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.

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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, 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.

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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.

In this episode of the From the Archive series, we look at a 2019 interview with Gus Sauter, the former Chief Investment Officer of Vanguard, who worked for more than 25 years at the company. Sauter is also an adviser to the Australian Retirement Trust, then Sunsuper.

Index and passive investing have gained momentum in recent years and it is estimated that about 60 per cent of investments follow passive strategies today. Considering this sheer weight of money and the move of more Australian superannuation funds to passive investing in recent years, it is easy to forget that index tracking and the popular investment vehicle for doing so, Exchange Traded Funds, were once controversial.

In fact, Jack Bogle, the founder of Vanguard, was not a fan when Sauter launched the ETF business for the company. In this interview, Gus takes us back to those early days and revisits the active/passive debate, a discussion he never tires of.

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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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Podcast overview Gus Sauter

1:00 You started a bank at age 8, is that true? 3:00 Then a goldmine in your 20s? 4:20 Gold is an Armageddon type of investment; if the world collapses, gold is probably going to be fine 5:50 My first stock 6:30 I've had the active vs passive debate literally thousands of times and 'no' I'm not tired of it. 7:00 Passive is a good investment strategy, but it is never going to be top performing in any given year 9:00 I'm not totally on board with the efficient market hypothesis 10:00 Why indexing works 12:00 But does the market capitalisation method work in fixed income, where you skew to the most in debt entity? 14:00 Over time, markets have become more efficient, compared to the 1980s. 15:00 Did Jack Bogle cut his holiday short to find out why you were adopting ETFs? 16:00 Jack disagreed on ETFs 17:00 The crisis of 1987, and the subsequent redemptions from mutual funds, shaped my thinking on ETFs 19:30 Is there more institutional takeup of ETFs in the US, than there is in Australia? 20:00 ETFs are not a product; they are a way to distribute index funds. 21:00 Not a fan of smart beta 27:00 You don't think there is necessarily a correlation between GDP growth and stock market returns? 28:30 You can take a great firm and make it a lousy investment by overpaying for it and visa versa 31:30 Working with Sunsuper 33:00 Do you see a lot of similarities or differences between the issues that investors in the US and Australia grapple with? 35:00 Should pension funds in Australia be more dynamic in their asset allocation? 37:30 What have you learned from past crises? 42:00 Jack said: "One day indexing is going to be really big and we'll have US$ 10bn in assets" We now have US$ 4 trillion.

Full Transcript of Episode 133

Wouter Klijn 01:00

Gus. Welcome to the show.

Gus Sauter

Well, thank you. I'm glad to be here.

Wouter Klijn 01:52

Let's start a bit with the start. I'm going to take you right back to age eight. There is a website that is called Buggle heads, and it has your buyer up there, and said that at age eight, you started taking deposits and making loans to neighbours, effectively starting your own bank. Is that true? And what is wrong with playing with Lego?

Gus Sauter 02:16

It is true. I'm hesitant to admit I think I probably broke several 100 banking laws. But yes, I didn't think my neighbours were going to turn me in. They would give me $1 or two, and I would turn around and deposit it in the bank and earn interest on it, and then turn around and give them the interest that they would have earned. So yeah, I was a little enterprising at eight and not too much into Legos.

Wouter Klijn 02:40

So where did you get the idea from?

Gus Sauter 02:43

You know, just from my parents and going to the bank with them. And I guess I was just curious about how money could make money for you and and really, that was the genesis.

Wouter Klijn 02:53

And then it also says that around in your 20s, you formed your own gold mine, but what inspired you to make that investment?

Gus Sauter 03:04

Probably naivety. I was working as a commercial real estate developer in Denver, and we were building, really about 11 story office buildings, and I was working on the financial side of putting these deals together, and this opportunity came along to develop a gold mine, and I figured, well, I'm the financial side raising capital to build buildings. Why can't I raise some capital to build a gold mine and and so I put a venture capital deal together. Took me about three years to run it under. Turned out to be a little bit of a frustrating point in my life.

