from all the senior consultants. But then there's always the point of changeover from one generation to the next, and whether you've got that right – whether the next generation is building up equity over time as they become more important in the business, so that, in the end, you can take the senior consultants out in an orderly fashion rather than causing a corporate event. When you look overseas, whether at fund managers or consultants, that's generally what's happened: one generation hasn't filtered the equity down to the next.

Daniel Grioli 1:12:32

Hasn't filtered it down?

John Coombe 1:12:34

Hasn't filtered the equity down over time, so they end up as massive equity-holders who need a corporate event to extract their wealth, because the people underneath can't afford to buy them out.

Daniel Grioli 1:12:46

Okay.

John Coombe 1:12:47

So it depends what you want to be. If you want to be the biggest consultant in the world, you'd better have somebody with a big chequebook behind you.

Daniel Grioli 1:12:56

In terms of consultants, there used to be four main ones in Australia institutionally – a lot of smaller ones too, but–

John Coombe 1:13:04

In the 1990s, there were 20.

Daniel Grioli 1:13:06

There were 20. Now you could argue there are almost only two of any real size – we won't say who they are. But whether it's two, four, or some other number, is the market getting too concentrated? Is there enough diversity of views?

John Coombe 1:13:23

No, it's nowhere near that concentrated. I'd argue there are 20 consulting firms today if you count the 15 or so sitting inside funds like AustralianSuper, Sunsuper, etc.

Daniel Grioli 1:13:43

Because people are internalising the function?

John Coombe 1:13:44

Yeah, they've internalised part of the consulting function. So it's not just the four or five of us – we're an add-on to internal teams now, helping them and providing breadth, while they provide the depth. So I don't think there's only four – I think there's something like 15, once you count the internalised teams.

Daniel Grioli 1:14:15

That's an interesting take on the concentration issue. So, moving on to the home stretch, I have a couple of quick questions–

John Coombe 1:14:24

–make it hard? I've got five seconds to answer each one?

Daniel Grioli 1:14:31

You can take longer than five seconds, but I'd like to finish on a note where we have some practical tips for institutional investors, whether they're your clients or other institutions. What are some common mistakes you see institutions making that they should avoid?

John Coombe 1:14:53

I think the sole purpose test is a wonderful one – don't get distracted by all the other things around super. Concentrate on delivering member returns. You can get a little distracted at times by the peripheral stuff.

Daniel Grioli 1:15:16

I think that's good advice. Most institutional balanced funds target CPI plus 4–5 per cent. Is that realistically achievable, and if so, what can funds do to achieve it?

John Coombe 1:15:31

It's more like three to three-and-a-half for a balanced fund, near enough, but it's achievable on average – though we don't need any big mistakes along the way. Look, the margin over inflation we're going to achieve over the next decade is going to be lower than what we achieved over the last ten years, because of where we're starting from. If we'd had this conversation in 1998, I'd have said the returns out of a super fund over the next decade were going to be lower than the decade before, because of the starting point – and I agree with Jeremy here, the starting point is vitally important to what you can expect over the next decade. We're starting relatively expensive, in a historical context. If we stay expensive over the ten years, we'll probably get a balanced return of CPI plus three. But if we go from expensive to cheap, the next decade could be quite difficult, because we're starting from an expensive point.

Daniel Grioli 1:16:54

Okay, and how can they achieve it?

John Coombe 1:16:54

I wasn't a great believer in private equity in the old days – I was a bit sceptical – but when you look at what our funds have been able to achieve owning businesses in the infrastructure space, and I'd add owning property in the property space, if you do private equity well – doing a lot of co-investments and things like that – I think owning businesses, owning the capital structure, and controlling how and when you allocate capital across it puts you in control. If you really do that well, there's a lot of money to be made.

Daniel Grioli 1:17:42

Aren't you worried those businesses are getting more expensive than public equities, with a lot of money chasing them?

John Coombe 1:17:48

Yes, of course. But if you own a great business, with good management that you've incentivised properly, the fact that you control when to put more capital in to help it expand, and when to draw out your dividends – you're in control. And if you do it really well, I do think these are wonderful ways to generate wealth.

Daniel Grioli 1:18:19

Okay, so what would you say are the biggest challenges facing institutional investors at the moment?

John Coombe 1:18:26

Getting set into the assets we just talked about, because you're right, a lot of people have reached the same conclusion I've just articulated, and a lot of them are trying to get into that space. Many of them are saying, "For the next decade or so, we're in a growth phase, and after that, a mature phase," so in the growth phase they're getting set into these businesses and paying up to do it. Only time will tell whether they've paid too much – it'd be lovely if you could buy these wonderful businesses at half of what we have to pay today, but we're in a competitive space. The one warning I'd give everyone is that the world has much more savings today than it has ever had historically. Look at China – you took 500 million people out of poverty and turned them into capitalist savings machines. They're looking for investments, looking for places to put their money – as are hundreds of millions of other people – and that doesn't even account for all the extra wealth the average Australian, the average person in the UK, or the average American has generated. Every one of those people is looking for somewhere to put their money to generate a real rate of return. We're in a world full of money looking for investment returns.

Daniel Grioli 1:20:07

Okay, final question: what are three things institutions can do to improve their investment decision-making?

John Coombe 1:20:16

We talked about philosophy before – be very clear about what your investment philosophy is. It will serve you in all circumstances. If you have a belief system, it will stand you in good stead going into the future. You won't get everything right, but you'll have a story to tell your members: "We're managing the money this way, for these reasons." As long as you're disciplined about that, you will win in the longer term, whether your philosophy is growth or value. You win in the end if you're disciplined. It's the ones who waver between what they believe one minute and the next that get into trouble.

Daniel Grioli 1:21:02

Okay, John, it's been an absolute pleasure having you on the podcast. Hopefully we can have you back as a guest in the future.

John Coombe 1:21:10

Thank you, Daniel. All the best.

In this episode of the I3 Podcast, Aware Super CIO Simon Warner joins us to discuss how his unusually broad background across fixed income, equities, public and private markets shapes his approach to investing. Simon explains the realities of implementing a total portfolio approach within Australia's DC superannuation system, balancing risk, liquidity and cost while empowering specialist teams rather than imposing top‑down macro calls. He also talks about Aware Super's evolving organisational structure, its global expansion via London, and the changing role of CIO in today's superannuation industry.

Follow the Investment Innovation Institute [i3] on Linkedin Subscribe to our Newsletter Explore our library of insights from leading institutional investors at [i3] Insights

Overview of podcast with Simon Warner, CIO of Aware Super

[02:00] Simon's career path: Simon outlines his journey from JP Morgan balance sheet risk management (rates and FX) to AMP Capital and then to Aware Super, spanning fixed income, equities, multi‑asset, and private markets.

[04:36] From trader to investor: He reflects on moving from being a trader in highly liquid markets to a broader investor, stressing how this built a rigorous risk‑management ethos that underpins his work today.

[05:50] Total Portfolio Approach (TPA) in super: Discussion of TPA and why implementing it is different for Australian super funds (with member choice and labels) compared to sovereign funds like the Future Fund or NZ Super.

[06:55] Constraints of the Australian super system: Simon explains key constraints: DC structure, direct B2C member relationship, liquidity for switching/redemptions, and dual focus on net returns and costs in a competitive market.

[09:30] "I sometimes wonder whether commentary on TPA isn't code for top-down decision-making?"

[10:33] Practical TPA and risk premia vs idiosyncratic risk: He describes building a common language and philosophy around risk premia vs idiosyncratic risk, using infrastructure as an example to think about embedded factor exposures across the whole portfolio.

[15:33] Active vs passive and future of data in private markets: Simon talks about using analytical frameworks to separate what should be cheap beta/factor exposure from what is truly idiosyncratic alpha worth paying for, and how better data in private markets will enable more scientific portfolio construction.

[17:14] Restructuring the investment team: He explains recent organisational changes: grouping property and infrastructure under private markets, creating dedicated accountability for liquidity and implementation, defensive assets, and having public equities report directly to the CIO.

[23:31] Internal vs external management: With ~30% of assets managed internally, Simon discusses when Aware chooses internal management versus external managers, stressing competitive edge, proximity to assets, and reserving higher fees for true idiosyncratic opportunities.

[28:48] Global expansion and the London office: He outlines the rationale for the London office—access to deeper global markets, managing domestic capacity constraints, building trusted co‑investor relationships, and carefully embedding Aware's purpose and culture offshore.

[31:00] "We are at our SAA in terms of illiquid asset classes, so there is no urgency [to increase]"

[35:29] Role of super funds and member expectations: Simon positions Aware as already vertically integrated, with large non‑investment teams focused on member engagement and advice, and discusses balancing performance, cost, and responsible investing for a diverse 1.4m‑member base.

[40:18] Lessons, mentorship, and the CIO as 'director': He shares lessons from mentors like Mark Beardow and Adam Tindall on process, humanity, and psychological stability, and describes the modern CIO as akin to a movie director: setting vision and culture while empowering specialists rather than micromanaging decisions.

[41:30] Make your investment process a perspex box that you can describe to yourself, to people around you and to the people that will occupy your position in the future

[49:00] The role of an CIO is somewhat akin to a [movie] director: you have to have some level of consistency of vision and consistency of what you are trying to achieve

Full Transcript of Episode 137 of the [i3] Podcast

Wouter Klijn 00:00

Welcome to the [i3] Podcast. I'm here today with Simon Warner, who is the Chief Investment Officer of Aware Super, which has now become a 235 billion superannuation fund. Simon, welcome to the show.

Simon Warner 00:14

Thanks, greatly appreciate it.

Wouter Klijn 00:17

So, you took on the CIO role at the end of last year, and I was looking at your background. I spent a long time at AMP Capital, long time at JPMorgan Chase, but you have both had very senior roles in the equity side and the fixed income side. That is kind of unusual for a CIO. Can you tell me a little bit about how that came about?

Simon Warner 00:41

Yeah, well, so a lot, a lot of my career is a story of serendipity, and maybe me being active about making loads of opportunities that have come my way, but a lot of it is about a embracing the path that life has put out for me. I started, I started my career at JP Morgan, as you say, or one of the prior banks that now makes up JP Morgan, and my first job there, and the job that I had for 11 years was working on a on the balance sheet, managing the strategic interest rate and currency risk of the bank, which in many ways was sort of an internal hedge fund, so operating in, you know, the world's most liquid, most highly arbitraged markets to try to add value that then parlayed into a move into the buy side where I worked at AAP Capital, first within the fixed income team, and then my last job at AMP Capital was running equities, fixed income, and the multi-asset area, so the part of that business that used to manage the superannuation monies, but the last job I had there included the front office, but it also included all the support staff and all of the distribution product technology, etc. I then took a break and re-entered in this role under Damian Graham, my previous boss, and the old CIO here, where I took a role for him, looking after private equity, public equities, infrastructure, and property, and so over the course of that journey, I've been very lucky to have been either a direct practitioner or very proximate to decision making across pretty much everything that we do here now at Aware, that certainly I would emphasise, has not made me an expert at all of it, arguably an expert at not any of it, but it has given me a level of proximity and a level of understanding and a breadth that I do think is like you say, it's a bit unusual.

Wouter Klijn 02:36

Yeah, so do you see yourself today as more of an equity guy or a fixed income guy?

Simon Warner 02:41

You try not to label yourself, because they tend to be a little bit of rivalry between those two simple camps, and I think one of the things that I would, I would probably frame it differently, I think, I think you know my time at the start of my career operating in those markets that I described, I think that creates a level of rigour around risk management that is a really strong foundation for any individual within investment within the investment industry, and so I made not only have I made this journey from fixed income into equities from the public side into the private side, but I suppose I've had a bit of a journey from being a trader to being an investor, and that training I do think creates a very strong risk management ethos that to my mind is a critical pillar for a great investor as well, and so I would not proclaim myself to be a great investor, let me be clear, but I do think that foundational skill or foundational approach has been one of the things that I do hold on to.

Wouter Klijn 03:50

So that's interesting. So there's the equity side, the fixed income side, and then the trading side as well. And I was sort of thinking of it. You mentioned briefly JP Morgan was sort of like an hedge fund type approach. All of those roles seem to filter quite well into, you know, what is very popular today is the total portfolio approach, where you know you look at the total portfolio and see where the gaps are, and we've looked into this recently a bit. Obviously, within a super fund environment, it's very different to implement that than say the future fund to New Zealand super, where they can get rid of a strategic asset allocation. Super funds can't really do that, they have to be true to a label in their investment options. So, what we've seen is that funds try to do more of sort of an overlay, or completion, as Canadians call it, and that seems to translate sometimes in a little bit of a hedge fund type of techniques, and we see relative value, we see global macro trade, is that something what you're thinking of as well, and what are your thoughts on TPA in general?

Simon Warner 04:55

Yeah, yeah, so as you allude to there, I think. Think understanding our context and understanding our task within our context is sort of foundational for understanding about what the best way of going about our business is, and without wanting to repeat what you said, one of the features of the Australian superannuation industry, or the two features that I think are really salient, is one is that we are a DC system, and secondly, we are B to C entities, and so we operate with a direct relationship with our customer base, or our member base in our case, and they can switch at any time. We have a, we have a really tactile and close relationship with the beneficiaries of our capital, of the capital that we're lucky enough to manage for them that brings to bear a few constraints and a few features of the way that we have to operate the portfolio. One is we have a risk tolerance, obviously, but most investors would have that. Secondly, we have a binding liquidity constraint, so we have to maintain liquidity across the fund to meet those redemptions that our status as a DC and B to C entity come with say, and finally we operate obviously in a competitive system, and so we not only have a net return target, but we have a separate and discrete cost target, because the nature of the marketplace is that the member base or the potential customer base cares not only about not just about net returns but independently of that they also care about cost and so those give us some hard key constraints and and for my mind TPA is at the very headline level How do you create an environment, a culture, a system, a method of sharing information, and a method of deploying capital, such that you're optimally managing to those two constraints. So, not thinking about, you know, competition for a liquid capital, for example, on that liquidity constraint, but thinking very clearly that every time we deploy into an asset that is illiquid, it is drawing upon a scarce resource and creating environments, not only, as I say, the softer stuff around culture, but also, you know, the harder stuff around investment process and a consistency of approach that allows you to make those trade-offs in a mindful way. The thing that I would fall short of, in terms of the way you framed your question, is that I sometimes wonder whether commentary around TPA isn't code for top-down decision making. That is absolutely not the way that I would approach my task. You know, I think my role is to create an environment where, where the all of the 180 odd people on the team are being their best, and that we are creating an environment where the expert is making the expert decision and empowered to make that it's not about trying to get everybody to think in top down macro terms, it's about trying to get people to be empowered to deliver on their sphere of expertise.

Wouter Klijn 08:05

Yeah, so how does it translate into sort of practical changes if you're not trying to sort of manage things from the top down? How does that translate in how you think in sort of your approach to these completion strategies, or is it more a question of active versus passive? Is it more just enabling the asset class heads to do their job? How do you think of it in practical implementation?

Simon Warner 08:33

Yeah, so you know, the first, the first thing I'd say here is that, you know, a bit of what I'm about to say is me thinking out loud, it's something that we, as a group, are thinking through. What's our best approach to it? As I said before, it's we're not in a position I think where we can take a cookie cutter approach that someone's worked well elsewhere and just apply it, because our circumstances are slightly different. You know, our starting point is to try to think in terms of how do we create a commonality of philosophy and of language that is giving us a level of consistency, but not constraining each individual team to give us breadth and diversity, as well as to be able to deploy and invest in the way that is best for their sphere, and simplistically, what we've tried to do in that respect is to be really clear about thinking about individual assets, asset classes, and the whole portfolio as clearly as we can in risk premia versus idiosyncratic risk terms, acknowledging that in practical, in practical terms, it's very.. it's often impossible to separate the two, and in mathematical terms, it's almost impossible to scientifically decompose it. But what we can do is at least talk in principle, you know. Infrastructure is a good working example for some of this, but it definitely applies across the board for me, where you know an infrastructure asset that has more equity. Risk and is in a particular sector and is in a particular jurisdiction and is one of the very best assets that we can think of, given all of that, that's a cascade of a combination of risk premia that we would expect to get rewarded for over the medium term and more asset-specific idiosyncratic risk, return risk, risk elements, thinking about that clear headedly, or even just having a framework where you talk about those that combination openly has been a way to unlock a level of holistic thinking, so to what extent have you got a an infrastructure or property portfolio that has embedded in it risks that are not that were not incorporated in your capital market assumptions when you did your SAA, for example, and then what does that mean, thinking about where you've got either diversifying or reinforcing risks across the portfolio rather than just thinking about them in one sector, now to support that language is a good, is a good first step, and then to support that with some level of consistency around your analytical framework, so thinking about, you know, your ex ante IRR models within private markets, for example, as being a waterfall of different risk-free country sector and equity risks, and then that there are parts of the business case that you might want to, the ex ante business case, that you, you label very clearly idiosyncratic risk, it's a particular efficiency uplift within the asset, it's a merger plan, maybe, or it's a divestment of part of the business, so just thinking about that in those terms and having some level of consistency, so that you can create a conversation around those trade-offs.

Wouter Klijn 11:48

So, in that example of the infrastructure investment, are you looking to pull apart the different drivers of risk and return within that investment, where you look at what comes from factors, what comes from idiosyncratic risk? Is that how you look at it?

Simon Warner 12:02

I think again, acknowledging that we don't want to be the tyranny, we don't want to have false specificity because we're putting a number against something, it's not necessarily mean it's scientific. So I want to be very clear about that. A lot of this is about directionality and about intent rather than trying to break things down in a scientific way, but that's absolutely right. Yeah, so I think in terms of, you know, what are the characteristics that we wanted that we're seeking from infrastructure when we think about the SAA, what are those correlations in normal circumstances? What are those return objectives? What are those, you know, in the case of infrastructure, what are those defensive characteristics as well? Then getting quite clear about how individual assets and then the portfolio as a whole is mapping back to those characteristics, to what extent through quite appropriate risk-seeking behaviour are we layering in other factor exposures that might be optimal ways of allocate of accessing those factors, by the way, and then on top of that, being really clear about where idiosyncratic sources of return come in, the reason that this is important from not only a portfolio risk point of view, but coming back to that other constraint that we have around cost, is because at least in principle, borrowing from the more scientific environment in public markets, you prefer to have your external pay aways dedicated to idiosyncratic sources of return that you can't replicate, you know, so you can't create that scientific separation, obviously, in most private asset classes, you can create a conversation that helps you make better decisions.

Wouter Klijn 13:33

So it's not, you know, a clear scientific separation, but does it change the way that you think about the role of active and passive strategies and passive enhanced strategies in the portfolio?

Simon Warner 13:44

Just sticking with private for a moment, so you know, one of these, or this conversation that we've had up until now, that's part of the reason that we bucketed private equity, property, and infrastructure under one banner of private markets, under my colleague Jenny Newman, to create an environment where we can make some of these trade-offs. It's not quite your question, but let me just go on this tangent for a moment. You know, I do think that over the next 15 or 20 years or so, as data becomes more available and more granular and more and more trustworthy in private markets, you'll be able to create the environments where you can be more scientific about some of the portfolio risks, and so thinking in these terms is, I think, a prerequisite for taking advantage of that forward-looking data world, where you're going to get a better sense of individual assets and their risk exposures, and the performance of them, and what is really driving them. So, that's that's one of the things that we're seeking to do. I do think, as you say, a lot of it does come down to are you creating analytical frameworks both within asset classes and then across, where you're being as optimal as you can be, acknowledging that it's ultimately something of an art and something of a science about passive or factor exposures you'd rather not. Pay for, and you'd rather you'd rather label that explicitly, that we're trying to just get some sort of benchmark or beta or factor exposure, and then we've got this other part of the portfolio, which we're very happy to pay up for, that is giving us things that are really unique.