Wouter Klijn 03:35

I can imagine. So looking back, what is your view on gold today? Because a lot of investors think that gold is a bit speculative. It doesn't have any inherent value. How do you look back on that?

Gus Sauter 03:47

Yeah, so I started that in 1982 and that was really kind of the height of the gold mania, the gold rush, and I was looking at a little bit more like a mining company, as opposed to the lustre of gold itself, although I must admit, if we were mining for salt, I probably wouldn't have created the firm. So my view then was to hopefully make money mining gold and selling it immediately, not holding on to it. My view is that gold is kind of a Armageddon type of investment. If you if the world collapses, probably gold is, is fine. My view is the world is not going to collapse. And so I, you know, gold doesn't give you any sort of rate of return. It is, you know, as you indicate speculative. You buy it with the idea you can sell it later to somebody at a higher price. There's no dividend on it, no interest. So I think if people do have it in their portfolio, it should be a small, small part of the portfolio.

Wouter Klijn 04:47

Yeah, well, I'm glad the world is not coming to an end. So we had banks, we had a gold mine. You mentioned real estate. How did you get started in the asset management industry when my gold mining venture went on?

Gus Sauter 04:59

I had a good friend from business school who had kept in contact with me, and he went to work for Pimco, who is now the famous bond management firm, and he kept after me, and kept telling me that I belonged in the investment management industry. And actually, quite honestly, I felt that as well. I bought my first stock when I was 11 or 12 years old after after the banking experience and and I loved investing, so I followed his advice. And interestingly, I had some opportunities, perhaps, to go with PIMCO out on the West Coast, in California, but I grew up in Ohio, in more the centre of the United States, and I wanted to go back home. Unfortunately, there just aren't many investment management firms in Ohio. So I worked for a bank in Ohio in their trust investment area, and got experience.

Wouter Klijn 05:47

And I think that that first stock was that a basketball team.

Gus Sauter 05:51

The basketball team was actually my second stock. Yes, my first stock was a snowmobile company, and my second one was the Cleveland Cavaliers. I'm proud to say I was one of the original owners of the Cleveland Cavaliers. I grew up 90 miles south of Cleveland, so, yeah,

Wouter Klijn 06:07

So taking it to Vanguard, not looking at individual stocks, but we're looking at indexes, and even to deal this day, we still have this discussion about active, passive. You know, what is better? Do you get tired of this conversation?

Gus Sauter 06:27

You know, I've had the debate 1000s of times, literally 1000s of times, as we were trying to build indexing back in the 80s and 90s, it was not well received at all. And it was really a brick by brick business building venture, and I was invited to many, many conferences, and interestingly, they would have me on a panel, and I'd be in a debate with somebody else, and it would always be a top performing, active manager. So you know, you're always kind of with with your back in the corner. Indexing is a very good strategy and appropriate for most investors, but it's never going to be top performing in any given year, it's going to be a good performing investment that really compounds over time into top performance. So I actually, I do love the debate, because I think it shows the advantages of indexing and also allows for the advantages of active management to complement indexing.

Wouter Klijn 07:18

And it seems that we have moved on a little bit from one against the other two, where I think we see more especially amongst the larger funds that don't always have a choice to go 100% active, that they say, well, we'll do both. We will have a core allocation to passive, and we'll do some things around it in the active space. Do you feel that the this debate has become more sophisticated around this issue.

Gus Sauter 07:42

I do. I think a lot of investors have realised that there are significant advantages to indexing, and it should be a core portion of their portfolio. It's a great foundation, because it's going to provide you with very competitive returns that will outperform a majority of investors in the marketplace. So it's a great place to start, and you have a good deal of confidence that it will provide that rate of return for you in the future, at the same time the satellite portion. So a core satellite approach, you can use the satellite portion to invest in actively managed funds to enhance your returns that you get from an index fund. So if you if the index fund is your your ballast, or your foundation, hopefully you can add some incremental return above and beyond that, without too much risk, by investing in active as well thinking about indexing. What is indexing?