Wouter Klijn 15:14

Yeah, so as part of that, getting that clearer picture on the portfolio, and you alluded to this a little bit earlier, you've made some changes in the structure of the investment team, where you basically have now the asset class heads reporting directly into you. Can you tell me a little bit about the thinking behind that decision?

Simon Warner 15:34

Yeah, so you know, thinking about the key strategic challenges that we have, which is to perform in a competitive industry and to deliver at a competitive price. What are the key challenges, or the key, the key problems that you've got to solve for in order to deliver that? Well, it's delivering optimal returns for risk, it's delivering optimal returns within a liquidity constraint, and it's delivering, it's allocating your, your cost of the cost to construct your portfolio optimally, that was one of the principles around the organisational design. The second principle was a level of representation for major parts of the portfolio as direct report of the CIO, and thirdly, we wanted to create an environment where that leadership team did have a set of really diverse perspectives to solve the difficult higher order problems that we have, both as portfolio managers, but also as business leaders of the investments team, and so the key changes we made there were one to bucket infrastructure and property under one overarching organisational design, creating a lot of freedom within those to be this for the specialists to carry on being those specialists. So we have terrific sector heads across those three, and they are still responsible for investment performance within those sectors. It's Jenny's task to create an environment where the holistic is better than just the individual health. The second piece we did was to create a level of dedication and focus around implementing the portfolio as optimally as we can, so internally we call that implementation alpha. The way that that manifests itself in the organisational design is to create focus around liquidity and markets under Mike Clavin, so really, go against making sure that we are optimally implementing all the changes that we need in the portfolio, deploying cash when we can, minimising our cash drag, making the most of our balance sheet, interacting with the marketplace in the optimal way. You know that that's appealing to us, because it's it feels like lower risk and more stable sources of uplift, or at least avoiding slippage, seems like the first thing we should be trying to do. The second piece was creating a level of dedication around defensive assets under Sonia Bailey. You know that will be an increasing part of the portfolio as our member base ages, and we move more of our cohort into more defensive or pension-like options, and then finally creating public equities as a direct report of the CIO, you know, public equities is the biggest single source of liquid of capital allocation for the fund, it's the thing that drives outright performance the most, and it can often be one of the things that drives relative performance a lot as well, so having a direct line of sight was important for me there.

Wouter Klijn 18:22

Yeah, now before those changes took place last year, Aware Super also codified its investment beliefs for the whole team to have a consistent framework to basically follow. Of course, a lot of those things were already more or less informally ingrained, and it's sort of split out in four different parts. Some of it we talked a little bit about already: active management, the belief in active management, understanding risk, and getting compensated for risk, being a long-term investor, and operational sort of implementation. If you look at those ones, how does that sort of inform your investment philosophy today? Is that you equal weight those investment beliefs, or what is driving your, your investment philosophy?

Simon Warner 19:12

Yeah, so you know, one of the features of taking this, this role at this time is that I'm really lucky to be standing on the shoulders of giants, so I inherit a team that has been, that has been built over a long period of time by my predecessor, Damian Graham, and the leadership team are all people who were part of the team prior to me taking this role, and so I feel very privileged to have taken on a great team with great bones, and many of the much of the difficult building work of getting an investment capability off the ground has been done by the great people before me. So my core task is to try to optimise that that blessed position that I've inherited in terms of these investment beliefs. As you sort of allude, many of them have existed for quite some time, and there's quite a lot of flexibility to interpret those in a number of different ways, and to be honest, that was one of the features of creating them as investment beliefs, because we do believe that, as a, you know, as an asset owner, as a universal owner, but also as a team that has that internal capability, we not only have breadth where we are assessing the whole of investable universe, but we also have depth where we've got the top-down more macro decision-making capability, but we've also, at the coalface, got India, you know, stock selection capability in equities, for example, obviously across our private market suite as well, and so we want to create a set of principles that are fit for purpose for that whole canvas. It's not very easy, and we've complemented them, as I say, with a level of focus that builds, I think, upon some of the language around being clear about alpha and risk premia, about being clear headed about how we are getting the most for anything that is scarce, whether that's liquidity or fee or risk, and that over time I'm hoping and expecting will create an environment where we all talk the same language, but we are all empowered, like I say, within our own areas of domain expertise to really go off and get the best opportunities for our members.

Wouter Klijn 21:31

So, one thing that it doesn't talk about is internal management, and I think Aware is currently at about 30% of assets are managed internally. What are your thoughts about internal management going forward? Is there sort of an ideal number, a magic number? Is it a 5050 split?

Simon Warner 21:50

Yeah,

Wouter Klijn 21:50

What is your thinking there?

Simon Warner 21:51

I think in many ways it's a, it's a bit of a copy of before, so we, when I think about across the board, we've got the ability to deploy through third party managers or directly ourselves in pretty much every major asset class, so that that basic capability build has been done, and we're now in a privileged position to make a really informed and and discreet choice about under what circumstances, either within or across those that opportunity set, we're better off doing things ourselves versus giving it to an expert or an external expert. I suppose there are a few dimensions that that I try to bring, or we as a team try to bring to the table when we think about that. One is a level of humbleness around what our competitive advantage is as an investor in any given investable universe. What's our proximity to that investable universe? What's our kind of innate competitive advantage or edge versus other participants? So, you know, simplistically, I suppose Aussie dollar cash might be something where you think, well, we've got quite a high level of adjacency, but quite a high level of proximity, we should be able to think that we've got a similar information set to the very best actors in the marketplace, and so that's something naturally I think we could do ourselves, mostly same is true, maybe of core property in Australia, there are some other activities that we're either a long way away from the ground when it comes to what's being invested in, or the very nature of the activity is so diffuse and so also specialised that we've, it would be, it would be hubristic of us to claim to have kind of a natural competitive advantage, so you know, VC global VC, or global mid-market PE, just a huge and broad investable universe, you know, a lot of it, a lot of it, a long way away from where we sit for this conversation in Sydney, and the bulk of our team is still based in Australia, and so we've got a level of humbleness that that's something that we would prefer to partner with. Now, there's a whole raft of stuff in the, in the middle, so the other, the other spec, the other dimension that I would bring to that is the same as before, and that is, you know, again, I often come down down to infrastructure as an example, because it's just such a rich asset class that illuminates that it's not because it's always on my mind, it's just it illuminates a lot of these principles, you know. We would much rather, we would much rather, in principle, partner with an external manager and pay them really heavily aligned economic fees for an asset that's got lots of idiosyncratic risk that we can't access without them in principle, if we can access it without them, and it's largely beta or risk premia that we can get our head around on a desktop. We'd rather not pay that fee. We're not necessarily doing that to save outright cost from our current position, because I feel like we've got the ability to manufacture. The portfolio very economically, but it's about making sure that we're rigorous about allocating that scarce resource fees as optimally as we can. You know, we pay away a lot of money to external managers, and it's one of our core responsibilities is to make sure that those are allocated really effectively for the benefit of our members.

Wouter Klijn 25:19

Cost is always an important driver in that debate, but one of the benefits, as well, or one of the problems that you're trying to solve with internal management, also has to do around capacity constraints, and especially as the fund grows larger and larger and larger in places like Australian equities, it becomes increasingly more difficult to allocate in an active external way, are you at one point forced to just take on more internalisation?

Simon Warner 25:47

I feel like we're quite a way off. I think in terms of being able to get risks set in the market in a way that is manageable, is diversifying, and is accretive to the whole portfolio, we're not yet bumping up against some of those considerations. I feel like it's less of a, it's less of an internal external conversation necessarily than more being increasingly scientific about where capacity constraints might bump up against expected information ratios, and where in one particular domain do you hit a capacity constraint? I mean, the most obvious one, I suppose, in our domestic environment is it would be small cap equities, where you know to what extent is there a capacity constraint there, but that's that's the same philosophy I think we can apply elsewhere as well. At the moment, we're a large investor in the Australian superannuation context, but we're still a medium to large investor in the global context, and so there's plenty of space, I think, for us to grow.

Wouter Klijn 26:48

Yeah, yeah, fair enough. Talking about that international context, Aware has opened an office in London and made some commitments around deploying money there as well. I think the number of 10 billion has been thrown around, obviously. That is constrained by, you know, your fiduciary obligation to your members. It has to make sense. It has to stack up as an investment. But what is your, what is your idea about the role of these foreign offices to the fund and future plans to expand the footprint outside of Australia,

Simon Warner 27:23

So you know some of it interfaces with the question you just raised about about capacity constraints domestically, so I do think it is true that the system and ourselves as one of the larger investors will continually continue to seek pools of liquid capital markets where the liquidity is there for us to be able to deploy without so much cost, and so without so, so much consideration of capacity constraints, and so global allocations, I think, over time are going to creep up as we find the domestic market becomes more saturated. So that was a big reason for launching the London office with that we did about three years ago. We again are very blessed to have inherited a situation where that London office has been, you know, formed by two great leaders, Damian Webb and Jenny New March, who went over there and helped form that office, helped him help higher up the private equity infrastructure and property teams that are there, as well as the spine of support functions that we have in London. I think our task there, and that has yielded results already for members, so we're getting good pipeline. I feel like the Australian, the Australian investor base in general, is well thought of in Europe, and we're well known now as a cohort, so we're getting good access to, I think, we, as aware, are trusted counterparties and trusted, trusted co-investors, and so we're getting good access to good deals, and we're beginning to deploy, I think our task in the next two or three years, at least, is to consolidate on that, both from a business point of view as well as from an investing point of view. We are at RSAA, broadly speaking, in terms of most of our illiquid asset classes, so there's not the urgency that we've had in previous years, to get capital deployed, we're really thinking about optimising these portfolios from here on out. That's not to say that we can't add extra strings to our bow in London in the next few years. You know, there are some obvious areas where we think we might be able to put people on the ground there to give us better, better capability and scope for better, better outcomes for our members, but it's, you know, any business that makes its initial foray into a different time zone, into a different culture, especially, I guess, for us and our system, you know, we are in, we do have a unique ownership model, and that comes with it, a relatively unique culture as asset owners, as part of these bc entities that we spoke about before, as part of a member of profit for member organisation, you know, how do you create sustainability in foreign jurisdictions around the nature of who we are as an employer, of who we are as an investor, and the nature of our beneficiaries, who are very, you know, they're unique. Relative to others, and making sure that we really embed that in a sustainable way, we want to do that in a really considered and focused and thoughtful way. Now that we've now that we've built that office off the ground and up and running,

Wouter Klijn 30:14

So does that mean that you want to be largely maintain an Australian-based organisation with its staff, the majority still based in Australia, and I asked that in particular because you mentioned you might have to look beyond liquid assets within the London office, see what other opportunities are there, and obviously we have the example of Australian super having moved pretty much their entire global equity capability to London, building out an internal team there, is that something that's on the cards as well?

Simon Warner 30:48

So, you know, I think the fund is going to be around for 100 years, well past me, and over that period of time, it would seem natural to me that we become a more globalised organisation, it will be the decision, the decision rights of people who follow me, probably about the pace of a lot of that. I think my task in this, at this stage of our historical evolution, is to create a legacy of very strong foundations around how we take a domestic business and make it a global business. I suppose my perspective is that I think that that's not that is not a trivial task. It's a difficult task. It's a difficult task to thrive in environments that are not, not, not close to a home base, especially when you've got an organisational identity that is very much you, you know, I think that aware is aware as a profit for member Australian Superannuation Fund, and that makes it different from other investors and other employers in as we go into these other jurisdictions, you know, one thing I think that is non-negotiable in investing and in business more broadly, is real alignment with purpose and culture, and we need to be really clear that the alignment that we create around purpose and culture is really enduring in those foreign offices, because they come with enormous opportunities, but these, these initial forays, at least, when you're still forming and haven't necessarily been stress tested, it comes with some risks as well. It comes with risks around individuals, it comes with risks around around how you deploy. It comes with reputational risks that we might not have full visibility into at the moment, and so it's a careful, considered approach. But I think over the very long term, it's natural that we're going to be heavily, heavily populated with folks outside of Australia, just not in the next two or three years.

Wouter Klijn 32:47

Yeah, yeah, fair enough. That expansion is still sort of along the lines of super funds as basically managers of asset expansion, assets for members, but as funds grow and as we head towards more, more people shifting into retirement, the argument can be made that super innovation funds will have to become more like full service organisations, and sort of thinking about your background at A and B and at JP Morgan, do you think, do you see at one point, where super funds are no longer just investment houses, but become more, you know, fully vertically integrated financial services companies.

Simon Warner 33:29

Well, I think we are already vertically integrated in the sense that we have that direct relationship with our customer. What really differentiates us from other institutional investors, you know, sovereign wealth funds, European insurance companies, or the UK pension cohort, or the public schemes in the US, is that we do have that direct relationship with the customer. We've spoken about what that means for the management of the portfolio, but what it also means is something about the entity itself. So, at Aware, we've got, you know, 1700 odd people, about 10% of them work in the investment team. The rest of them are focused around the other activities of the fund, obviously administration, but also very much so around connectivity with the member base, about ensuring that they are, you know, well informed, well cared for, and that we're helping them with their journey through accumulation into retirement, as you say, and so in many ways to my eye we are already there. I wear different hats in this role in different contexts, but one of the hats that I'm wearing very frequently is as a member of the executive group. You know, I'm very lucky to be working for the best CEO in the industry, but we at the executive level have a, you know, we're not focused on the on only on the fund and on investment performance, we're focused on all sorts of other metrics around the health of the organisation and the benefit that we're delivering to members and the sustain. The long-term benefit that we're delivering to members, and so in many ways we're already not purely an investment house, we are a, you know, a member, a member service organisation that is obviously, we do know this sole purpose test that our core purpose is to deliver, deliver income in retirement for our member base, but doing that is not just about buying low and selling high, it's about creating the environment and the connectivity that we're assisting that group through not only accumulation into retirement, but then also as they go through retirement, how do we make sure that they're in a position where they're making the most out of their hard-earned money.

Wouter Klijn 35:36

And I think Aware also is unique in that situation where it said for many years a strong base in financial planners and employs its own financial advisors. Do you sort of do you get feedback from the member base on ways that influence the portfolio in terms of how they think about investment options, and you know what they understand of investing in how to translate in how you can communicate it?

Simon Warner 36:04

Yeah, well, you know, working as a, as an investor within aware, you know, one of the wonderful things is the connectivity with the end beneficiary. So, the end beneficiary for us in our situation is not, you know, a member number on a, on a spreadsheet, or it's not a, you know, a pool of capital that's for the benefit of a, of an, of an unnamed set of cohorts that are made many steps away from you. You know, we, we can hear about the human stories of our members on a daily basis, and we really go out of our way to expose ourselves to that, and we go out of a way, our way as an executive group to really share some of that, in terms of your question. Absolutely, we get, we get real, real time feedback on the way that we are performing, both, which we welcome, both in terms of our outright performance, our relative performance, but also the kind of way that we go about our business, you know, one of the things that we haven't articulated so far in the conversation is, is member expectations that are beyond that price and return target. There's also a general expectation upon our member base that we operate in an ethical way, and we do the right thing, acknowledging that the right thing means different things to different people, and on our member basis, 1.4 million Australians, and that represents the gamut, the spread, and a spectrum of opinion on on any matter we might want to put on the table, and so we're not in the business of of ethical investing, we're not in the business of aligning to an ethical framework, we are in the business of managing responsibly and managing to their long-term benefit, but fall short of, you know, some of the more active impact style investing that others do. Although there are parts of our cohort who would like us to do that, we're lucky enough to be able to provide investment options for them, which are a little bit more along that part of the spectrum, and so they're welcome to invest with us through those kinds of options, but we've got to be respectful for the for the big lump of co of members who are not daily engaged in their balances or the way that we're operating, and we're doing the right thing by them as well.

Wouter Klijn 38:18

Yeah, yeah, so we started this interview discussing your very background in equities and fixed income, and even sort of the hedge fund type strategies. If you look back across sort of the very different organisations that you've worked for, are there any lessons learned that you could share with our listeners?

Simon Warner 38:38

What I mean, I again, I would lead with I feel remarkably lucky. I feel remarkably lucky for the organisations that I've worked for, and remarkably lucky for the people that I've worked for. You know, the very best organisations and the people that I've worked for. It's been, it's been a real alignment of culture, it's been an alignment of personal development, it's been an alignment of principles to me. Those are really sacrosanct. I think I've been given, you know, I owe a lot to Mark Beardow, my first boss at AMP Capital, in one specific professional way, and then one personal way, which I'm also happy to share, but his level of rigour around an investment process, articulating an investment process, making your investment process a perspex box that you can describe to yourself, that you can describe to other people around you, and that you can sub, you can describe to people who will occupy your seat into the future creates a lasting legacy for the organisation, and creates a lasting asset for the organisation, and that's one of the primary things that we're tasked with doing, is not just delivering returns today, but institutionalising the way that we operate into the organisation, not so that the way that. Operate today can persist forever, but so that you've got a framework for improvement, for improving it, and enhancing it. And Mark really, really drummed that into me. The other thing that he drummed into me was a level of humanity and a level of care for me was I was going through difficult periods in my personal life, and he was always there for me. And through those sorts of experiences, you, you know, you really breed loyalty and more, even more motivation.

Wouter Klijn 40:26

Yeah, Mark is a great guy, and I think a lot of his background has dealt with investing in sort of an insurance context, which, of course, places a lot of emphasis on risk management. Has that sort of influenced you?

Simon Warner 40:39

Yeah, that's right. I mean, so, so that time I spoke about when I was with First Chemical Bank, then then Chase, and then JP Morgan, you know, the in that sort of very liquid, very fast moving, you know, more dynamic hedge fund space. Frankly, I found that very difficult. You know, I think that that is a very difficult task within, within of the spread of things that you could do in financial services, trying to figure out where interest rates and currencies are going. You know, the most highly arbitrage markets in the world is not an easy task. It forces you to be really rigorous about the way that you're thinking, and it forces you to be really rigorous about risk management. Interplaying with that, it forces you to be really rigorous about your own personality and how you create an approach to your task of investing that is congruent with who you actually are, what your risk tolerance is, and what your strengths and weaknesses are, and be really scientific and open about that. There's just not a lot of room for ego in that space. It will find you out very, very quickly, you know. Mark really embedded that into me as well, and I, like I said at the start of the conversation, I really hope that's one of the things that I've brought to throughout my career is a real focus on thinking about our role, whether it's if you are a trader or if you are an investor, the thing that you are as well is a risk manager, but that's the core lens that you should bring to the task of your role every day, in terms of deploying the capital in the portfolio,

Wouter Klijn 42:03

So Mark was one of your mentors. Do you try to fulfil that role for others within Aware? Do you have sort of a more or less formal structure for trying to develop mentorships?