Wouter Klijn 08:28

And I think in the past, you have made a strong point around an index is a market capitalization weighted construction. Why do you feel strongly that it has to be only that type of model?

Gus Sauter 08:45

So it turns out that there are two rationales for why indexing should be an attractive investment number. The first one is based on the modern Efficient Market Hypothesis. I personally believe the markets are quite efficient, but not perfectly so. So I'm not totally on board with the efficient market hypothesis. If you if you believed in the efficient market hypothesis, then clearly the only thing to do is index. I mean, that states that everything's fairly priced and you shouldn't spend any money trying to outperform because you're not going to be able to do it. The other argument is what is called sharp math, or Bill sharp was the inventor of this simple concept that in aggregate, investors get the rate, the market rate of return. I mean, in aggregate, investors own the market. They own it by market capitalization. In other words, they own more stock in in, let's say, Facebook or or Microsoft or bhp, than they would in a small company. So that, by definition, is telling you that investors, in aggregate, own by market capitalization, some will outperform, but others will underperform by the same amount. I mean, to the extent everybody on average gets the market you can't all be above average when you introduce. Costs into the equation, and costs are really significant. I think people really dramatically underestimate the impact of costs. Then all of a sudden, the marginal outperformance before costs become underperformance after costs. And that's really why indexing works, because it's extremely low cost. It's a handful of basis points, or a fraction of a percentage point that you pay in costs, and you get largely the market rate of return, and you'll outperform a majority of investors because of that, but that argument is based on market capitalization weighting. There are, as you're implying, other ways that people are coming up with indexes equal weighting, or things called fundamental indexing. Those really give you something very similar to what you get with capitalization weighting, with tilts to it. So in other words, there are segments of the market, there are large cap stocks, there are small cap stock, there are value oriented stocks, and there are growth-oriented stocks. So all of these different segments of the market will perform a little bit differently from the market as a whole. And when you weight things differently from a market cap weighting, you're actually inadvertently tilting towards one of those investment styles. So when you equal weight an index, you're getting a tilt towards smaller cap stocks. And it turns out that you can just invest in a small cap, a small cap index fund that is capitalization weighted, and get a very similar return. Same thing when people tilt towards value, when these fundamental indexes, they're basically a tilt towards value. You can get the same return if you use a capitalization weighted index that is tilted towards value, so the capitalization weighting is less expensive. You don't have to rebalance as much. It's lower cost than fee wise that most of these other types of indexes charge. And it's it's more tax efficient because you basically buy and hold so I think you can accomplish if you want a small cap tilt or a value tilt, you can do it with capitalization weighted indexes.

Wouter Klijn 11:59

I think part of the debate around market capitalization model is around. Is this the best way to construct an index? And I think where this debate becomes most clear is within the fixed income space, where there are issues with having the largest exposure to the most indebted entity in the index, even though that represents the market. Do you think that's a fair comment? And can we still call them indices?

Gus Sauter 12:26

So you know, going back to the sharp math, the bill sharp math, which is a mathematical tautology, again, you know, in aggregate, investors are going to get the market rate of return when we start to think of other asset classes other than stocks, like bonds, fixed income. The concept still applies. If you want to be a top performer, outperforming the average capitalization weighting still makes sense. It's true that you put more weight in in companies that have or countries, for that matter, that have greater debt. And people have said, well, so you're taking more risk because you're investing in the most heavily debt laden companies or countries, but at the same time, that's already implicit in the pricing. So in other words, if there's additional risk associated with investing in either that company or that country, it's going to be reflected in a higher yield, a higher rate of return. So so you're really being compensated for that. And the people who say, Well, you know, you're just taking on greater risk, you're being compensated for taking on greater risk. And again, the only way to ensure that you're going to be a top performer over the long term mathematically is by relying on that sharp math and owning the entire market capitalization, weight weight market.

Wouter Klijn 13:42

So this is where the efficiency of the markets come back in, where it says, Okay, this is greater risk, but it's priced accordingly.

Gus Sauter 13:51

Yeah. So you know, as I said earlier, I don't believe in perfectly efficient markets, but I don't think there are grossly inefficient markets either. And actually, over time, I think the markets have become more and more efficient. I mean, I think back to the 1980s when I started in this business, and quite honestly, active management was a lot easier back then than it is today, and that's because there were greater inefficiencies. So there were greater opportunities to take advantage of mispricings. Today, those mispricings are very small, and even if they're not precise, they're not grossly wrong. And so, you know, it's very, very seldom that you would find a company or a country that is much riskier than its yield would indicate.

Wouter Klijn 14:33

I would like to take you back a little bit to innovation in the index space, and especially the exchange traded funds. I understand that you were one of the earlier believers at Vanguard within this vehicle, but I also heard that when Jack Bogle, the founder, found out that you were going into ETFs, that he cut short his holiday and came back to grill you on why you're going down this route, even though he was supposed to have retired already by that stage. What happened there?

Gus Sauter 15:01

Yes, Jack was retired at that point, and Jack always went on vacation for the whole month of August. He had a house up in the mountains, and he went away for the month of August. We happened to announce that we were going to launch ETFs while he was away. I mean, that was just pure coincidence. And since he wasn't working with the company anymore. He wasn't aware that we had been working on this for, actually a couple of years. It took a long time for us to to launch because of our unique structure and getting it through the regulators. But so Jack did find out when he was on vacation. I don't know that he actually came back early from the vacation, but, but the day he got back it at Vanguard, and so he still had an office at Vanguard where he did his research. And we have a building that has the the dining area, the dining hall, that most of the employees congregate for lunch, and it has an upper level and a lower level. And I entered it the lower level to go grab some lunch, and Jack happened to be standing in at the upper level, at the top of the stairs, and he saw me at the bottom. And this this foyer is typically filled with lots of people around lunchtime, and Jack has had a booming voice, and he held out, gosh, what the heck is going on around here? So you know, Jack was vocally not in favour. Or, you know, I'll say it's that Jack was against ETFs. Jack and I agreed on an awful lot of things, but we disagreed on that one.

Wouter Klijn 16:33

Did he ever turn around on this topic?

Gus Sauter 16:35

No, he was very vocal, you know, till his final days that he did not like ETFs.

Wouter Klijn 16:42

So what attracted you in ETFs as a vehicle?

Gus Sauter 16:45

I started with Vanguard in 1987 to be precise, October 5, 1987 some of your listeners will recall that October 19 was the crash of 87 two weeks after I started. And I think we're all shaped by our experiences, and that was a scary one for me. I was actually managing the very small equity group at that point in time, but it put a lot of pressure on us. And, you know, we had some withdrawals, and I was trying to sell stocks to meet those withdrawals that day. And that really kind of shaped my thinking. When I started thinking about ETFs, I started thinking that we were we had just come out of the late 1997 period, which was known as the Asian contagion, and the markets became very volatile. Then we went into the summer of 98 which was the Russian debt crisis, again, volatility in the markets, and I was worried that we might experience another crash of 87 type of event. So I started thinking about, how could we enable investors that wanted to get out of our funds, enable them to get out of the funds without impacting the fund itself. When an investor gets out of a fund, you have to sell off some of the investments in order to fund their redemption. So I started thinking that if we had a share class of ETFs in the same fund. In other words, you could invest in the Fund two different ways, either directly with the fund, like you typically would, or through the ETF share class. It turns out, because of the mechanics of the ETF share class, if an investor happened to own that share class, they could sell that on the stock exchange, which is where you trade ETFs, and it would have zero impact to the fund. And so I reasoned that if investors were so inclined to sell, they would be attracted to the ETF share class and not to the conventional share class, and that would enable them to have all the flexibility they want without disrupting the investors that were long term oriented and leaving the fund with additional costs. So they really complemented each other.