Simon Warner 42:14

So you know one thing he was very good at, and then my final boss at ANP Capital Adam Tindall was just a master at it was, how do you, how do you toggle between being a teacher, a coach, and a mentor, stroke sounding board, maybe just a sympathetic ear. It's easy to drop into one of those roles, but being that the right persona for the right conversation at the right time is is extremely important. So, I had an early boss today at Chemical. He was very supportive and a total expert at what he did, but he was completely hands off, right? He was like, 'You go away and the best way for you to learn is to make your own, your own mistakes. I think, in hindsight, I would have probably preferred him to be more of a teacher than a coach. At that stage in my career, I needed somebody who said, 'Look, this is the way I do it. It might not work for you, but this is the way that I do it, in specific detail, and I encourage all of the folk on the investment team to be that person in some circumstances, then in other, in other circumstances, you're going to be well, look, this is the way that I would, I have approached in the past, it doesn't seem like it maps directly onto this situation, and indeed, you know, my, my approach is probably stale relative to the way that you could perform it, these are some of the principles you might use. I'm here to help you assess whether what's good or bad. I'm here to coach. And then there's the other end of the spectrum, where you're, you know, you're the psychologist or the sounding board or the mentor, if you like, where you're there to help create psychological stability within the person to be the best that they can be, because it's a hard game, isn't it? It's a hard game because you can't be blind to investment performance, that's ultimately what you're here for. And there are a cohort of members in our case who does, who do deserve and demand us to be delivering returns for them, and yet, if in investing you are focused on returns, you will lose the game. You have to be in a, in a position where you're relentlessly focused on the method, that relentlessly focused on the process, relentlessly focused on your inputs, acknowledging that in many cases that is going to lead to things that you regret doing, you know, if you're not making investments that don't go 100% according to your, your preconceived plan, you're probably not doing enough, you know, and even if you're even if you've got a perfect, a perfectly conceived investment pro. Process, it's going to be wrong a lot, and how you create an environment where you're able to manage that specifically within the portfolio, specifically within an asset that you manage, but vitally within yourself. How are you able to create a level of dispassion and detachment that's not at the expense of some of the gut feelings that we all have. I'm not suggesting we become automatons, but I am suggesting you need to create an environment where you are turning up to be your best every day, and that is a unique question for all of us. You know, some of some people just kind of have it, don't they? Some people, and I would, I would confess that I was one of them. And when I was younger, I would, I would feel my mood, my heart rate by my P and L, and that is not a sustainable position to be in to make good decisions. And so, so a large part of my job now is is to create, making sure I'm creating those environments where not only the leadership team but everybody in the team has that psychological stability to be their best.

Wouter Klijn 46:12

It's interesting that you say that, because we had a discussion here at [i3] in the last couple of months about the role of a CIO: are they still investors, or have they moved on to become more managers? Yeah, it seems that you're thinking about that same sort of sort of plan, where you're basically moving more towards the management style rather than a pure investor.

Simon Warner 46:34

Yeah, so you know, I don't often have conversations with people that last more than half an hour, I don't start bringing up movies, so I do think that the role of a CIO is sort of akin to a, it's sort of akin to a director, where you do need to have some level of consistency of vision and consistency of what you're trying to achieve, but you've got to have the light touch that allows that acknowledges that the task is extremely specialised and probably becoming more specialised as we speak, and that the worst possible thing is for a generalist to come in and try to replicate or second guess a specialised task, and so what I'm trying to do is do both of those things at the same time, me with the leadership group creating a level of consistency about what we're trying to achieve, how we show up, what we really believe in, what are the key principles that we really believe in, and what's our intent here. We're not, we're not acting without intent, but we're acknowledging that the extremely diverse and specialised expertise that we have here on the floor, and then one level of separation around where we go down into our manager base, we're in the privileged position to try to maximise that, not to go in and question it, and not to go in and try and try to replicate that level of specialised knowledge, but not to disempower you by, you know, fall into the trap of being disempowered. You've got to have your hand on the tiller, and you've got to know the direction you're sailing, but you can't make every call.

Wouter Klijn 48:12

Yeah, yeah, fair enough. So, CIO is a movie director.

Simon Warner 48:16

Oh, don't, don't quote me on that. Come on,

Wouter Klijn 48:17

You're on the record. I think that's a good title for my next project. Simon, thank you very much for your time. I see we've run out of time, but thank you for your insights, and it was great talking to you.

Simon Warner 48:31

Thanks a lot. I really appreciate you, and I appreciate everything that you and [i3] do. You play a really important role in our community, so thank you very much.

Wouter Klijn 48:38

Thank you.

In this special episode of the [i3] Podcast, we're partnering with the University of Technology Sydney for the Circle the Square roundtable discussion. Today's topic focuses on environmental risk and the repricing of stability. For most of financial history, the environment was treated pretty much as a given, stable enough to model around, reliable enough to insure against, and predictable enough to build on, but that assumption is now under pressure.

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Key Takeaways

• The foundational assumption is breaking. Finance, insurance, and infrastructure planning were all built on 12,000 years of environmental stability. That stability can no longer be taken as a given, which undermines actuarial models, long-duration asset valuations, and infrastructure design.
• Insurance is the canary in the coal mine. Insurers were among the first to feel climate risk directly through claims. APRA has flagged that one in four Australian households may soon be unable to afford home insurance — effectively making the taxpayer the insurer of last resort.
• Disclosure isn't the same as resilience. Reporting frameworks like TCFD are a useful starting point, but simply mapping risks doesn't mitigate them. True resilience requires collective, systems-level investment — not just individual firm-level action.
• Short-termism is a structural problem. Pension funds have long-term liabilities but face peer-comparison pressures that punish near-term deviation, creating a mismatch between the time horizon of the risk and the incentives of the managers.
• The Monday morning question: Are the assumptions underlying your portfolio — on insurability, asset longevity, and gradual linear change — still valid, or are you already running on outdated models?

Speakers

Martina Linnenluecke, Director, Centre for Climate Risk and Resilience, University of Technology Sydney Kristy Graham, CEO, Australian Sustainable Finance Institute Rob Prugue, Lecturer, University of Technology Sydney, Anchor Fund Wouter Klijn, Host, [i3] Podcast

Overview of Circle the Square podcast

06:00 The world has seen a stable climate for the last 12,000 years. What happens when we move into a new regime? "We've assumed that environmental stability was a freebie, but the last 20 years has shown that is not necessarily the case. And the markets are beginning to take notice." 09:00 "Climate and environmental risks are no longer abstract externalities; they are felt across sectors." 11:30 We are seeing that in some countries, climate change is factored into infrastructure planning. Does that happen in Australia? No, but it should 13:30 "Climate science has become a political debate. As a result, policy is set based on the political climate not the science itselft." 16:00 We are seeing increasing standardisation of tools or frameworks across asset classes and providers and that matters because it enables you to look across your portfolio 17:00 "It often starts in an ESG function, which develops a centre of expertise, but in the organisations we work with now it sits right across the whole organisation." 24:30 There seems to be a disconnect between the way in which the investment industry assesses climate risks compared to how climate scientists assess it. "We do see more sophistication around how scenario modelling is used. But there is certainly a communication issue" 25:30 "It certainly is not just a temperature increase; it is a much broader, systemic issue." 29:00 "For a pension fund, to walk away from your long-term liabilities when it comes to climate risk doesn't really add up." 35:30 "APRA is concerned that one in four households will not be able to afford insurance in the future. In coastal towns, it is 50 per cent." The rise of insurance deserts 37:30 The silver bullet is building models that support resilience, rather than the current model, which is disaster recovery after an event has occurred. 50:30 "We don't have DCF (model) for opportunity cost"

Full Transcription of Episode 136

Wouter Klijn 00:00

Welcome to the i3 podcast. In this special episode, we're partnering with the University of Technology Sydney for the Circle the Square roundtable discussion. Today's topic focuses on environmental risk and the repricing of stability. For most of financial history, the environment was treated pretty much as a given, stable enough to model around, reliable enough to insure against, and predictable enough to build on, but that assumption is now under pressure.

Environmental risk is moving through the financial system in a way that is becoming harder to ignore. Insurance premiums are rising and cover is narrowing. Infrastructure built to last decades is now decommissioned ahead of time, and capital is being asked to fund a transition whose policy settings keep on changing. So, this is not an ESG conversation. It's a question about the structural foundations that finance has always taken for granted, and what happens when those foundations start to reprice.

Today we have three speakers who are well placed to assess where the pressure lands in this discussion, who absorbs it, and what the response could look like. We have Martina Linnenluecke, who leads the Centre for Climate Risk and Resilience at UTS, and has spent a career examining how environmental change reshapes companies, industries, and financial markets. She was also a key contributor to the Intergovernmental Panel on Climate Change's sixth assessment report.

We also have Kristy Graham, who is the inaugural CEO of the Australian Sustainable Finance Institute, an independent body that works with Australia's largest financial institutions to realign the finance sector and ensure capital flows to activities that will create a sustainable, resilient and inclusive economy. Kristy, I think you were also involved in the establishment of the first Australian Government Impact Investment Fund.

And, of course, we also welcome back Rob Prugue, who is honorary industry lecturer at UTS and one of the driving forces behind the UTS Anchor Fund, an educational investment fund managing real money managed by students. The question we're here to explore today is, what does finance do when the assumption it was built on is no longer holding? Rob, maybe I can ask you to set the scene.

Has environmental risk moved from externality into something that investors now have to price, underwrite, and perhaps insure? What do you think?

Rob Prugue 02:37

Thanks, Wouter. And thank you for this opportunity.

I guess, like the rest of us, I too have been wondering for quite some time now about the impact on the environment, not just in my everyday life, but as an investor thinking about capital markets, pension funds and superannuation, and how they manoeuvre around these highly heated discussions around environmental science.

What triggered it for me was some years back when I did the Camino de Santiago, and had the good fortune of meeting many people, one of whom was a professor at Oxford, a palaeontologist and climatologist, which is an interesting mix.

Naturally, it raised a few eyebrows, and I asked, "Please explain." He said, "Well, we study the environment through studying Earth's history," and he reminded me that, of Earth's 4.5 billion-year history, roughly the last 12,000 years have been the most environmentally stable, and humanity, as we know it, thrived and flourished under that stability.

Of course, we had storms, of course we had volcanoes erupting, of course we had floods, but for the most part the environment and the seasons were predictable. That allowed farming, agricultural growth, town growth, and a level of prosperity that humanity had not necessarily seen before.

So that got me thinking. If that's true, what happens if we start moving into a new regime, and how will we adapt? We're so accustomed to that stability and predictability that it flows through everything from actuarial science and the pricing of insurance products through to assumptions on long-duration real assets. The generator is going to be there. The airports are going to be there. The assets are not necessarily going to be damaged in ways we haven't priced.

For many decades, if not centuries, we've assumed that environmental stability was a freebie, a free get-out-of-jail card. The last 20 years, or even 15 years, has shown that is not necessarily the case.

So, while politicians and others debate the science behind environmental science, there are movements afoot. The markets are beginning to take notice.

Wouter Klijn 05:22

Yes, Martina, if I can move to you, do you already see a realisation of this entire strategy and potentially more on the operational side of businesses?

Martina Linnenluecke 05:35

Yes, I think we are definitely seeing that climate risks are increasingly factored into decision making, and the science is clear. We are going to see very fundamental changes in environmental conditions. We are going to see massive shifts in temperature. We are going to see changes in extreme events, which are going to be very impactful, and in the conversations that we have with leaders in industry, we can definitely see that these risks are already felt.

Certainly not across every sector to the same degree or extent, but we do see that some sectors are starting to be very concerned, especially when we look into changes in extreme events and how that affects everything from supply chain, cash flows, asset values, insurability, financing costs and operations, but also strategic viability.

So, there's now a real question around where should we invest, how are we investing, and what can we do to protect these investments in the long run. In many sectors, especially those with long-lived assets, these are very difficult considerations, because some assets have lifespans of 30, 40, 50 years. We can't just go in and replace all that infrastructure all at once. That also means it's very important at this point in time to really see how we can make those decisions going forward, so that they last us for the next 20, 30, 40 years, in a way that is climate adapted.

So, from my point, climate and environmental risks are certainly no longer abstract externalities. They are felt increasingly across sectors, they're already impacting strategic decisions, or have at least started to in many sectors, and we also see that these risks are becoming more visible generally across our communities as well. Examples include flooding, bushfires, and heat stress. In particular, we're getting more and more days with extreme heat.

We see supply chain disruptions as a result. We see water insecurity concerns, also around food supply and food supply chains. But that's only the impact side. Then we also have the transition risk on the other side. What's happening in terms of changes in regulation and technology is certainly very impactful in some sectors as well.

In Australia, now we've got mandatory climate-risk reporting, which to some extent is more of a reporting than an adaptation exercise. But I think it is definitely raising awareness that there are physical risk and transition risks coming in. In other markets, we already see carbon being priced in, but also investor expectations are changing. So, yes, we see that these environmental risks are starting to become more visible, and they're starting to be integrated. Environmental change is definitely starting to matter from an economic perspective. But in particular at this point in time, the question is also, how can we adapt to these changes, and adapt to them in a way that makes sense, while factoring in the very significant environmental changes that we're seeing.

Wouter Klijn 09:01

Yeah, so you mentioned that some investments have longer term horizons, 30 years. What does that mean when you look at it by asset class? Infrastructure often has a very long lifespan. You can take that both ways, either, well, we won't divest from this investment for another 30 years, so we have time, or you can think, well, we're going to hold this for 30 years, we have to start now to understand what's happening to this asset over the longer term. Do you see any approach to that?

Martina Linnenluecke 09:33

What we definitely see is that in some countries climate change is very much factored into infrastructure planning. So when infrastructure is built now, there needs to be a provision, for instance, for sea level rise. When we look at road infrastructure, bridges, especially in exposed and vulnerable areas, they are being built with a certain consideration for flooding, for sea level rise, and for other types of extreme events. Has that necessarily happened here in Australia? Perhaps not.

Should it? I think so. But that includes every type of asset that is longer lived. We've got power stations, transmission infrastructure, transportation infrastructure, road infrastructure.

Even things like housing are also, I think, a very big area where we need to see changes in climate adaptation happening as well. A lot of the housing stock that we've got here, when you look locally here in Sydney, is not really adapted to climate change. These are not really infrastructures that are built for a changing climate, so I think there's a lot of work to do. The smartest way would obviously be to start factoring in these decisions right at this very moment, so that we are not unprepared 10, 15, 20 or 30 years down the track from here.

Wouter Klijn 10:55

Yes, it's a very sort of, I think, already tangible issue, because I was just reading an article about Tuvalu, and they have one international airstrip, and they're trying to raise the land around it, because it's already being affected, not just from high tides, but also from water coming in from the ground because of the rising sea levels.

Rob Prugue 11:16

I know that well, because I was meant to be in Kiribati as well, and Kiribati and Tuvalu are going to be among the first climate refugees. But that aside, in long-duration assets, particularly real assets, there's another factor above and beyond what was just mentioned, and that's policy.

For some reason, in the last 10 or 15 years, science has become a political debate. We see that in health science. We see it in economics as well, including the idea that tariffs are somehow a straightforward revenue earner, which contradicts what we know. The same is true in environmental science. Policy settings can now change depending on the political agenda, not necessarily on the science itself.

Generation is one good example, whether it's coal, gas, nuclear, solar, or in the case of the US, wind farms that were nearly finished and then became too green, so let's turn it all off. Policy is another situation that needs to be considered.

Wouter Klijn 12:35

Yep, for sure. Kristy, if we may turn to you. You speak with a lot of the financial institutions here in Australia. Do you see them starting to build tools and frameworks around this problem?

Kristy Graham 12:47

Yeah, absolutely. And I would add that it's not new for the finance sector to be thinking about and integrating some of these environmental risks. Just this morning I was at the 20th anniversary of the UN Principles for Responsible Investment, so that is an initiative that has been going since 2006. It now includes in its signatory base over half of the assets under management globally. So it is not just the longevity of long-term investors thinking about and integrating these issues using a range of tools, but also the uptake, particularly in the last five to 10 years, and the penetration right across the financial system.

I would say insurers have also been very acutely aware of these physical risks because it impacts very directly on their business models, and banks are increasingly recognising and using a range of different tools and approaches. Where we've got to now is that there are industry-wide standard tools and frameworks, which is very helpful, because previously you could assess transition risk or physical risk in a range of different ways, and it depended on the advisory firm or the expertise you were able to have access to.

What we saw with global frameworks like the Task Force on Climate-related Financial Disclosures, and now the ISSB taking up those standards, is that there's a much more standardised way that not just investors and the finance sector, but also the corporate sector, can use to assess and mitigate the risks, but also identify the opportunities. The finance sector are obviously aggregators of information from the real economy, and that consistency and standardisation really matters, so that you can aggregate and look across your whole portfolio. We're not only seeing standardisation of the tools and frameworks, but also a much more sophisticated way of applying them and taking decision-useful information to inform strategy and the future direction of these institutions.

Wouter Klijn 14:45

Yeah, we started in the beginning by saying this is not an ESG conversation, this is a much more systemic financial stability discussion. Do you see this as well in the way that organisations approach this? Is it very much like these are a series of ESG tools or ESG framework taxonomies, or is there more a growing sense that this affects everything we do throughout the organisation?

Kristy Graham 15:12

I think what we're seeing, as organisations become more mature in their understanding of the commercial realities of all of these risks, is that it becomes integrated into core business, whether that's investment teams, risk teams, product development teams. So we see in lots of the organisations we work with that it will often start in a responsible investment, sustainable finance or ESG function, and they will develop a centre of expertise. But where lots of the organisations we work with now are is that that's integrated right across the organisation. Its reporting might sit under the CFO or the finance function, but there are inputs and expectations that the investment teams and right across the different product teams will all contribute to both mitigating risk and identifying opportunities.

Wouter Klijn 16:02

Yeah, now environmental risk doesn't fit neatly into financial models. I was thinking we had one time a conference where somebody stood up during one of these discussions about environmental risk and said, well, one of the reasons why it's hard to deal with is because it's an unaccounted for risk. We don't really know how to incorporate it into our system, and that has to do with different sets of information out there, no standardisation, but also because when you model this out, there are a lot of assumptions that you have to make. These are long-term trends, very far into the future, and it made me think, I was talking to Rob about it, Peter Drucker, the management consultant. He said, "What gets measured gets managed." He didn't say it exactly like that, but close enough. And this is hard to measure. Maybe, Martina, I can ask you, is it possible to build a comprehensive framework around this in a way that is easier to deal with?

Martina Linnenluecke 17:03

We've definitely seen the attempt to build a framework with the TCFD recommendations, and now also the adoption of climate-risk reporting here in Australia. I think that's provided a starting point. Organisations are exposed to different categories of risk, and they are guided through a process to assess those risks, looking at physical risk, transition risk and other risk factors.

Importantly, it also changes the outlook towards the future. This reporting is no longer about past performance and past financial risk. It's really about assessing what is going to happen going forward.

How does our exposure look when we factor in different climate scenarios? In my view, this is the most interesting part of the reporting exercise, but also the most challenging to implement, because it requires a lot of expertise in understanding climate risks and modelling. That is not necessarily expertise that has traditionally been held by companies, or traditionally factored in.

There's still a lot of sense-making going on around how best to do it, and a lot of uncertainty around how to make scenarios that sometimes seem very abstract more tangible. How can we operationalise them for the company? What do they mean for specific sectors, locations and assets?

There are all sorts of different ways to downscale them, but more importantly, it is forcing exposure to a changed reality. We no longer have business as usual. There will be a different reality, and the question becomes, what does that reality look like?

The impacts will be felt differently across sectors, firms and locations, based on exposure, operations, infrastructure and indirect exposures such as energy costs. So there is definitely a lot to think through. It really requires an understanding of future change, and how future change is going to have consequences.

There are indicators that companies can now use to report, and under the current reporting structure there are categories that need to be reported on. But in my mind, the interesting part is where we see that there's still a lot of expertise needed to fully engage with future scenarios and what they mean.

There is uncertainty in these scenarios, which obviously we have to acknowledge, because the scenarios are not a given. They are changing as we are changing as a society as well. Factoring in different types of policy changes and different types of physical risks will lead to different future scenarios. Sometimes it's confusing when it comes to selecting the best scenario, and there is not necessarily one best scenario to select.

That creates uncertainty around what future we should look at or prepare for. But again, it forces exposure and engagement with a changed future. It also requires companies to think through how to address it. For instance, two firms may disclose the same type of exposure to heat or extreme weather, but ultimately it comes down to who has the operational flexibility, resources and capital required to adapt. In my mind, those are the interesting questions that we get into with these types of reporting exercises.

Wouter Klijn 21:25

Yeah, so a while ago I looked into the criticism around integrated assessment models and the tendency to look at a very isolated environment and not necessarily take into account trends that move across countries, across jurisdictions, and it struck me that when I looked at the literature that's out there from climate scientists and the way that the finance industry incorporates it is quite different. To give you a tangible example, I've looked at a couple of superfund reports, and they do these scenarios where they say, okay, this is the impact on our portfolio at two degrees, three degrees, four degrees, five degrees, six degrees, and even I think at six degrees it was like, ah, we think it's about 1.2% lower than what it is now. Then I showed it to the climate scientists, and they were like, at six degrees we're dead. So there's a big difference in how they deal with these forecasts. Is there any improvement on that, or what do you think about that?

Martina Linnenluecke 22:26

Yeah, look, I think sometimes the scenarios that we see coming out from the sciences are used in a very instrumental fashion when they are incorporated, like you just mentioned, in a report, in a straightforward way, without looking at the bigger picture behind it. We do see more sophistication around it, which is part of this evolution in how companies are engaging with climate risks and future scenario analysis.

Part of the issue is that these fields have traditionally not really connected to each other. Climate science was never started with a view towards informing finance, and finance was never started with a view towards needing to be informed by climate science.

So, there's definitely a communication issue at the intersection of these fields. But there's also where people like myself come in, with the work that we are doing within the Centre for Climate Risk and Resilience, where we are really looking at ways to communicate those risks, visualise them and make them tangible. The point is to bring them to life rather than have them remain an abstract risk that is just factored in as a number in a modelling exercise.

It is definitely not just a temperature increase. It is a very systemic, comprehensive change that we are going to see, affecting all levels of society. If we've got a six degree rise, just to take your extreme example, here in Sydney, there will be parts of Western Sydney where areas might become uninhabitable, or where it will be very challenging to provide enough cooling and shade in some communities. So all of that creates a much bigger systemic issue.

Water stress, how do we get enough food on our plates under such a scenario, and other risks like that. I think the systemic nature of the risk is a really challenging part to fully incorporate and fully understand, but I think we need to engage with those questions.

Wouter Klijn 24:37

Yeah, and Kristy, what efforts do you see to convert these types of risks into action?

Kristy Graham 24:43

Yeah, I think this point that you were making, Martina, about the capability that is needed, and that being probably developed in other disciplines, is something that we work with across the finance sector quite a lot. There's a multidisciplinary approach that is needed for financial institutions to understand these risks, to make sense of them, and to apply them in a business context as well. So we see that being a huge unlocker of not just better mitigating risk, but also capitalising on those opportunities, and being able to forecast, not predict, but to look at the range of potential future scenarios and what that would mean for business models and strategy.

At that point, what we do see, and this is across business and finance, is people, because they don't necessarily have the technical capability, find tools and frameworks that make it very clear what and how you need to do as a base level. That is really important and a really critical way to get started in better understanding these risks. As I said, the tools and frameworks are growing, both in sophistication, but also importantly moving from a risk to an opportunity lens, and that's where taxonomies come in place. They identify what sorts of investments and economic activities will support the climate transition.

So, rather than needing to understand how different sectors may evolve, and crunch all the science on an individual investment level to see whether a particular technology or activity will support the climate transition to net zero, a taxonomy outlines those activities and measures, so that it's much easier for capital to flow towards those measures that are supportive of the transition. And we see now the taxonomy being adopted across the market.

I think we're up to the sixth or seventh taxonomy-aligned transaction in the debt capital market space, and a number of sub-sovereign, as well as bank sustainable finance frameworks, are now aligned with the taxonomy. So, it is something that the finance sector both supported the development of, and now is finding really useful as a tool.

Rob Prugue 26:57

Yeah, what I don't understand, because I've heard that before as well, Wouter, is that other than maybe endowment funds, pensions have a long-term liability that we're trying to immunise. So, by definition, we have a long-term outlook. Some of the biggest investors in unlisted real assets are pension funds, because they say we like the long tail of it, and it matches our liability. So to then walk away from the long-tail implications of the environment doesn't really quite add up.

I'm not really sure about that. Secondly, I think we need to differentiate between inputs and outputs. The output is that we're seeing the numbers firsthand because many super funds are large investors in insurance companies. Even catastrophe bonds are now an asset class that they're looking to invest in, so they are investing in these asset classes. They have access to this information. Whereas the data may be difficult to model, not trying to model it or understand it is an active bet. It's an active bet that may or may not pay off, but if you look at the numbers, it probably won't pay off.

Lastly, I think it's true that most boards and ICs don't necessarily understand the full implications, and I respect that. But do they understand the billions of dollars going into data centres? Do they understand what the payout is going to be? Do they understand that the shelf life of many data centres is five years, yet the amount of money required to build them runs into billions?

So the irony is, we have a long-tail outlook, we invest in long-tail and long-duration assets, but when it gets complicated, even though the numbers are right in front of us, we claim it's too difficult and put our arms in the air. That's where I would challenge trustees and IC members.

Wouter Klijn 29:03

There is that inherent tension between the short term and the long term within the finance industry, because you obviously saw that when Russia invaded Ukraine, there were a lot of funds here in Australia that had moved to low carbon indices as benchmarks and got hit more severely than other funds, and that caused a little bit of a rethink with some of those funds. So you will have these types of points during the next couple of years as well. How do you deal with that short-term tension where we have to be the best fund over the next five years versus the longer term systemic issues that this is referring to?

Rob Prugue 29:46

Complete mismatch, and it starts from the top. You've heard me numerous times bickering about heat maps, where it's a race to the middle, where if a pension fund moves in a certain direction, and for a short period of a long-duration portfolio objective it is not meeting that relative to peers, they get penalised. So what almost requires, in your example, is everyone has to do it, so therefore there won't be financial consequences and regulatory consequences for veering into something that's in front of us. The regulatory system around many super funds requires all or none, that everyone has to move in that direction. To do that in the world of investments, where there's always a buyer and always a seller, is very challenging.

Wouter Klijn 30:46

You brought insurance up with catastrophe bonds. I think we've seen some of the insurance companies becoming probably first aware of climate change and the impact on their business, just by the nature of it affecting their claim experience, and affecting how they price their coverage. But ultimately they can't carry all of the risk, and that will filter through at the same time. Some insurance might become impossible, and I think it's sometimes said that for any economic activity to occur, you need to have insurance first, otherwise nobody's going to take any risk. How do you see that moving when environmental risk becomes too much for insurance companies to carry, and it filters through? Does it filter through to other companies, to members? What do you think around that?

Rob Prugue 31:35

Well, let's look at insurance and why it exists in the first place. It takes away the sting of the unexpected. If we date back to insurance roots, or Lloyd's and shipping, through to modern day, as investors, as lenders, obviously we want to know that there is an exit where a return is not only generated but at least the capital is returned.

The reality, though, particularly with insurance, is that while politicians debate the science around the environment, right beneath them is a situation where households are feeling it immediately. Ask any household what their home insurance was five years ago versus what it is today.

APRA itself is concerned that in future, one in four households may not be able to afford insurance, with some rural and coastal communities facing even higher pressure. So who insures these homes? Who insures these farms? Who insures these businesses that exist up and down? We know here in Australia, 90% of our population live within 100 miles of the coast. I think it may be even higher than that, but regardless, we are a coastal community.

Whether we're talking floods, bushfires, or any other type of environmental damage, these rural communities are feeling it immediately. The challenge, however, is that even though we see these numbers, it's become politicised, where the rural community is now concerned about sustainability of their livelihood. I'm not talking about their actual homes or businesses, but employability. Whether there's an affront against carbon energy, whether it's coal mining towns in the Newcastle area, or whether it's LNG in WA, these communities are very vocal about climate issues, and politicians, particularly populists, are grabbing into that.

Regardless, insurance is an environmental risk that has now become an input. It's now visible. It's not just visible in portfolios, it's even more visible in households. And so now we need to understand that insurance affordability is creating these insurance deserts where people can no longer get insured. Do we honestly believe that the government will let these people go uninsured if a catastrophe occurs? If not, then the ultimate underwriter is the taxpayer.

And before anyone gets overly up in arms, we've handed out more billions to corporations that were on their knees because it was necessary, so-called. Ask yourself that same question. When a large portion of rural Australia is unable to insure themselves, who is the ultimate underwriter of that insurance package? It's you and me.

Wouter Klijn 35:10

For sure. Kristy, when we talk about insurance, it's more or less like an expectation that an event has occurred, and insurance is dealing with the aftermath of that. How do you look at models that firms come up with that try to anticipate these things from happening and potentially direct capital towards mitigating these risks?

Kristy Graham 35:36

Yeah, and I think that is the absolute silver bullet in this adaptation resilience space, shifting the investment to build resilience in advance rather than the current model, which is supporting disaster recovery and rebuilding after an event has occurred. Governments have that model of funding as well, and that is the insurance model. That said, a number of insurance companies are working much more proactively with their customers to support them to build resilience at the household level, but there's still a lot more that can be done in that proactive space.

There's been lots of research that has demonstrated the economic payback of that. For every dollar invested upfront, you save $9.60 in recovery costs. The Australian government is already spending 38 billion annually on natural disasters, across governments in Australia, and that's projected to go up to 73 billion a year by 2060 if there's not a huge amount invested up front in adaptation resilience. So the numbers are very clear and compelling. There's a range of reasons as to why that value is not able to be captured in investment models at the moment, and why it's difficult for both governments as well as private businesses and investors to make that case for those upfront costs and expenditure. That said, there's a range of things that the work we've done with other players right across the finance sector shows will help to shift that dial.

One is around valuation approaches and frameworks, and the Actuaries Institute has done a huge amount of excellent work on the relatively small tweaks that you can make to the way valuation frameworks that the public and the private sector use to shift that business case, to make it much more compelling to make the investment upfront rather than the recovery investment.

The other issue often with adaptation resilience investment is the benefits or the avoided losses don't necessarily accrue to the same actor that is making the investment upfront. So if you're investing in community-based infrastructure, a local council whose source of revenue is from all ratepayers, there will be only a certain small portion of those ratepayers that will benefit in terms of reduction in their insurance premiums, for example, those that are most flood affected if it's flood resilience works. So there's a range of interesting models that are being used internationally to try and use various different structuring approaches and multi-stakeholder collaborative co-design processes, so that you can solve some of those issues.

The other issue often is that there are projects at small scale, and so for a commercial investor, that's not necessarily at the scale or the aggregation that makes it attractive for them, and they're not always able to capture the commercial benefits. Again, structuring and project preparation facilities can support with that, and blended finance is another approach, where it's combined public and commercial capital, so that you can put those investments at a risk and return that's acceptable to a commercial investor over time.

Wouter Klijn 38:53

Yeah, on this list is also adaptation finance. What's that?

Kristy Graham 38:58

Yeah, so all of those models that I was talking about are a version of different types of adaptation financing structures. There's also when you've got existing assets and you're a long-term investor in an existing asset, increasingly those equity holders are seeing value in improving the resilience of an asset to reduce operational expenditure over time, particularly when there is a disaster. So, there's a number of fund managers and others who very actively work with their assets, whether they sit on the board or they're a minority shareholder, but a significant shareholder, to improve not just the understanding of the risk but to invest capital to improve the resilience of those assets, which will over time reduce operating expenditure and insurance premiums for those assets.

Wouter Klijn 39:47

Yeah, Martina, we often talk about disclosure is not the same as resilience. You can show where all the risks are, but what are you doing about it? Can you tell me a little bit from your perspective, what does real resilience look like?

Martina Linnenluecke 40:02

That's a big question. I'm not quite sure if I can answer that in the time we've got available, but I'll try. When we look at resilience, and I've done a lot of work around resilience, there is this common understanding that there is a negative impact, be that on a company, on a household, or on some other type of entity, and then the effort is always to go back to where we used to be, to bounce back to previous conditions. That is what we typically understand as resilience.

The challenge with climate change, or the added challenge we are now facing, is that simply building back to where we used to be is often not the answer anymore. For example, when communities are flood affected, there has been a negative impact, and if this community builds back in exactly the same way, it could be seen as resilient, because we go back to exactly the same state we were in. But that is not really creating any type of risk mitigation or insurance against future events.

If we're exactly in the same position, exactly in the same spot, doing exactly what we used to do, it's not really preparation against future risks. So the added challenge with climate resilience is that we need to think about ways to build back that factor in the future risk that is unfolding. We need to see resilience in relation to a changed future. Simply bouncing back, or building back, is often not the answer in these situations.

Disclosure alone, as you said, does not necessarily lead to resilience. I can disclose all sorts of things. It doesn't mean I'm resilient when the time comes.

I think what is very important with resilience is that resilience is a collective effort. With mitigation, let's assume I'm a high carbon emitting company. I can look internally for solutions. How can I emit less carbon by innovating, or by looking into more energy-efficient infrastructure investments? With resilience, it becomes much more difficult, because resilience does require a much more concerted effort within society.

For instance, if I'm a company affected by sea level rise, it's often not sufficient to build my own seawall around my own assets. I'm part of a broader societal problem. I'm embedded within broader infrastructure that's affected by sea level rise. Consequently, if I'm not located in a resilient community, or in a community that at least has some level of adaptation in place, then it just means I can't be resilient under those circumstances.

So it is much more of a systems issue, which means it's also much more of a coordination challenge and an investment challenge, which creates real questions around who should be paying. Kristy, you already said who is benefiting from this, who makes these types of investments, and it often does require public-private partnerships to make these types of changes that pay off.

But there are also real difficulties in seeing the payoffs, because we are very bad when it comes to recognising avoided losses. Everyone sees the big impact that a disaster has and how quickly we can build back, and that's often seen as the success story. The faster we can go back to normal, the better it is, and that's often equated with success. But where we do not look for success is in avoided losses. We can't see them. They don't feel like we've accomplished anything.

It's invisible, and this invisibility is a real challenge. People can't really see what would have happened if we hadn't made those types of investments, and that's often stopping these considerations. It is much more impactful to act when something has happened, rather than prevent it from happening.

I think these are big considerations here, but one additional important point is that resilience is not just about having defensive infrastructure in place, or defensive assets. It's a proactive approach around how we absorb shocks, adapt operations, be flexible and recover effectively. Sometimes it requires a transformation of business models.

It requires a much more multi-level way of thinking as well, and obviously does not just relate to climate change alone. We've had many other shocks, and a lot of them are really impactful. Resilience is definitely something that should not be developed just with one particular threat in mind, but as a capability that allows a lot of flexibility, no matter what the extreme event or adverse condition is that we are facing.

Wouter Klijn 45:29

Yeah, Rob, from the investment industry, we look at risk from two sides. Of course, it's risk that can wipe out your capital, but also, you can't make money without taking on risk. That's where the returns, to a degree, come from. Why is more money not flowing into this area in terms of prevention and dealing with environmental risks?

Rob Prugue 45:51

I've always said, if we could patent air, water, and a clean environment, we would invest in it, but we disregard it because it's free, or we underestimate its value because it's free. The thing to consider, I guess, is that for many of us, we are accustomed to market cycles, and those market cycles were met with enthusiasm, and then eventually mean reversion. As Martina mentioned, this is much more structural. This is itself a very structural event, and how we build a resilient model around it isn't just a portfolio issue. It's a policy issue. On top of that, Martina's point was very valid.

Imagine, being Dutch yourself, building only a wall around your small house, but there's no wall around it, or New Orleans, or southwest England, or southeast England. Excuse me. It would serve no purpose. This is a societal problem.

Our challenge right now is that we're trying to look at it through lenses that aren't necessarily built for that, and because those lenses aren't disclosing what we need to see, we either disregard it or put it aside as too complicated. I'll deal with it tomorrow. But the more we go down that path, the more, pardon the pun, the wave builds, and therefore the longer it takes to unwind from that.

As for portfolios, as I mentioned before, how we address that, the numbers are there. Whether we agree on the validity of whether it's one degree or two degrees, talk to any actuary, talk to an insurance company, they have the numbers to show you of the claims, they have the numbers to show you. We can debate all we like about the science of the environment, but when we equate it back to the actual economy, at least as expressed through insurance, the numbers are already showing a huge uptake. Whether you see it directly through the insurance books, or through the premiums that we've been paying, it's getting increasingly harder to ignore.

Wouter Klijn 48:16

Yep, and what do you think of Martina's comment that, to a degree, what you're trying to achieve with addressing these risks is for things not to occur. So, if you're trying to put capital to work, you often want an outcome. In this case, you often work to prevent things and hope that stuff doesn't happen.

Rob Prugue 48:33

We don't have a DCF for opportunity cost.

Wouter Klijn 48:36

Yeah.

Rob Prugue 48:37

It was that simple. What is the growth rate that I would use for environmental issues? Martina said it well, that environmental science was on its own. We, as investors, we're the generalists, particularly pension fund investors. We're paid to take long-term views, and we have a portfolio that has large exposure to long-duration assets. So there perhaps is a gap between our due diligence and how we manage the portfolio, and what the inputs are that we assess versus what we're investing in.

Wouter Klijn 49:19

Perhaps we can draw the conversation a bit closer to home. Look at Australia, obviously we have a very unique economy in the sense that it's heavily reliant on resources, heavily reliant on energy, and also agriculture to an extent. These are all sectors that are in the crosshairs of environmental risk. What is your sense, and maybe Kristy, I can come to you. What's your sense of how stakeholders deal with this issue, that any action that we take will be felt in the economy, and then an extension of that, especially in regional Australia. And sometimes these communities are not always brought along in the discussion, they just get rules imposed on them. What's your sense around that? Is it harder to implement here, and what can be done?

Kristy Graham 50:11

I'd like to reframe the question, which is all about when you mentioned crosshairs of change happening to communities. There are many communities that are driving this transition and see huge economic opportunity from a green export future economy that Australia is in the box seat to take advantage of. So yes, we have an agriculture industry that is among one of the best performing sustainability-wise in the world. We also have a huge mining and resources sector that can provide things like copper, critical minerals, iron ore that will be absolutely needed for the transition, not just of Australia, but for the world.

There are a number of different regions and communities that are seeing and working to develop what that economic development vision for the future looks like, and are bringing in investors and partners and different parts of government around that community-driven vision. So I absolutely agree there is a need for communities to be in that driving seat, and to be actively shaping, driving and bringing others in to support what will be a big transition globally, but particularly in a number of different local communities.

But I wouldn't want what we see in mainstream media to be the prevailing narrative of this happening to regional communities, rather than many regional communities absolutely getting in front and driving this transition so that it benefits them and the future prosperity of the businesses and the regions that they live in and have lived in for a long time.

Wouter Klijn 51:44

Yeah, Martina, what do you think about this? I mean, risk does tend to hit differently in different areas. Does it make it harder to create policy or frameworks?

Martina Linnenluecke 51:54

Yeah, what we're definitely seeing is that there is a very uneven distribution of risk and impact. There are definitely parts of Australia that are much more exposed, but we also see a huge variability in terms of the extremes that communities are exposed to, and certainly also different needs for support and different transition requirements.

Not all of that is reflected in policy decisions, especially when they're taken in a very top-down fashion. It's not necessarily giving that diversified policy set on the ground. But I agree with the comments that Kristy made. We're definitely seeing a lot of momentum at the moment. We are seeing that a lot of communities really want to be part of a transition that's happening.

We're seeing a lot of momentum, both in rural and remote areas, but I think also in the cities as well. There is a lot of momentum, actually, to see what we can do, and the underlying driver, I think, for a lot of people is to live in an environment that's worthwhile living in. There is so much that we can do, and create a much more liveable environment. Certainly, we see that in Europe, just putting cycling infrastructure in has so many benefits.