Wouter Klijn 18:46

Yeah, and is that impact mainly in terms of taxation?

Gus Sauter 18:50

It's, it's both taxation and transaction costs. Yes. So the taxation piece would be, if you have to sell off an investment that is appreciated in price, you have a capital gain you have to pay tax on. But at the same time, if you have to sell off, you have transaction costs of selling the investments as well. And so we would avoid all of that by if people were in the ETF share class.

Wouter Klijn 19:11

I think to a degree, the initial take-up here in Australia was mainly retail, and we don't see a lot of institutional investors using ETFs other than temporary parking money or tilting how's the situation in the US? Is there more institutional take up?

Gus Sauter 19:29

There is a little bit more institutional take up in the US. So we see institutions using them for any number of reasons. Sometimes they use them for long term investments. Sometimes, as you indicate, just short terms, they might be migrating from one type of investment to another, or from one manager to another. You can imagine a large institution that has a manager, and they might fire the manager, but they need market exposure while they're looking for a new manager, and so they might move, for short term, into ETFs. So I'd say ETFs. Are used considerably by institutions and tremendously by the advisor community in the US.

Wouter Klijn 20:07

So what do you think is going to be the next innovation in indexing or in ETFs? Is that around active ETFs, or perhaps the Smart beta ETFs? What is your view on that? Yeah.

Gus Sauter 20:18

So the interesting thing a lot of people talk about ETFs as being a product, and I've been pretty vocal saying they're they're not a product. They're a way to distribute a well known product. In other words, it's a it's really just a different way to distribute an index fund. If you look at all the ETFs they can be done in a traditional mutual fund, ETFs in the United States are legally organised as mutual funds with certain exemptive relief. So they come out of the same part of the tax code. To me, ETFs are really just another way to distribute. I do think they will grow into a way to distribute active funds as well the Smart beta concept I'm not a big fan of. In fact, we had what's become smart beta in the early 90s. We started, I mentioned earlier about the different segments of the market, and that's a little bit of what smart beta is all about, is targeting different segments of the market. You know, talked about fundamental indexing. That's fundamental indexing turned out to be difficult to market, so you rename it smart beta and like, why would anybody get dumb beta if you could get smart beta, but it's really just getting different exposure to different segments of the market, and you can do that through capitalization weighted indexes, which we have offered since the early 90s. But I think my objection is they're being marketed as something that will provide you long term outperformance, and I just don't think that's going to hold up. And I think investors are expecting more than what these products can deliver.

Wouter Klijn 21:52

You talked a little bit earlier about the market structure as well, and that you said that in the past, it was probably a little bit easier to be active, and today, markets are a little bit more efficient. There has been a lot of discussion as well about the impact that the large technology firms have on the structure of the market with capital light models, and potentially has changed the structure of the market as well in the sense that there's less ability to participate in the growth. Do you worry about these types of developments?