This is such a small-scale example, but it takes cars off the road, it allows for more physical activity, it makes people feel a lot better about their day if they're not just stuck in traffic, and so on. There are all these small-scale changes that we can implement quite easily that add up to a lot of change as well.

But coming back to the more fundamental issues, we definitely see an uneven distribution of climate risk, physical risk, and transition risk as well, and it's deeply tied to the sectors and distributions that we see in Australia around resources, agriculture, energy, energy export issues, and climate-sensitive sectors. There's obviously huge exposure in parts of Australia, but then, as I said, there's also a huge variability in terms of the physical risk, ranging from bushfires to drought. In some parts, we see other types of extreme events, extreme heat, cyclones. So there's also a lot to deal with from the impact side.

When we look into the climate projections, none of this is really forecast to get much better, which creates a significant concern. But more to the point, looking into any type of transition, I think it's really important that this is an equitable transition, that this brings people along in being part of it as well. As I mentioned, it's not just about infrastructure investment, it's also a huge part around social and regional resilience, and cultural change within society as well.

So, yes, at the end of this, I think there are also huge opportunities involved, because we can really look into building a better future.

Wouter Klijn 55:24

So I was speaking a while ago to an economist, and he suggested that perhaps if you look at areas like the Hunter Valley, that is very dependent on coal, perhaps there should be more of a government-driven push to restructure these sectors and potentially build an EV industry in the Hunter Valley. Do you think it needs to be more government driven as well, to force almost this change?

Martina Linnenluecke 55:53

In my mind, the most effective change is the change that's occurring across all parts of society. I don't think it's particularly good if policy just steps in and forces an issue. It's not really going to be accepted within local communities, especially if it goes against some of the locally held values. By the same degree, just having this ground-up movement can sometimes also be ineffective if there's no supporting policy trigger.

I think, looking across what the evidence tells us, and the research tells us, the most successful transitions in society occur where every part of society can actually benefit from the transition, but can also have input into these types of decisions. So it's not top-down, it's not bottom-up, but I think it really needs to happen at all levels. Certainly, that's hard to achieve.

There is no perfect solution to it. But in my mind, it really requires supportive policies that encourage new sectors to evolve, that encourage investment in renewable energies, that certainly support a phase out of fossil fuels, but at the same time it really needs to bring the communities along as well. Simply discontinuing fossil fuels is not going to be a solution for some regions. It really needs to be part of a broader transition, and there needs to be consideration around, how do we best structure this? How do we create other opportunities? And how do we do it in a way that this is an equitable transition and provides opportunities to people as well.

Wouter Klijn 57:38

Yeah, Rob, you got some views on this as well, because I think you say policy risk is an investment risk.

Rob Prugue 57:43

Absolutely, I would add social consent to that.

Wouter Klijn 57:46

Yeah.

Rob Prugue 57:47

Before I do, to your point about communities that have ties to carbon energy, be it coal or LNG, let's look back at Wollongong versus Newcastle. Back in the 60s, they were both economically thriving off steel. Steel left. Newcastle had an advantage. It had big black rocks underneath it, or nearby, that opened up a new industry.

If we look at the history of Australia, we've had many industries come and go. In the mid-1800s, one of the largest industries and exports was fur, seal fur. In fact, we almost went to war with the US over a land fight over seals.

My point is that economic history is full of cycles of what works and what does not. But if we work to create moats that protect certain cycles or certain industries, as opposed to protecting the broader system, those are two different things. We've become more transactional. What's in it for me? And that transactional politics has, I would argue, been a key factor in driving the breakup of the LNP between the city conservative and the rural conservative.

The city conservative is more willing to embrace the challenges of environmental issues and has morphed away from the traditional conservative movement towards the teal. The rural community has been more hesitant because, again, their chequebooks depend on it, their salaries depend on it. So some have been gravitating more towards the populist rhetoric of One Nation, Clive Palmer and others.

Whether mainstream politics recognises this or not, this is not just a social and structural issue. It is a heavily political issue founded on a level of social consent. And as we all know, there's a hell of a lot of misinformation out there.

Case in point, on the South Coast, if you drive or walk along the coastline, you'll see houses with large banners saying no wind farms. Never mind that the wind farms are going to be so far out. I respect that people have a democratic right to vote against it and be against it, but some of the reasoning I saw was not necessarily logical, and that lack of logic was driving a lack of social consent, which was influencing policy out of frustration.

Wouter Klijn 1:01:03

So how do you get them to come along on the journey?

Rob Prugue 1:01:07

Ironically, these are the same towns that are seeing their insurance premiums rise, and at a substantial amount. So whether we embrace it or not, climate issues cannot just be treated as a political debate. We have to find a way to look at it fundamentally for what it is, strip away the misinformation and politically motivated rhetoric, and look at it for what it is.

Is it perfect? No. But this is how the political divide works. If it's not perfect, if it's not yes or no, I'm not interested. No, our world is in the middle.

Wouter Klijn 1:01:58

Does it require a big disaster, you think, before we see some real change happening in this space?

Rob Prugue 1:02:05

Define big disaster. My friends in Kiribati will tell you we're there, so big disaster depends on who "us" is, perhaps. But it's interesting to the point I think Kristy made, that some rural communities are embracing this. I'm going to take a punt, and I'm going to assume that those communities are not necessarily tied towards carbon energy, such as the South Coast and the bushfires that we see in the South Coast. I know they've been very proactive on these environmental issues and building resilience because they suffered so severely during the bushfires, whereas that same level of interest towards a more resilient outcome is less visible in carbon energy rural areas.

Then you have the areas that are more exposed to tourism that probably have more of a stake in mitigating climate change, but even the city people as well, the city conservatives in the eastern suburbs, few would be negating the issue around environmental challenges, and I think that was one of the big drivers of why they were frustrated with mainstream politics, and they went towards the independents.

Wouter Klijn 1:03:20

Yeah, so Rob, you suggested to end up with a thought experiment to a degree, where let's assume it's tomorrow, Monday, you come back into the company floor, the boardroom floor. If you're a CIO or a trustee or a policy maker, what different questions should you ask on this Monday morning than before we started this conversation? Do you want to have a crack at this?

Rob Prugue 1:03:48

Sure. I guess at the end of the day, it's the same question we should always be asking. Where are the risks? Where do they lie? And where does the portfolio still assume that the old hedge is holding?

I would fathom to guess it's going to be more exposed in the long-duration real assets that are illiquid, where they're having a 20% exposure. Sizable. That doesn't mean that if the proverbial hits the fan for those assets, it's not going to hit the other assets. Of course it is. It's going to hit government bonds, it's going to hit spreads, it's going to hit equity markets. But with an illiquid asset, you hold it. You cannot unwind.

And where are we assuming some linear adjustment to this nonlinear risk? If we look at it that way, perhaps that will flag, and super funds and pension funds have been very proactive in attempting to quantify this, but again, I would just put it more simply. What parts of our portfolio are assuming that the old hedge will hold?

Wouter Klijn 1:05:04

Martina, can I ask you the same question? What questions should we ask on a Monday morning?

Martina Linnenluecke 1:05:09

Yeah, absolutely. I'm not sure if that's just the question for Monday morning, probably more a fundamental one, but I think one of the important questions is, what do we value? I think that's very important. Do we want to be part of the problem?

Do we want to be part of the solution? In my mind, that is a very fundamental question, because it really comes down to what's driving the change, and whether or not people want to change and do things differently. More fundamentally, it would also be around the assumptions on which the business model, or any type of risk modelling or financial modelling, is built. I think there's a set of really important questions around what assumptions we are making, and are they still holding? Are they still the same assumptions?

Historical data points have always been very important around insurance pricing, infrastructure design, planning and capital allocation. But are these assumptions still holding, or are there a different set of assumptions that might have to be made because climate change is obviously complicating a few things?

Historical baselines are now becoming less applicable and less reliable. Tail risks are becoming more important, extremes are becoming more important, but also on shorter time horizons. There are sometimes these, it's a one-in-50-year event, or one-in-100-year event. This is no longer as applicable in this day and age. So, questioning those types of assumptions is, in my mind, very important. Perhaps as a thought experiment as well, go with a different set of assumptions and see where they take you. Is that still what you're doing?

Is it still viable if you are using a fundamentally different set of assumptions? You might not want to keep them, you might not want to implement them, but as part of the scenario planning that I mentioned, having different assumptions can be a really important starting point just to challenge some of the thinking. It might be something people want to adopt, it might be something they don't want to adopt, but at least having that awareness of the assumptions being made is already, in my mind, a really important point to start the conversation.

Wouter Klijn 1:07:38

And Kristy, maybe not on Monday morning then, but what are the fundamental questions?

Kristy Graham 1:07:42

Mine is building on Martina's, so they can tackle her question first, and then come to mine, which is also based on this idea of scenarios. If you were to think of what the world, Australia, our industry looks like in 10 years' time, what is the range of possibilities? What is the range of best case, worst case scenarios? And then if we as a company or an organisation were to lean in to give the best chance of success at the best case scenario, what would we do differently to what we're doing today? How can we use all of the things that we have at our disposal to get us closer to what that best case possibility looks like?

Rob Prugue 1:08:27

It's not a lack of investability. I mean, we've shown it. The world investment world has invested billions and billions and billions towards AI, where none of us really know how that's going to end. We have invested in a story without certainty of some terminal value. So therefore, if we're willing to do it with AI from an investment point of view, perhaps we should look at the same approach from a positioning point of view.

Wouter Klijn 1:09:01

Yeah.

Rob Prugue 1:09:01

With regard to the challenges, and to Kristy's point, the best, worst-case scenarios, we do that in most assets already, and to extend this into this matter is challenging, but it's challenging in every asset that we do it under.

Wouter Klijn 1:09:17

Yeah.

Rob Prugue 1:09:18

Other than cash.

Wouter Klijn 1:09:20

So we started the conversation with looking at whether the assumptions on climate and climate risks have changed, and whether this will filter through more and more into the financial system. I think, for my audience in the investor world, it raises a lot of questions around whether the portfolio is running on assumptions that no longer hold true. Are you assuming a level of insurability that might have already moved on? And as you said as well, is there an expectation of a gradual change that might turn out to be much more jumpy and much more volatile going forward? Now, I'm not sure if we answered any of these questions, but hopefully we certainly have given people something to think about.

I would like to thank you for participating in this discussion. So, thank you, Kristy, Rob, and Martina.

In this episode of the [i3] Podcast, Conversations with Institutional Investors, we speak with Con Michalakis, Chief Investment Officer of Funds SA, which is a $50 billion investment manager for South Australian public sector superannuation funds and other approved state authorities. Con is well-known in the Australian investment industry, not in the least, for his outspoken views on a variety of investment topics, including gold, crypto and asset allocation, much of which has historically been disseminated through his notorious Twitter or X feed.

We trace back to Con's roots as a quant and value investor, and discuss how this continues to shape his current investment philosophy, despite the fact that he calls himself now an ex-quant. We discuss the changes in governance and the implementation of a TPA lite framework at Funds SA, while we also touch upon the turmoil in private credit.

Finally, Con admits that he was wrong about innovation and disruption being the most dangerous words in investing, while he stands firm on his dislike for crypto and dynamic asset allocation. Enjoy the show!

Follow the Investment Innovation Institute [i3] on Linkedin Subscribe to our Newsletter Explore our library of insights from leading institutional investors at [i3] Insights

Overview of Podcast with Con Michalakis, CIO of Funds SA

03:00 I'm more of an ex-quant these days

05:00 In my heart, I'm still a value person and a contrarian; I like to invest in areas that are unloved or where capital is scarce

09:30 When I joined Statewide, the GFC hit. It was the worst I'd ever seen and Statewide was in trouble

12:00 By the time we merged with Hostplus, we were one of the top performing funds in the country, but that first six to nine month period was hell

13:30 Covid was short in terms of the market bounce back. What was hard was early access to super

14:30 Governance changes at Funds SA; "There were a lot of meetings here at Funds SA"

16:00 Having a risk management lens and no more siloes is a key part (of the new governance structure)

16:30 You used to have a photo of Trump on your desk to remind you of risk. Do you still have that? "No, I see enough of him!"

18:30 Making changes to the investment committee

21:30 We cut our tracking error budgets for Australian and global shares down by half to almost two-thirds. We've introduced passive, we've introduced quant systematic, and we have an active sleeve. You can't be full one or the other.

23:30 The world has changed: there is faster money, there is pod shops (fund managers that distribute capital across numerous semi-autonomous teams (pods) led by individual PMs) and there is instant reaction

24:00 You have to embrace dispersion across styles and managers

27:00 Implementing "TPA Lite".

27:30 "The idea that you are going to do dynamic tilting, or that you are some sort of macro guru, I call that a Comic Con of Asset Allocation. Everyone dresses up in their favourite character."

30:00 There is a slight survivor bias in the group of TPA proponents that the added value is based on

35:00 You said previously that innovation and disruption are the two most dangerous words in the industry? "I was wrong".

39:00 There was a shoe company in the US that was going bankrupt and pivoted to AI and the stock price went up 5x. Clearly, there is some nonsense going on.

43:00 Crypto; if you want to have it as a digital Ponzi scheme, go for it.

45:00 At Funds SA, we have zero Australian private credit

46:00 Some sort of global small/midcap manager, who has never done private credit in their life, is saying it is going to die. What do they know?

52:30 My worst investment? Probably, single strategy hedge funds.

55:00 Con's Twitter/X presence

Full Transcript of Episode 135

Wouter Klijn 02:56

Con. Welcome to the show.

Con Michalakis 02:57

Good to be here. Thank you for inviting me.

Wouter Klijn 03:00

No worries. So I want to take you back all the way to the beginning to get sort of a sense of your thinking on investments. And I believe you studied mathematical science in Adelaide, then went on to do a Master's in financial economics in London, and ended up at the Oxford Said business school. So there's sort of a combination of, you know, purely mathematical thinking, but also strategic thinking. How has that shaped, sort of, your outlook on investments?

Con Michalakis 03:28

Yeah, sure, so I would say I'm more of an ex quant now. I mean, it's a long time ago since I did option pricing and was a quant So, but still, you know, numbers guy in terms of how I think about it, and to be, to be honest, you know, the younger people that I've worked with, whether it was at Statewide, Hostplus, at Funds SA, to say they're brighter, they're more technical, they're more up to speed, so they've way taken over. So I would, I would call myself ex-quant. I still think in terms of numbers, still, you know, pretty Stemmy. And there's a bias across all three firms that I've worked for for sort of STEM type thinking, you know, science, technology, engineering, maths, the but you can't just all have one I have now believe that you can't just be one grade. I still think you can take stem people and teach them finance. It's hard to take finance people and teach them stem but you need, you need all sorts. And some of the best thinkers are not necessarily the way they think and critical thinking. They're not always just stem types. I've learned to embrace more diversity in that and interesting some of the managers that we've invested in, you know they come from interesting historians. So you got a critical thinking is more important. But, yeah, definitely bit of a buy. As the stem.

Wouter Klijn 05:01

Yeah. So how would you describe your investment style now? Then, because, of course, you mentioned three firms you you worked at Pezna for a while, which is a value shop, a deep value shop. Do you still have some of that thinking as part of your DNA, or are you looking more as sort of a contrarian investor.

Con Michalakis 05:22

I think in my heart, in my heart, I'm still a value person and a contrarian like to invest at the margin in areas that are either unloved or where capital is scarce, because highly likely the risk is that hasn't been priced in, and therefore there's a trade off. But definitely call it the maturity cycle, diversification, the ability to invest long term and make sure you have investments across a broad, strange range of strategies and asset classes, and not being sort of, you know, across the cycle, not having one dominating I think, is very important. I've learned that lesson, and it's a lesson that I know, but in my heart of hearts, if it's contrarian in value, it's probably my kryptonite.

Wouter Klijn 06:19

Yeah. So, so you learned those lessons. Can you give an example of some of the things, some of the trades? Maybe that taught you those lessons?

Con Michalakis 06:28

Yeah, probably bond allocation, fixed income, you know, like, if you look at the Japanese bond market, you know, it was the widow maker, you know, you didn't like it at four. Didn't like it at 3,2,1,or 0, it's come back now. So, you know, maybe the mean reversion took 30 years, but it's coming back. You could just got to be a bit you got to be a bit more smarter than naive mean reversion. Value Investing. There's been a value, statistical value, risk premium over 100 years, but you know, arguably, it's been very chopping. Hasn't worked since the GFC or prior to the GFC. If your portfolio, if you're running a diversified, multi strategy, strategy, multi asset portfolio, and you've let one style dominate your over a cycle, you're going to outperform or underperform because you're too biassed to that at the margin, though, you know, at the margins, I remember you're running a world diversified fund. Occasionally you get thrown these strategies and ideas where either the market has unloved it or there's an opportunity to extract return. That's pretty good. So, you know, we were a bit late to that at state. Well, I definitely noticed. Plus, when we did the sort of insurance link strategies with quota shares, we did that last year here too, at funds SA, and that's that's done really well, you know, in the small and mid cap, you know, where managers can probably do a little bit better. Venture capital, when that was unloved 15 years ago, we were late to that at Statewide, but Hostplus was very good. So you want to, you want to be diversified, but you want to go to early areas and adopt that if you can.

Wouter Klijn 08:11

So looking back on that, what does that mean for portfolio? This, is there still a place for value, or are you more style neutral guy?

Con Michalakis 08:20

There's a place for value and be conscious. If you're going to use a combination of passive, quant, systematic and traditional fundamental, you want to be conscious of what your and how your managers managing that. Some are core. Some identify as value. Some are kind of fighters, quality or growth. You want to be conscious of what you're carrying into that portfolio, except particularly in this incredible market movements that we've had, probably since Covid, for lack of a better word, that you're going to have dispersion. And that gets down to beliefs. Can you ride the cycle. Do you have the ability to, if you have good relationships and you trust your managers to reinvest when there's…, their style or, you know, there's always a style that they've had an issue with a couple of stocks, do you have the backbone to just stay in the game with them and reinvest?

Wouter Klijn 09:18

Yeah, you just mentioned that Covid period. Do you have any sort of lessons from that? Did you change anything in the portfolio to deal with sort of that volatility?

Con Michalakis 09:28

You know, when I joined statewide, it was a GFC, so, so I left Pzena, it was, you know, a couple of weeks off, and joined Statewide the first week, my first week that weekend, Fannie and Freddie was nationalised at the end of the week,

Wouter Klijn 09:44

yeah.

Con Michalakis 09:45

The week later, Lehman went under. Now we're in the GFC,

Wouter Klijn 09:48

yeah.

Con Michalakis 09:48

And that was painful. So really, from September until April, September 2008 April 2009 this was one of the most acute periods of investing I've seen. I. All when, famously, Westpac, had a failed rights issue early on my career, and I think it was Kerry Packer heard to bail it out. We've had Asian crisis, 9/11 but this was, this was up there with one of the worst I've ever seen, and Statewide was in trouble. It really didn't have a diversified portfolio. Didn't have a lot of cash or a lot of bonds. It had to pay hedges by selling equities. Luckily, Chris Williams had joined me, I think October, November that year. Jimmy Vernon Payne is now a consultant at Jana. Bill Watson, I think he's at first super, or is he moving to, you know, I think something like that. And all of that was happening live, and we had to manage that. And that was a really difficult period. We had to write off assets, we had to rebalance the portfolio, but to put in governance structure. We can talk a bit about that later. That was a doozy.

Wouter Klijn 11:02

So that was heavily equity focused portfolio,

Con Michalakis 11:05

that was a heavily illiquid portfolio, but more importantly, didn't have cash or bonds,

Wouter Klijn 11:10

yeah, yeah.

Con Michalakis 11:11

We didn't have any fixed income. Fixed income was a bit of a saviour. The Aussie dollar collapsed, the international allowed you to international fell by more. So that was a difficult time, and that taught us the importance of the diversification, liquidity, managing portfolio shape, not for currently, but looking out forward, and having a risk management system in that you could understand and also live by. I would say, though, by the time we merged with Hostplus, we were one of the top five or six performing balance funds in the country in terms of peer surveys, your future, your super we're the best Aussie equity numbers over most time periods, the most fixed the best fixed income numbers. Pretty proud that by the time we had merged with Hostplus, we were one of the best performing funds in the country, but that initial six to nine month period was hell

Wouter Klijn 12:06

yeah, I can imagine. I mean, I had in there that, like you must have done something right, because you survived for 14 years after joining state.

Con Michalakis 12:13

Well, ultimately, the central banks and the unbelievable amount of QE and reinvestments and bailing out the financial system. You know, one of the first responders was the Aussie dollar rallying, and we kept the hedge, and we used those hedge gains to rebuild asset allocation. And then, frankly, equity started recovering. I think by May, it bottomed out and it was on the rallying. But yeah, for that period, it felt it was uncomfortable. Now, covid, so, so, so the time we got the covid, we were so well diversified. We had risk management planning, we had liquidity ratios, we had stress testing in in play. And I was only for a week. I remember it was pretty late nights, early mornings, late nights. Chris was then the deputy CI, Chris Williams, who's now Hostplus, was the deputy CI. And I remember was one morning, Chris goes, Okay, now I'm worried this. There's no market. There's no market in bonds. The market was unruly. And I remember being on the couch one night. I was sort of had Bloomberg on, and I saw this big headline, unlimited QE and I remember saying, Okay, this is done. It's over. The markets will respond. So covid was short in terms of the bounce back. What was then hard for most super funds was early access. How would people tap into super How would you manage that? We were moving then to weekly Investment Committee meetings. We had a risk scorecard checklist. We were going through valuation scorecard stress testing. I actually thought we played that well. What surprised us was how quickly the markets bounced,

Wouter Klijn 13:58

yes,

Con Michalakis 13:59

and we had underperformed just, you know, in that immediate period. And then there was a vaccine that was announced. We had quite a few value strategies. They did really well. And then we came through. Yeah, the time we merged, performance was pretty good.

Wouter Klijn 14:14

So it sounds like that in a number of these like tricky situations, liquidity was a central theme in sort of trying to manage the risks in the portfolio, has that sort of changed your ideas on how to manage liquidity, and also in the current environment, where it's quite volatile, very concentrated markets, what is your philosophy towards liquidity?

Con Michalakis 14:38

So front and centre, you know the changes, the big changes we've made at Funds SA, they say was governance. We've set up, we've we've, there was a lot of meetings here. So there was a lot of meetings. There were a lot of people in meetings. We've tightened the meeting schedule. There's less people than meetings. We've broken down silos, and we've introduced concepts like, okay, we've got a proper investment strategy that embraces diversification. We've got liquidity ratio and stress testing. We've got fee budgets. We've got active fee risk budgets that we're implementing. And so we spend, really the first four or five months of every year updating our investment strategy policy, making sure it's fit for purpose, and then basically the rest of the year, reviewing the asset classes that are sympathetic to the overall investment strategy, and in that risk portfolio shape, managing the portfolio, not for today, but over the next 12 months, we have an unlisted forum that goes further and making sure we've got a enough liquidity. What's our effects? Hedging policy, terming out hedges, making sure if markets move, we can take advantage of what's happening. And that's that's that served us really well at statewide. I know it's served Hostplus really well, and we're off to a good start here, ending March. Financial year to date, I would say our balance fund's in the top quartile. Early days, nine months and one year I've been here 14 months. But having a risk management lens and the and shaping the portfolio is and no more silos is a key part.

Wouter Klijn 16:21

Talking about risk management. I've heard that you used to have a photo of Trump on your desk to remind you of risk did you bring that to Funds SA?

Con Michalakis 16:29

No, I see enough of him. I see enough of him everywhere, whether it's news or media. I don't need a photo. It was a joke. I think the team went to some charity and they got a maga hat, and I had a photo of him and Putin, I think, on my desk, which was good, because 2016 election was unusual. If you remember how markets traded, they priced a Clinton win and then a Trump win in the reverse was like, bit like Brexit, actually. And so no, I see enough of him, and I see enough of his policies and and I see enough of the reactions to the markets to tweet, so I, I he's a constant reminder. I don't need him.

Wouter Klijn 17:06

You don't need to be reminded of that. So you mentioned that setting down a proper governance framework was important in sort of reshaping the portfolio Statewide. Can you tell me a little bit about what you think are the essential ingredients of that governance framework?

Con Michalakis 17:22

Yeah, sure, and I starts here with Funds SA so, you know, 14 months in, what did we do? Start with the basics. We actually wrote a plan. I wrote a plan for the board, and what we said was governance strategy, team, structure and within government, Jana coming on as a full of service asset consultant. I've worked for Jana for a number of years, and they've been a great partner, and I consider them not a service provider. They're a partner to us, and we, we, we, we, basically, we rest on their shoulders. We don't have to make things we we can get a lot of their IP and thinking and basically build on that in terms of governance. It was recasting the Investment Committee. There's now a smaller Investment Committee. We have an independent chair, David Holston, who was my asset consultant, then retired, then joined Statewide as the chair of the Investment Committee and board member. He's here as an independent but making sure that's in that's in play, doing things like Investment Beliefs, having detailed asset class reviews, bringing the team together. We have a weekly portfolio construction forum where there's the investment strategy team and the asset class heads. Once a month, we invite Jana as well to that, having papers prepared, going through the shape of the portfolios, what's happening in the markets, trying not to be short term, and managing this for the medium to long term, that's been the, probably the biggest changes here, plus the usual, introducing liquidity ratios, thinking of risk, thinking of how you're going to diversify the portfolio, and being small enough to take advantage of strategies and ideas, should they present themselves? They don't often, and we don't think we can trade our way through it, and we can talk about DAA coming up, but just being aware and being able to execute quickly

Wouter Klijn 19:29

Before we jump into DAA, I want to talk a little bit about Funds SA in sort of the broader investment industry here in Australia, because it's relatively unique. You have worked at a super fund as well. At Hostplus, obviously, they are subject to a whole set of regulations where they need to pass a performance test on the Your Future, Your Super that has influenced how they allocate, especially on the passive, active side of things. At funds, I say you don't. Really have those restrictions. Does that give you an edge or an advantage in finding opportunities that super fund?

Con Michalakis 20:07

Oh, yeah. So we're about 50 billion in assets, and over 90 per cent is the local state pension scheme, Super SA that we run money for it's regulated by the state. So we're like a state, sovereign, if you want to, in that sense, and it has constitutional protection, which is a unique feature. I do think, not being having different being regulated by the state, we have unique and we have some unique tax advantages. Gives us a bit of an edge. We can think about how to invest the portfolio. We still shadow, for lack of a better word, we still shadow Your Future, Your Super we think about the risk we're taking from that lens, but we can free ourselves from the day to day regulatory of an official APRA burden, for lack of a better word, and that gives us, I believe, some unique advantages that we can we can exploit.

Wouter Klijn 21:17

Yeah,

Con Michalakis 21:18

That doesn't necessarily mean that some advantages can be also a balast, because it's active management is difficult. Can't just blindly do it, and hasn't worked for a long time, and it's particularly in recently, it's been a very difficult area. And you know, one of the one of the things we did in the previous review is we had pretty large active tracking error budgets that was purely active in Aussie and global shares. We've basically cut that down by a half to almost two thirds and and one of the reasons is we've introduced passive we've introduced quant systematic, and we have an active sleeve, and we want to let it go, just, just so we, you know, again, diversification, even within Aussie or global equities, it can't be for one or the other.

Wouter Klijn 22:09

Yeah. So is that active component more of a satellite allocation, is it a relatively small?

Con Michalakis 22:15

It's more sort of, yeah, core satellite approach to the active might be a bit more satellite. You can have some style neutral managers. You might have some small to mids value or quality growth. But we, you know, we manage that within a mix, and our tracking error, you know, is moving, you know, maybe in the past it was in the threes. It's now in this of the one, one and a half at both Aussie and global equities,

Wouter Klijn 22:40

that active, passive element is quite interesting in the light of the current environment, because we've seen, you know, equity markets more or less rally for quite a number of years now, concentration in markets, which makes active management quite difficult. But if we would were to see a flip or some sort of recession, that's often where active management shines as well, where they can reduce sort of the downturn. Are we setting ourselves up for failure in that sense, because we're moving away from that active element, and then when a crisis happens, we might not have enough of that.

Con Michalakis 23:16

I mean, we were pretty active at Statewide. We had quite working very well in Aussie and global. And as I said, global, by the time we had finished that net a fee Alpha was pretty good. Aussie was unbelievable. Closer to 2 per cent I would say to you, the world's changed. There's faster money, there's pod shops, there's instant reaction. We've seen it even. I mean, look at between March and April. You basically had equities, you know, fall anywhere between five and 8 per cent and in the first two weeks of April, they basically come back. And in coming into the third week, we're now setting new all time highs,

Wouter Klijn 23:56

yeah,

Con Michalakis 23:56

so the Fast Money response, and what I've I believe, is that you have to embrace dispersion, dispersion across styles, strategies and managers, and in this world of faster money, moving money, you probably want a bit of everything. And the idea that you can be totally active sounds romantic, but I think the path dependency will kill you. The idea of being totally passive, we have some tax advantages that doesn't totally make sense to be totally passive, and the idea of being totally systematic, well, fine, but there was a thing called a quant winter in 2007 and these things will happen. So why not have a bit of everything if you can, but be careful, you know, set your tracking error budget, set your allocations, and try not to one of the things I think that could be happening in industries. If something's not working, they're closing it down, and then they're just going straight to this that's working. Well, okay, that's creating flows and opportunities. When that sort of stops, that's going to create some opportunities on the other side. And I think the other side of that could be an environment where active managers who are targeted and doing well will do better.

Wouter Klijn 25:26

Yeah, yeah. So as part of that, move to towards more passive, basically reducing tracking error, but then we see funds doing a little bit more on the dynamic asset allocation side, where partly is sort of trying to implement some total portfolio thinking, putting trades on top of the portfolio that are almost a little bit hedge fund, like relative value trade, global macro trades. What's your view on that? Is that something

Con Michalakis 25:56

This is going to be fun. So one of the things I one of the things when I came at Funds SA is that there was, there was a lot of siloed behaviour. So there was the asset class, people were doing their own things. Then there was sort of an overlay, doing their own things. What I brought is, everyone's in the room once a week, and we're thinking of what's the long-term strategic asset allocation. Now markets move so you move away from that, what's the commitment to if you've got private capital investments, whether it's equity infrastructure, what's being drawn down, what's being distributed? There's foreign exchange movements, how you should think about the foreign exchange. There's also demographics. There are flows in that. Are flows out they're switching as well. And so I come across from a, I'm going to call it TPA Lite,

Wouter Klijn 26:47

yeah.

Con Michalakis 26:48

So I come across from a total portfolio. What are our exposures? Where, where would you want to be? And if we don't really have strong ideas, run them very close to the strategic assets. After all, it gets reviewed every year, right? We've spent a lot of time spending that as what a research, time looking at that with our asset consultant. The board adopts it early in the year. And if we don't have an idea, stay close to that, then markets drift. And it's all about the rebalance, the idea that you're going to do dynamic tilting, or that you're going to do overlays on top, or you're some sort of macro guru. I call that the Comic Con, right, of asset allocation. Everyone dresses up in their famous in their favourite character. One's a dynamic tilter, one's a post Keynesian, one's a Keynesian. One's a value guy, one's a trend. Great. You can have it. It's all yours. I just think it's noise. And good luck trading that in the last three or four months. In fact, good luck trading that since Liberation Day, and good luck trading that since covid. Because how many people would have told me bonds went from zero to four or 5 per cent and equity market set new time, all time highs? So I think we take a broader portfolio lens, manage that from a portfolio construction level, figure out where the opportunity sets are. Allow a little bit of flex, but you're not going to see us trading frozen concentrated orange juice and pork bellies.

Wouter Klijn 28:22

So do you see DAA as a form of market timing? Yeah,

Con Michalakis 28:25

They can have it. You know, I've heard about other funds. You know, they do SAA, TAA, DAA, macro thematic. Yeah, all yours. It's up to negative. Good luck to them.

Wouter Klijn 28:37

So I had taken you as a little bit of a TPA cynic. But obviously you're

Con Michalakis 28:43

Not totally a TPA cynic. I just, you know, I read the study, and I did start at Watts and Wyatt, and there's Thinking Ahead Group. I think the ideas of TPA are good. The complete adoption, am I going to be the purest TPA, and I know there's been some great funds out there that have done it, that's theirs. I live in a world where we have different clients who have different needs. We have one client who has a sort of an absolute hurdle cash flow for 30 years before it goes negative. I have super clients who, you know, they want us to manage a CPI target. They want to manage against peers. They're switching in between funds. There's demographics. I look at everything, not just through a pure TPA. Call it TPA Lite,

Wouter Klijn 29:30

yeah.

Con Michalakis 29:30

And you know that study that showed all the TPA funds outperforming before I had a good look at it, it felt a little bit like, nothing against my old colleagues, but that looked a little bit like consultant swab.

Wouter Klijn 29:42

Yeah, I looked at that report as well, and I think they came up with 180 basis points or something, but it seemed to be just an aggregate of the funds that were included in that group,

Con Michalakis 29:53

Slight survivor bias, right?

Wouter Klijn 29:54

Survivor bias, but also not necessarily relating it back to TPA. It's just, you know, here's a group of TPA. People. And I think there was even a Swedish fund in AP7. I think it is, which is, to my knowledge, highly geared equity fund. It's not quite comparable

Con Michalakis 30:09

yeah, comparable we, we look at portfolio construction across the thing, we think about what, what, you know, what are we doing to diversify? What are we doing to beat objectives? You know, sometimes your illiquidity mismatches on what's what's a good proxy, where's the actuals? You know, like you maybe want to have some more linkers than nominals in your bonds at the moment, because it's working with better within your overall fixed income allocation. That's how we think about it. We want to term out our hedges. But the idea of being pure TPA Lite, or pure What's your equity equivalent ratio? Yeah, you can have it. Whoever does that. Good luck to them.

Wouter Klijn 30:45

Yeah. Do you think that is to a degree related as well to how large investment team is? Is it easier to do TPA and sit around the table in a relatively small and mid-sized team?

Con Michalakis 30:57

So I've been very lucky that within Statewide, Hostplus and Funds SA, we have relatively small teams, and I think that means there are no silos. That means that we can be far more sort of linked up, to use the term in terms of how we're building portfolios, and have the key people, the discussions in the room. I think that's an advantage that we enjoy wherever you use external managers. We do the implementations internally, of course, but we It allows us to just think a bit and build portfolios, as opposed to trying to manage a lot of people.

Wouter Klijn 31:39

Yeah. I think in a past interview, you sort of stated the importance of stating your opinion and letting the board know what your thinking is. Is that you know possible in every organisation? Or does that need to be created like a culture created around speaking your mind?

Con Michalakis 31:57

Oh, again, maybe luck, all three funds I've worked for boards wanted trust and transparency. There's the Funds SA. It's seven individuals. It's incredible board. And one thing I enjoy, you know, from the chairman, John the CEO, and our board members, is, obviously, I'm not a shrinking violet. So they enjoy the two-way communication, and I think they they want transparency, and with transparency, you can build trust. And so they like the fact that we can have these discussions. Same at the IC. I do think smaller committees allows to have better conversations. That's so the board is, you know myself, the deputy CIO, whoever's presenting, if there's an asset class, the IC, there's there's John, myself and David Holston, the deputy, Kelly, who is sort of like our she makes the trains and run on time in the implementation group, and it just jells at these meetings. It just allows good discussions ample time to have that. And you build trust because they know what you're thinking, you know what they're thinking, and you get, I believe, a better outcome,

Wouter Klijn 33:14

Now Funds SA has gone to quite evolution in recent times, apart from the organisation growing quite rapidly over the last couple of years, you also had a new chair in. Guy DeBell, had a new CEO with John Although John Piteo has been there since 1995 I believe.

Con Michalakis 33:35

Yeah. So I think it's two years so relatively new, yeah. So John, Guy, there's a couple of new board members. Been a few new executives, obviously, new CIO, new deputy CIO, we've added to our implementation team, where Kelly's almost like she's like our COO within the within the investment team. I do think it's a sense of renewal, but I'm probably not the right person, because I've only it's 14 months, but I gather that over the last two years, the Funds SA has changed. It's in a sense that it's more focused on investment returns. Clients are important, and the people who are responsible for managing this business wrapped around making sure we've got appropriate it's really good data and tech that we have here. So yes, I'm part of that change. I think investments has changed a lot, and the team has done a good job, really. I mean, there was a lot of changes, changing governance, beliefs, strategy, no more silos that they've had to go through a lot of change in that responded world to all of that, plus having me

Wouter Klijn 34:55

Fair enough, there's also a lot of change happening in the industry itself, and one of the things that a lot of people talk about these days is AI, artificial intelligence. And I sort of, when I was preparing for this interview, I found an old interview with the AFR, and you said that innovation and disruption were the two most abused words in the industry. Do they? Does it apply to AI, what's your view there?

Con Michalakis 35:22

Okay, I read that article, and I reckon that's aged like a bucket of prawns in the sun. I reckon I was wrong. Okay, so, so this is, let's this is, this is where, you know, you sort of read that went, Oh, I think we are in the age of innovation and disruption. And I severely underestimated, I think that was 2012 Yeah, maybe not. Yeah. A bit later, I think there's been a lot of disruption and innovation, whether it's the digital whether it's obviously now with AI, I think AI is a, is a, there'll be new versions of energy, there's there's ways of living. There's also some bad disruption in terms of, we're in a multipolar world. You know, the cost of warfare has gone down, so the marginal propensity to war goes up. You know, we grew in a pretty balanced world post the war, that we knew we had one world, and now it's, it's bifurcating into various regions and so, so I think I was wrong, having said that, you know, is it as innovative as we've got the round will and introduce fire? Probably not. But the world is changing, and I think we should embrace that, particularly if I think about Australia. And as an allocator, you know, the world has changed since GFC, in some ways, not for the better. We have to deal with energy resilience and climate. We have to deal with critical minerals. What does ai do to the workforce? What does it do for people who gain from the expected productivity gains? Does it go to capital or labour? If it goes all one way to capital, not labour, there will be riots. There will be a greater disparity in terms of wealth and income. People will be unhappy. There will be volatile elections, social media and the rise of that. So I think there's a lot going on in the world, and we just got to make sure whatever as innovation happens, that the gains are shared.

Wouter Klijn 37:47

Do you think it changes as well the asset management game, especially on sort of the active management side, where access to data is easier, it's harder to gain an edge.

Con Michalakis 37:59

So I think the biggest winners in that have been the quant funds and the systematic funds, who are naturally very data enriched and aren't afraid to embrace large language processing models, systems. Much more sort of, might be a bit of P-hacking to use the stats term, but there's, there's a lot more sort of mining and using of alternative data, they were much better than the fundamental types. Probably the systematic quantum are much better job in risk management, more than anything else, the risk management's kept them in the in the game, more than, say, the fundamental types. They're learning those lessons. But you know, when we see, we look at it here, internally, at Funds SA, and then when we see with our managers, it doesn't matter if it's a credit manager, an equity manager, a passive manager, voting of shares. People are using AI in their business. They're using it initially as a tool. We use it here across there's a lot of people, vibe, coding, building macros, building things. It's it's changing. Do I think there's a bubble in parts of AI sector? Absolutely. Do I understand the valuations of some of these large language models that are burning cash and on record valuations? I do not. There was a shoe company the other day on the New York Stock Exchange that was going fail, going bankrupt, pivoted to AI stock went up 5x right? Clearly, there's some nonsense going on. But whenever there's an innovation cycle, or whenever there's disruption, you do get, you know, the old Manic Panic and crashes Kindleberger, you know, one of the bubble things is there's an innovation cycle, and that's part of the game.

Wouter Klijn 39:51

Yeah, yeah. In some parts of the industry, there's a bit of a reminiscence of the dotcom bubble where, you know, you just had to come to your company name and the share price went up at the same time. You know, you see chips are still TSMC came out today, and I think they still had a record profit on selling the chips to the AI sector. So there is a real story there as well.

Con Michalakis 40:19

It's a real story. So Nvidia, the foundries in Taiwan, like TSMC, these are these companies are printing real profits, right? They and Google's another one. So, you know, it's not bubbles can sometimes be overused. But there's, you know, there's some interesting valuations away from them that, you know, it's hard to get your head across,

Wouter Klijn 40:40

yeah. But do you think that that shifts the structures in the equity market as well? There seems to be, you know, the size factor comes back, but almost in the opposite way, where, you know, large caps are dominating, outperforming,

Con Michalakis 40:53

I think when it gets priced in, and we've had a well priced in, I think there will be again, when you get so much, maybe the value person in me, the valuation dispersion, the opportunity sense, will come in. And lately we've seen that with the EM bounce back pretty hard. We're starting to see a little bit of, we're certainly seeing a lot of good alpha, but also some good returns out of the small to mids. So, you know, we had the rise of the Magnificent Seven. The first version of that look a bit bubbly. It's sort of corrected, and now we're getting the sort of the AI type plays. It's it's part of cycles. You can't pick them. You can't pick them on the way up. Good luck picking them on the way down. You just have to be conscious of what positions you take and make sure that at the margin you can sort of lean against it. And, you know, I have opportunity on the right tail in terms of VC or some of these companies, and then on the left tail be diversified and managing your active exposures. I do think the business that we're in of managing capital, whether you're an asset owner or a fund manager, will be changing over the next five years.

Wouter Klijn 42:09

In what way?

Con Michalakis 42:09

Hard to say how it morphs. But you know, if the agentic AI and the models and the and you can develop personas, and they have memories in those models, you know, do you need as many analysts? Do you need to see? I mean, it starts giving you that. So while that rises, you will need the correspondent rise and people almost acting as human whisperers of AI and that output to boards and individuals explaining what that means. So, you know, there's, there's going to be a coincidental rise of those two,

Wouter Klijn 42:43

yeah.

Con Michalakis 42:43

But you know, the first one has more of an employment impact than the second one,

Wouter Klijn 42:47

Yeah, yeah, for sure. So we're not at a stage yet where you should just hold passively the top 20 or top 50 stocks and just let them get on with it?

Con Michalakis 42:55

I don't think I mean passive is a valid part of of any portfolio. But again, I'm not a person you know full TPA or full passive or full active, you know, like I you can have it all right, don't? You don't have to vote against it, but in a default setting where you don't know what you're doing, you don't know where the world's going. Sure, passive and systematic will give you that that beta exposure, but you know, you probably at the margin, can do with a bit of active.

Wouter Klijn 43:31

Yeah, yeah, sure. Okay, so you said you were wrong on the innovation and disruption. You've also been quite critical on crypto. Were you wrong on that as well?

Con Michalakis 43:41

No, that's a load of nonsense. And the thing look, crypto, if you want to have it as a digital Ponzi scheme, go for it. Shoot your lights out. Congratulations. But it's not money. That's the thing that bugs me. When people turn around and say, crypto, or even the gold bugs, gold is not money, and crypto is not money. And we saw that when we went through and with oil in the crisis. The first thing people wanted was cash. And basically, and I would sell all the other nonsense because they wanted cash. I You don't do gold back that. You don't do crypto back there. I'm not, you know, stable, this whole sort of stable area, interesting, the way, sort of FinTech, and that's processing interesting, but, you know, there's been a lot of nonsense in that you can have it that's that's happy to provide the chips and the shovels and the data that they need. But, you know, sustainable crypto, give me a break. You're burning. Energy is already scarce, and what's that used for?

Wouter Klijn 44:41

I think you called sustainable crypto a vegan tomahawk steak.

Con Michalakis 44:45

And once it was, apologies to vegan Tomahawk steaks, which probably, you know, tastes a lot better than the rubbish that's built out by some of those crypto types.

Wouter Klijn 44:54

Fair enough. Another sort of point of discussion in the industry at the moment is private credit. It, and we've seen some liquidity issues with some of the funds. But what's your view on that? Is that a problem with private credit, or just the wrapper that?

Con Michalakis 45:09

So I should say at Funds SA we have zero Aussie private credit.

Wouter Klijn 45:14

Okay,

Con Michalakis 45:15

I feel pretty good about that, actually. So zero, we have about 60 basis points of global private credit. So we're in an interesting situation, but we've put on some really well established global private credit. We've just put on some clo equity, both secondary and primary. I actually think the opportunity space looks good for us because we're underwriting into that. We don't have any existing ones. I think some of the commentary written about private credit has come from it's interesting. You've had all the big, large players in private credit saying, yeah, there are problems, but it's not systematic. Who's on the other side is some sort of global, small, mid cap manager who's never done credit, and they love saying it's a bubble, it's going to die, right? And so what do they know, right? I mean, I mean, the reason they're upset is probably because private credits up there are higher up the cap structure getting their returns. Don't believe private credit, per se, is the SPV of real non-recourse real estate debt of 2007 that's going to cause some sort of crisis. Banks, private credit managers, long term sort of locked up capital that does this is it will, will look will make sure that the system does what it has to do. Are there problems? Yeah. Then one of the big problems is that there was a lot of these BDCs. And when you have a listed entity with unlisted assets, and you offer a liquidity redemption window, it's always the same thing. In any crisis, in any dislocation, it's either leveraged money or money that's not there for strategic reasons, that wants to depart, that creates the opportunity for others to come in and take advantage if they have to sell out of discount. Now are there private credit loans or issues, whether it's been in SaaS software disrupted by AI, or, frankly, bad lending. Course, there are, are there in 5000 equity stocks in the global capital market? Are there 50 or 60 that are in big trouble, or at 70 or 80 that could be in fraud? Course, they are. So you know, you're always going to have problems right in loans. But is it a big systematic issue other than the retail, you know, illiquidity, BDC type, or occasionally bad loans, sure, but I don't think it's a systematic issue.

Wouter Klijn 47:52

Do you see it potentially as throwing up some opportunities for a fund like you?

Con Michalakis 47:56

Oh, yeah, we're taking it as we speak. You know, we're allocating to special sits managers or people who can provide capital and solving for the opportunity. And we're, you know, again, we've come in underweight, so I should be saying private credit is really bad, but I just don't believe it and we're gonna, we'll take advantage of the opportunity across our manager set. We're pretty excited by it.

Wouter Klijn 48:21

Yeah, yeah. Fair enough. So going forward, what's on your agenda for Funds SA? Is there still a lot to do in the portfolio?

Con Michalakis 48:29

So I'm pleasantly surprised how well the performance has been. We're off to a really good start again. Strategy, governance, team. Jana non silo, I really would love to have the third fund I've worked for to continue to have very lucky at stay white, first quartile. Hostplus is a machine, right? It's, I still speak to some of my old colleagues, that is one of the, one of the great funds, and will continue to do all because it knows what it's doing. Yeah, we've turned it around here at Funds SA and my focus is to keep that turn around really happy where we are. But this is like a cricket game, right? It only takes one bad ball and you think you slug and you're bold and you look like an idiot. So happy where, where we've where we are in the process. Early days, very early days, but we got to maintain that focus. Managing portfolios for our clients and members is a privilege, and we can't take, we just can't stop. We got to be on the game and making sure we're aware of what's happening.

Wouter Klijn 49:37

So you mentioned Hostplus, when you look at Hostplus, it does really well, but it also has a very clear sort of target client base. They're young people. They have a long runway, so they can take a lot of risk, which has led to the asset allocation that they have. I think at Funds SA, it's probably much more of a mixed bag in terms of. The demographic of their member base. Does that make it more difficult to set a strategy?

Con Michalakis 50:06

Yeah, so Statewide also didn't have a lot of cash flow, right? So being a smaller team, the unique tax advantages and obviously they're not being regulated by APRA and the setting up the governance structure, I think gives us, and being 50 billion and not 500 billion, and not trying to manage really large cash flows, it allows us to be a bit more nimble and take advantage of the opportunity. Should we get it? And so, like, last year, I was that all of funds. So whether it was the investment team, the finance and ops team, the legal and odd, you know, we've had a couple of opportunities, and we turned them around, going through the process, you know, Investment Committee negotiating commercials, operational due diligence, commercials, and we can turn around within there's one we turned around in eight weeks,

Wouter Klijn 51:06

yeah,

Con Michalakis 51:07

and the the manager said, We've never seen this before. And they manage some sovereign wealth, money, some large pension. Funny. So having the ability to invest, sticking to your beliefs, I think is a Core Advantage. One of the questions I get asked a lot, and I think you were going to ask me, is, you know, what's the best investment you've made in your career? It's the people.

Wouter Klijn 51:34

Yeah,

Con Michalakis 51:34

It's the people. So having being surrounded by really core bunch of people that you can trust. I had that at Statewide. I had that at Hostplus, and we building this at Funds SA as a core, bunch of people, close to your consultant, close to your investment committee and board, and being on this and being committed and not stopping, like being at it, just focused on doing this. That doesn't worry me, because I think we know what we're doing, and it's starting to show on the results.

Wouter Klijn 52:08

Yeah, yeah, for sure.

Con Michalakis 52:09

And you can be niche, you know, we can do a 20 or 30 million VC and 20 or 30 million co invest at our size, and we can do a couple of these, but if you're 300 billion or 150 to get access, and to do that, it's much harder, and just sizing that and taking advantage of that opportunity set, it's I find it easier to run less money than more money.

Wouter Klijn 52:34

Yeah, yeah, for sure. Now, usually I don't let people get away with just talking about the best investment. Can you tell us what was your worst investment and what did you learn from it?

Con Michalakis 52:43

My worst investment, and what did I learn from it? So throughout all the career, probably single strategy hedge Funds was the worst investment. I'm not going to name names, but at Statewide, we had single strategy and you know these, they're all great, big names, big personalities. They promise you diamonds and they give you rocks, right? And we moved away from that at Hostplus. And this is, again, this taught the importance of working with great people. There's Greg, Sam and myself. It was Chris at when I was at statewide, and Dan who it continued lessons just wasn't working. We moved with John to a sort of an allocator model where they were closer they could implement, they could do overlays that was Blackstone here at Funds SA and say Peter, who runs the alts team, has moved from those single strategies to MAN and Blackstone, they're highly specialists. They know what they're doing, and it's worked very well, as opposed to trying to manage these on your own, which are really difficult,

Wouter Klijn 53:53

yeah, yeah, I can imagine.

Con Michalakis 53:55

So I gave you an investment, and the asset class so far, it's turned around. I feel good about that. The other one was, I remember going down the rabbit hole on tail risk.

Wouter Klijn 54:08

Was this the crisis mitigation stuff?

Con Michalakis 54:13

Yeah, yeah. And, you know, you put it on, it works until it doesn't, and then doesn't work. Your people lose going, and then you take it off and, you know, we never got to invest, thankfully, at statewide and Hostplus, and we had a tail risk here at Funds SA, we took it off and we put, put it to productive capital that can make money. Because, remember, you are diversified. You know, the one thing we spend with members is take that, take a traditional balance fund. Equities are down eight, 9 per cent you're about half in equities. You've got fixed income cash now, when bonds move away in a stagflation that could, that could hurt. You've got a bunch of infrastructure and property real assets tend to do okay, so you don't feel the full effect of that. That's the beauty of diversification. And you know, you have to remind people, so the idea that I'm gonna and I'm. Sorry to tell him, and I hope he doesn't call me, you know, idiot, moron, imbecile, than he does, but it's just too hard,

Wouter Klijn 55:08

yeah,

Con Michalakis 55:09

To be fair, and to be fair to him, he does say you should be invested in equities and have this, yeah? Well, we just do balance funds. We've got high growth funds, balance funds, conservative funds. You have the journey for a member. We've got different tailored solutions for clients, so sticking to your strategy and being diversified works.

Wouter Klijn 55:28

Yeah. Now we might finish up with a bit of a personal note. I think a lot of people, apart from, of course, knowing you as CIO, also know you from your Twitter feed?

Con Michalakis 55:39

I've locked that now, are you probably on there, so you still see it?

Wouter Klijn 55:42

Yeah, I actually do. But you know, you got a lot of opinions on there. What do you see of the role of that? And do you use Twitter as well for, you know, getting some market insights?

Con Michalakis 55:55

Well, you get a lot of information very quickly. You also get unfortunate, a lot of fake information.

Con Michalakis 56:01

But I remember many years ago, I did an interview with the Advertiser on this. It started off for football and music. It just morphed into fin Twitter back in the glory days, which was pretty bare knuckles and fun. I've actually met a lot of people through that. Met them around the world. You've met interesting people. You then go to private sort of messaging. So just gotta it's like anything in life, you can use it for good and use it for bad. Use it for noise. Mine's more selective.

Wouter Klijn 56:34

You say it started with music. And I saw some of your comments are around Joy Division, punk music. And I was looking at that, I'm like, That's not just standard business school playlist,

Con Michalakis 56:47

But you'd be amazed. Our chairman famously was interviewed, and he's a big punk rocker, really, Guy, Guy, you know, he will wax lyric on Husker Du or,

Wouter Klijn 56:58

Really?

Con Michalakis 56:58

Pixies, my old co-deputy, CIO, Greg, at Hostplus, we could lose three years just talking about Nick Cave or Joy Division. So, no, no, you'd be amazed. You'd be amazed. How many people come out of their shell when you start doing the music. You'd be, it's more diverse than you think.

Wouter Klijn 57:21

Oh, good, good.

Con Michalakis 57:23

Including the metal types, you'd be amazed how many metal types. I'm not going to out them, but there's some crazy ones out there.

Wouter Klijn 57:30

Fair enough. Fair enough. Now I looked at it and I'm like, Oh, I can now safely bring up my vinyl record collection at some stage, which features a lot of punk, but we'll leave it for another time. Thank you very much for this conversation.

Con Michalakis

Was a lot of fun.

In this episode of the [i3] Podcast, I'm speaking with Jo Leaper, who is the Head of Operational Consulting at asset consultant JANA. We talk about the next evolution of risk management, where risk doesn't reside just with a dedicated team, but is addressed by all functions, including the investment team. When implemented well this form of holistic risk management is not simply a cost, but can lead to operational efficiencies and even alpha. Afterall, investors need risk to produce returns, but how you manage that risk is the key.

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Follow the Investment Innovation Institute [i3] on Linkedin Subscribe to our Newsletter Explore our library of insights from leading institutional investors at [i3] Insights

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Overview of Podcast with Jo Leaper, JANA

01:30 Why is operational due diligence important? 06:00 What I'm seeing is investment governance getting more involved and almost acting like a bridge between the investment team and the risk team. 13:30 Hopefully, we will get to a world where risk is not a cost of business, but it is an enabler of outcomes 17:00 New regulation will always cause a little bit of friction and in all honesty it should 19:30 There is already a strong focus on valuations and risk in unlisted assets, but it will get more intense 23:00 We talk about 'risk sensible' a lot; funds still need alpha 23:30 Is there such a thing as operational alpha in risk? Absolutely. 25:30 Managing risk in a $2tn organisation. Employing multiple custodians and services providers

Full Transcript of Episode 134

Wouter Klijn

Jo, welcome to the podcast.

Jo Leaper

Thank you for having me.

Wouter Klijn

So today we're going to talk about operational risk and operational due diligence. Why is that so important?

Jo Leaper 01:36

Operational due diligence, it's always important for investors to know what they're investing in, and if you're not doing operational due diligence, you're not necessarily understanding what that actually understanding what that actually is, because the risk is important to the portfolio. You need the risk to generate alpha. But if you don't know what those risks are, if they're hidden, then that's where you fall into a trap.

Wouter Klijn 01:52

Yeah. So what are some of the main challenges in managing this?

Jo Leaper 01:57

Really the complexity and a lot of the investments that clients have, and the market has, are investments that have come up over time, and in those spaces, historically, you had a pretty good idea about what you were investing in. But assets are getting more complex. Structures of operating funds are getting more and more complex, and so none of them can know everything. So really for us, getting them to look at the operational risk is getting them to say, I can work with that, or I can mitigate that, or I can accept it. It's when you don't know what those risks are that the complexities really come into play. And I think particularly if you look at the current world, with geopolitical issues at the moment, even managing some of the structural issues and challenges in the industry, there are unintended consequences to those actions. So understanding what your managers are doing a it's a really good learning place, because they're doing this, and a lot of our clients are starting to invest internally as well. But it's just, it's a good way to say, You know what, that's commensurate with what our members and our beneficiaries are looking for. And we do want risk in the portfolio. We need risk in the portfolio. But if you don't know what it is, that's a problem.

Wouter Klijn 03:02

So yeah, it's right. The world is increasingly becoming more complex. I mean, you mentioned geopolitics, but you know, we also see AI and machine learning and so many different things.

Jo Leaper 03:10

It's a really challenging time from a risk perspective at the moment, because you've got a lot of participants in the market, not just investors, but a lot of market participants with legacy instruments, legacy technology, and the market is moving at a faster pace. The regulator is expecting more. Members are expecting more. And we've got a lot of data, but sometimes, unless you've got the right guardrails around how you're looking at it, how you're using it, are you going to get the right outcomes. It's the right intention. But you know, the end of the day, it's members best financial interests, not ours, not anyone else's, it's the member.

Wouter Klijn 03:44

Yeah. So you took recently a look at CPS 230 operational risk management approach guideline, and you, you sort of indicated that it signified a little bit of a shift in thinking about risk management. Can you? Can you walk us through that

Jo Leaper 04:00

Of course. So APRA has always been Prudential, like that's literally in their name, and they try not to be prescriptive in the way that they do this. When CPS 230 came across the desk, it really was to bring back a larger view of resilience and resiliency. And I think a lot in the industry are still wanting APRA to be a lot more prescriptive. And that's not going to happen. That's not what they do. It's not their nature. And so when you look at it, and you will look at what APRA is trying to achieve, their ultimate goal is really the same as the industry's members, best outcomes. That's what we want. And if you can do that by shoring up the system and the structure, APRA can't enforce particular investment styles, but they can try to make sure that the system has the right controls and the right mechanisms to manage turbulence when it happens.

Wouter Klijn 04:46

So I mean, clarity is always, you know, a key issue around regulations. I was recently at a conference where I think the word clarity and taxonomy were the two most used words, yeah, during the conference. But. But, yeah, in this complex environment, it can, cannot always be, you know, that straightforward. You can't describe it. So, so how sort of do you deal with that? And I think part of the shift in the risk management is also around integrating risk management so that you don't have separate silos with just investment risk or just operational risk. So you're working towards more of a holistic risk. To what degree do you think that investment team should take this on board in terms of the non investment risk? So Not, not, you know, the investments, the business side of things,

Jo Leaper 05:38

I think they have to be part of the conversation. It doesn't matter. And I've always said in public, it doesn't matter what investment strategy you come up with. If you can't implement it, if your operational teams, your custodians, your administrators, can't manage it, there's no alpha there. It's dead money. And so they do have to be part of the conversation. What I'm seeing, and what I'm liking seeing in the market, is this rise of investment governance being more involved and almost being as the bridge between the investment team and, say, the risk team, so that it's a much more holistic conversation members best financial outcomes is always the bottom line. If that's your guiding principle, you're doing well in the industry. But if you had two managers side by side that looked very equal, would you take the one with the lesser risk on I would Yeah. And so I think they really do have to be in there, but it's also about improving the communication and the decision making processes, and that they're part of the broader discussion. So if we go back to your previous question in terms of APRA and what they're looking for, they still want the same goal, same as what the investment teams want, which is members best financial interest. And so I think with CPS 230 and then, as you say, going into the businesses, by looking across the risk spectrum, they're going to end up with an overall better outcome, because the cost to member isn't just the risk in the portfolio or the fees. It's legal, it's admin, it's it, it's audit, all of those costs come in too. And so if you can find a way to structure or manage your investments to ensure that you're looking at those things as well, that's your true cost of investment. So the more you can find, I'm going to say strategic alliances, a synergy, whatever you want to call it, but the more you can get some cohesion there in the decision making and some understanding of each other's process, I think the better it will come together.

Wouter Klijn 07:20

So is it more a degree to a degree about communication, or do you think should it be a new function within the investment team?

Jo Leaper 07:32

A risk function that is one person responsible for line one risk has always been part of it. So I don't think that's any change really. In particular, I think the main change is actually coming through the FAR legislation, the financial accountability regime, because that's designating individuals as being specifically responsible for particular parts. And when you think about it, the board is absolutely responsible at the top, but they have to delegate. The board can't do everything. They can't know everything. The IC can't. The audit and risk committee can't, and each of those C suite executives or others who are designated accountable can't know everything about everyone else's role if they're not communicating, if they're not exchanging knowledge between teams, if they're not talking in advance of an investment, they're letting themselves down. The better ones will have their operational and risk teams separate to investments, but we'll talk to them regularly in terms of we've got this coming up. This is what we're thinking. Is that doable? Is that not doable? What? How long will that take the custodian? What will it cost me? And it becomes part of the process, not an add on at the end.

Wouter Klijn 08:29

Yeah. So do you think that this will change, then structures within organisations? Because I sort of had the idea around, okay, well, if we make this everybody's responsibility, then it ends up that nobody's responsible. Nothing gets done, right? So with FAR coming into place, and basically, I think it requires organisations to pinpoint people and say, okay, they're responsible. In practice, that might not necessarily work out that way. But do you think that structures might have to change to make this more smooth process, or

Jo Leaper 09:00

They already are. I think in a lot of cases, APRA has definitely given indications to funds with regards to where their operational function sits, where their risk function sits, where their finance function sits, and what should be within investments and outside. The main thing with SPS 530 was segregation of duties, and so a lot of funds have taken that to heart and done some really good steps to get going. And now we're seeing this move. And if you look on SQL LinkedIn, there are so many investment governance and investment risk roles coming up for advertisement now, because there's a recognition that there has to be a bridge between the two and a dotted line is okay, but it can't necessarily be sero to CIO, necessarily, because day to day, they're not going to be across the challenges. Whereas an investment governance person or investment risk person as line one working into line two, risk, that's a much better conversation. And there is also that the way the information bubbles up, the language that you would use with an investment committee about risk may be slightly different to what you would use with a risk committee about risk, and this allows us. To look at the operational outcomes and say, Well, hang on, what should be going to the IC and what is actually an ongoing risk that may need to be managed by audit and risk and funds are just getting there in terms of giving that some thought now too. Because really, if we're going to make the audit and risk committee delegated from the board responsible for the risk, they need to understand the investment side. But equally, the investment committee needs to understand the audit and risk side as well.

Wouter Klijn 10:25

So these sort of new roles that are created or that are out there, do they function as sort of a translator between the different teams? I sort of make the analogy where, you know, insurance companies often what we found that the investment team didn't really talk to the actuarial team, even though they worked off same assumptions. And, you know, there was obviously a liability question around there, but, but there wasn't really a lot of communication, and the language was quite different. That could potentially be a problem here, too.

Jo Leaper 10:55

Yeah, it definitely can be. And I think they've always talked, but they're not always talking the same language, or they're using a word, and it's not necessarily the same on both sides. And someone who's got a good understanding of operations and investment or risk investment and governance can be that conduit. But it's also when they're looking at new investors or new investments rather, that they can then say, Hang on a second. What's going into the mandate? CPS, 230 if we go back to that, or 530 has quite a bit of onus on the asset owners of what they need to understand. There's been a big move and a much bigger shift towards including some of those requirements in the mandates or inside letters, and having the investment team do that. They're looking for a practical outcome. That's their job. That's what they're very, very good at. But an investment governance or investment risk person will look at it from the broader enterprise perspective, and so having someone in the middle that marries the two concepts and says, what's easy for the manager to facilitate to us in terms of information and what can we easily digest and use? Because it would be nothing worse than getting something back from the manager and nothing happens with the information. Yeah, that's really quite challenging.

Wouter Klijn 11:58

Yeah. So what is your sense of how much organisations are on top of this? The FAR regime is relatively new. It comes well this month into force in 2026 what is your sense there?

Jo Leaper 12:13

They started work on it quite a while ago. Yeah. And it sort of started around the same time as CPS 230 was just getting moving. And so I think they're reasonably well along in terms of the journey and designating what, who's accountable, who's accountable for what, etc. But if we go back to the premise of APRA and members best financial outcomes, and what we want to see with clients, it's that we want to see them utilise that legislation and structure to improve things, not to make it harder. Historically, I would have said that regulation was really additive. It's like, what's the next thing we can do that? What? How do we plug that hole? How do we make more sense of it? And you end up with boards with ginormous information packs that not sure they're totally understanding. And it's not because they don't have the intent to, and it's not because they don't have the capability. It's just that the volume of information is so much, and I think same with FAR, by stepping back and having those executives understand what their responsibilities are and utilise that in a, in their decision making and B, in how the information comes up to the ICS and the boards, we should see it evolve. And I think we've seen a little bit of evolution. But imagine the next two or three years, as far gets locked in, and as CPS 230 gets more settled, we start to see up as reviews of asset owners around that as well. Fingers crossed. We'll start to see that cohesion come, and then hopefully we can get to the world, which is what I'd really love, where risk is not a cost of business, it's actually an enabler of outcomes, whether that's investment or otherwise.

Wouter Klijn 13:39

Yeah, yeah. So when this all comes together, what are some of the main areas that you really want to take an extra look at? I think in the past, you have mentioned, like systems and security, costs, things like that, what are sort of the main areas?

Jo Leaper 13:53

Well, at the moment, the hot ones, ai, ai, has got the potential to do amazing things for our industry, but it's also got a lot of challenges, and where the industry is going at a very fast pace, so that that is a question, the integration of the broader operational costs back into that risk discussion is another large part of it, really strong alignment of roles and responsibilities. And I think what we're seeing across not just not just asset owners, I think it's actually across, whether it's investments or broader companies that the roles and responsibilities aren't always aligning with where the current role is and with historically, I think the world globally had a view that if you're the CRO, your job is this. If you're the COO, your job is that. But companies merge and morph and their roles change slightly. Now we've got new legislative requirements coming in. It's going to force some Dillon force some delineation, which is probably necessary. But at the same time, I think if you look at it from the positive perspective, it gives organisations a chance to go back and say, Hang on a second. If we did this now, starting from scratch, how would we set that up? Now? What would our structure look like? Who would be doing what? And so I think I. That's probably the biggest potential driver of immediate change, is making sure that your roles and responsibilities are aligned. Tech is still a huge one. It's never going to go away. Legacy technology in the industry, like I said earlier, is, it's quite challenging, yeah, and so yeah, there's a lot. But at the same time, if you've got the right premise in front of you of how do we get the best outcome? We should be okay.

Wouter Klijn 15:23

So do you think that the regulator, to a degree, want to go back to basics, and basically, as you said, not add something on, but to rethink the entire approach to risk management?

Jo Leaper 15:33

I think so. I was involved in the Appra and ask for discussions on CPS 230 and as you know, I'm leading the ask for working group for operational due diligence as well. And all the way through the comments from APRA was we didn't want this to be additive. They really do want us to look at removing something. But if I'm a board trustee, how do I get comfort that taking away that piece of information isn't going to cause me drama later? And that's where there really is a lot of work going on in the industry. There's a heck of a lot of work going on in the industry looking at what's going up to boards and what's actually being presented internally, because you've got this push pull between board and management, management that are doing the work want to present it. They need the feedback, they need the support and to know that they're doing a good job, which means lengthy papers, however, for the trustees to do their best job, a more efficient approach would be, let's just raise the anomalies. And it's finding that balance between the two, and some funds are making a lot more progress than others. Others are looking at what goes to the IC versus audit and risk or other committees as well. And so again, that evolution will continue. It'll be interesting to see where it goes.

Wouter Klijn 16:39

Yeah. Now this is an Australian regulation. It's not sort of a coordinated global effort, I think. And sometimes that can be quite tricky, because we require more information from a whole lot of external services providers, often. And I sort of remember when they were talking about valuation methods in unlisted assets that it's sometimes very hard to get it out of the managers that you employ. To what degree do you think that might, you know, cause some trouble in implementing this?

Jo Leaper 17:08

It will always cause a little bit of friction. But in all honesty, it should. It really should, no no. Because if you look at, say, you've got the ipef standards, you've got other industry groups that are designating what they believe is best practice. The ask for guidance note is looking to do that as well. But I think different markets are at different stages. Some of the alts in the US are incredibly developed in terms of the way they do the valuation committees, the way they do their independent valuations, how they validate and verify the information they provide. And others are in a much more, I'm going to say more infancy sort of state. They've absolutely got the right idea. If we want alpha in portfolios, sometimes we've got to accept a little bit of that risk, and that's where the individual risk appetites and risk frameworks make a difference. But it's certainly not a blank check to accept everything. And I think what we've learned, particularly since the original guidance note came out is that talking to those managers, having that conversation, starts to change the dialogue. You know, we've had managers where we've done DD reviews for years, and then five years later, they come back and go, Oh, we're actually about to uplift that is all that stuff you said still valid? And sure enough, that's what they take, which is great, but we're one voice. Some of these big managers could have 50 consultants asking for things, and unless we're collectively asking for the same we don't talk to each other. It's not necessarily going to align, but I do think there is a lot of focus on the unlisted market at the moment, particularly private credit, private debt and otherwise. And there should be, but it's an evolution as well.

Wouter Klijn 18:37

So is this going to affect the private asset space more or do we actually suppose more?

Jo Leaper 18:41

I think the valuation governance frameworks that are in 530 already are having that impact, but I think it will get more intense, because APA really wants to understand and so does ASIC. And unfortunately, as we all know, there have been some challenges in the industry around shield and first guardian and others in terms of look through and understanding what you're actually investing in, and at the end of the day, good governance will get you so far. The valuation processes can be as robust as possible, but there is always risk. And that's, like I said, it's that balance of is that risk in line with what we're trying to achieve for our members? Yeah, sometimes it will, and sometimes it really won't be.

Wouter Klijn 19:17

Yeah. So these new rules are basically they intended to uplift governance, make people responsible, personally responsible, for some of these areas. What is your sense on how much impact this new legislation will have? If I compare it, for instance, to your future super that had quite a massive impact on the industry? Is this similar?

Jo Leaper 19:40

I'm actually not sure on that one. I think with your future, your super the regulator was looking for very specific outcomes and trying to correct specific behaviours. But APRA, in the recent prudential standards, the cross industries and the super standards, they're saying Prudential. They're saying that it's they're not going to be prescriptive. And so. Don't know that it will be quite as much of an impact. But what I do think is that 230 in particular is allowing for the right sizing of risk, and that's not being prevalent in the past. So in the past it was you need to look at your manager. You need to look at it every year. You need to have covered this, this and this, and this is how they categorised and and there you go. Whereas now it's a much more sensible approach, from an mdfi perspective, to say, Hang on a second. My riskier managers deserve more attention. I need to work on them if I'm going to stay invested my less risky managers, okay, I still need to look at them. But where's the best place for me to spend members money and our resources that members are paying for to get the best kind of outcome? And so that right sizing is really critical. At the same time as we've been talking about, the alpha has to come from somewhere. And if you can find the right way to use 230 to look at those risks, you can really start to drive the uplift that you were talking about. And I think in our previous discussions, I've talked about giving Alpha its wings. Risk has to be part of the discussion to enable an investment it's not just a detractor. And I think historically, the world's been a risk cost, cost of compliance, cost of doing business, as opposed to hang on a sec. Are there things I can do here in my business to make it safer, potentially attract more money into the investment manager we're looking at and start to generate some real outcomes. The flip side, though, is the potential for contagion risk, because if we have manager concentration, which is where 230 comes into play, but we've also got those geopolitical risks, I think, as we were talking about before, there is so much more general risk across the market that April's right, there is the potential for a systemic event at some point, but there always has been, and there always will be. So the more prepared we are for it, the more we understand what our managers are doing, the better look we've got on the data, and the better way for us to try and look at correlation and causation as two different factors in there, there's a much better chance that we'll be prepared, and that's what they were wanting with 230 it's operational resilience. It's the readiness, yeah, and you can see at the moment.

Wouter Klijn 22:11

I think you mentioned before the sort of what is playing out in the private credit space as well, and in the US. Do you think that this will help prevent sort of, especially the super funds, investing in funds that might have over promised on liquidity or have too high of a retail base?

Jo Leaper 22:30

Yeah, and I think so yes, and I do think it is, if it's not already, it already is starting to prompt those discussions. And when we say that risk is necessary. It's understanding the risk that is necessary. And if this prompts those discussions, then I'm really happy, because that way they can look at it and go, does this work for us, or does it not? It might have fit in the portfolio. It doesn't now, or that opportunity we said no to that actually fits now because we don't have a better understanding. So I think it is that evolutionary discussion that private credit, private debt, feel like the hot topic at the moment, but really it's just about trying to get any funds, need to get extra alpha in there, and finding the best way to do that, logically and sensibly. We talk about risk sensible a lot.

Wouter Klijn 23:16

So you mentioned the alpha and talked about the concept of giving Alpha its wings. I think in the US, they talk a lot about operational Alpha. Do you think there is alpha in this sort of holistic risk management framework? I genuinely

Jo Leaper 23:29

I genuinely do we, particularly from our side, we get a lot of the operational alpha out of the operations side. Risk is definitely part of it. But unless you're understanding that whole of risk construct, you can't necessarily seek out the operational alpha, but the operational alpha can also extend into how my FX is being done. How am I actually implementing my trading What am I doing with my idle cash that sits at custodian if it's not getting a lot of cash return on it? And so if I was to say, take that operation sorry to the custodians in the world, take that operational cash and invest it that comes with operational risk, which means I need to be talking to my IT team, my risk team, my audit team. How am I going to be investing that? Am I in sourcing? Am I outsourcing? There is genuinely a possibility to generate more alpha from what you have already within the portfolio. It comes with risk with every change that you make. That holistic approach absolutely is a way to try to generate that alpha in a sensible way. Yeah, just understand it.

Wouter Klijn 24:30

So it's not just about avoiding disasters.

Jo Leaper 24:34

No, no, definitely, not definitely avoid disasters. Please, avoid disasters. It's about trying to find a way to do what the job is. Yeah, our job is to manage someone else's money. We have to do that in a really sensible way. And I'd hate to see alpha being left on the table, because someone could make the operations work. That's not a sensible approach to me.

Wouter Klijn 24:57

Yeah, so we started off saying that this is. Is becoming more important because the world is complex. Investments are more complex. Do you think there's also a element here where it's going to be harder for the more funds get larger and larger? I mean, we see some of them hitting, you know, close to $500 billion. How do you how do you manage risk in an organisation that's like one or $2 trillion?

Jo Leaper 25:25

I think that is a very interesting question that we don't necessarily have the answer to yet. Fair enough, I think we need to learn from what overseas peers are doing. There are definitely pros and cons to internal management at Every Size and every fund needs to make their own decision. In that sense, if we look at the US funds that are already that size, they've got 234, custodians, right? I'm not sure in this market that we're prepared for that, but we probably should be looking at multiple custodians at some point. They also have multiple securities lending providers. They also have much larger teams, but then their regulatory environment is different to ours, and so we can't say, Let's do what the Canadians do, let's do what the US do, or what the Koreans do, or Netherlands. It's what do they do. And what can we learn from Yeah, because other people have done this before us. So we'd be very naive to come in and go, right, we can build a model from scratch, but I do think a lot of a lot of investors would benefit from going back to the drawing board and saying, if I started this fund today at this size, how would I set it up? And that's quite challenging.

Wouter Klijn 26:30

Yeah, so you mentioned you're part of as far Working Group on it as well, and I believe you're coming up with a guidance note on investment management, operational due diligence at sort of a high level. What will this focus on a roadmap for funds to implement?

Jo Leaper 26:46

It's not a roadmap. It is more it is a guidance note. So it's more like a practice summary. What what we want to do is continue on the previous work. The genuine benefit that we want is to bring a benchmark to the market for what they should be expecting. Because when the guidance note was written, which was seven, eight years ago, to where general market practices are, has changed. There's no point leaving guidance as it was 10 years ago. There are really good innovations in there. And so with the guidance note, we've kept the same categorizations like trading and back office risk valuations, HR, etc, but what we have looked to do is bring together, and in the Working Group, we've brought together, got Jana as an ops DD consultant to asset owners, Mercer as an ops DD consultant to asset managers. And then we've brought in superannuation funds, obviously, as far and asset managers that are part of Asfa, as well as a legal component as well, to try and ensure that the guidance note reflects all of the different parts of the industry and how they work together. And so it's very different format. You know, we'll see a very different format there is the sort of documentation you should be asking for to try and validate, because we really are leaning into apras document and understand what you're doing. And so we're leaning into that a lot. It has an extra section on CPS 230 it is less prescriptive in terms of how often you should do the review, and it's trying to be more reflective of 230 in terms of risk adjusted approach. Let's use the resources sensibly and try and make sense of it. What is different about this model in Australia, though, we're the only market in the world where the manager pays for that review, right? Okay, and a lot, a lot of the feedback we got from overseas counterparts was that that's they're just not okay with that. And when it first started way back in the day, I wasn't okay with it either. But working with that model for so long and seeing that the reviewers are putting into the reports that go to the clients and prospects, exactly what the manager has said, typos and all. It gives me a lot more comfort that it's in there as it should be, because it's not an audit. This is where I really get into someone say, get on my high horse a little bit. I really want risk to not be seen as a cost. And yes, this is a cost. Yes, it costs the manager. Ultimately it's going to cost all clients. This is a pretty economical way, because it's a smaller fee paid for there. But what the feedback from the managers that I'm really enjoying, including overseas managers, which is great, is they are able to distribute it to any of their clients globally, to any of their prospects globally. That's really good, and because it gives us a standardised benchmark of good practice, as opposed to you had x many tests in this GSW seven that didn't pass, it's actually really good, genuine feedback for the managers, because a risk or a compliance review that they get done is often based against legislation as opposed to market practice. And so I think our clients and the as well as the asset managers that are using the reports are getting a lot more back and a lot more relevant information they can use to lift the quality of the market. And if the rest of the world wants to follow suit, great if they don't. This is where we're going at the moment, it's not for everybody. And as you said, as super funds grow more and more. Maybe this is useless, maybe it's not. But could it be useful, perhaps, in the retail space, in the platform space, when you're dealing with very high volumes of investments coming in and investors that may not be as savvy as some of our wholesale investors.

Wouter Klijn 30:14

Well, Jo, thank you very much for your time and for coming to the office.

Jo Leaper

Thank you very much for having me. It's been great.