Gus Sauter 22:27

I don't. I think that technology has been an advantage for investing and has reduced costs significantly. So I think on the transaction cost side, it used to be that humans were involved in all trading. And if you wanted to buy something, you had to buy it from a market maker, and or conversely, sell it to a market maker. Now it's done electronically. Almost all trading is electronic nowadays, and it cuts out a layer of profit that that middleman would would earn. And so transaction costs have plummeted. I mean, literally, from what would have been 1% or more if you, if you bought a stock, to now maybe a quarter of a percent. So that is a huge amount of savings to investors. That's a benefit. I think your question is also about investing in technology companies, they are light in capital. As you point out there, it's more human capital than physical capital. That's I don't think that distorts the market. It's just a different way of creating a business. And ultimately, you're investing in businesses for the profit they earn. And it doesn't really matter if the profit is generated by human capital or machinery, like a manufacturing company. So from an investment standpoint, you just have to analyse it differently. I think you were also asking a little bit about, do you get to participate in the early stages of, say, it being kind of venture capital, a lot of firms, Lyft just went IPO last week in the United States. Lyft is like Uber, if Lyft isn't here in Australia, and the people that created Lyft, it went for $22 billion IPO. So these are called unicorns, anything that IPO is for more than a billion dollars, and the venture capital investors do extremely well and and then ultimately, investors, public investors, get to participate after the initial public offering. You know, I think that's just the risk one takes in venture capital for every unicorn we hear about, there are 1000s of dead unicorns along the road. So you should be compensated for risk. And even when these companies do go public, they still generate good profits for investors. I mean, look at companies like Facebook or. Amazon or Google investors, public investors, have made a lot of money investing in those, those companies.

Wouter Klijn 25:07

Now, you did work with the Securities and Exchange Commission in the US on equity market structure issues. What did they focus on?

Gus Sauter 25:17

It was a number of things. So I worked for help four different commissioners, four consecutive commissioners of the SEC over a decade or more, and they were working on a lot of structural changes to the marketplace, you know, going from that old structure that I mentioned, where everything was driven by humans, and prices were priced in eighth so it was $10 point 125, cents, 12 and a half cents. They created decimalization, so things started being priced in pennies. They brought in electronic trading. They tried to make sure that electronic trading was fair across different platforms. So there are, there used to be three exchanges in the United States. There are probably 50 now, or maybe even more than 50 at this point in time, and it's not fair if you trade on one exchange when there's a better price on another exchange. So they were trying to link the exchanges together to ensure that investors would always get the best price they could. So I sat on a number of panels for the SEC and gave my thoughts and opinions as to how I thought things should be done, and had the opportunity to speak directly with all of the commissioners during that time period. So it was a lot of fun for me to as a practitioner, to help out with the regulators as they were, I think making great improvements in our marketplace.

Wouter Klijn 26:36

Yeah, expanding a little bit on this idea of markets and exchanges as a vehicle to participate in profit. A lot of the discussion around emerging markets is about the economic growth and GDP growth and how you can participate in that as an investor, but I think you are a little bit more cynical about the direct relationship between economic growth and GDP and how that translates into markets. Can you expand a bit on that?

Gus Sauter 27:06

Yeah, I can give you two examples that explain that GDP growth, economic growth and stock market returns really aren't correlated. So think back to the global financial crisis 10 or 12 years ago, as you recall, Everybody I talked to around the world felt we were going into a very slow growth economic environment, and I agreed with that view. And it turns out we were all right. We've been globally. We've been in a very slow growth economic environment. And then, if you'll recall, at the same time, because of that, people felt that we would have very low equity returns going forward because of this low growth. I was arguing that, no, it would actually be the exact opposite, that you would have high returns going forward because of the perceived risk in the marketplace. We'd had the crash of the tech bubble in 2000 to 2002 and then we had the financial crisis. And I think investors perception of risk was extraordinary. And you know, if you think, Well, if you were expecting a low return in equities, let's say equities have returned historically about 10% and if you expected, say, 5% would you invest in equities when you could get a 4% return on bonds, which, have, you know, a fraction of the volatility. Nobody would invest in equities. They'd put all their money in bonds for, you know, you wouldn't take all that volatility risk for an extra 1% so I was arguing that the stock market had repriced itself so that it could provide great returns going forward. It's all about pricing. That's what determines future returns. You can take a great firm and make it a lousy investment by overpaying for it. Conversely, you can take a lousy firm and make it a great investment by underpaying for it. So it's all about where you price things initially, and the markets had pulled back dramatically, pricing things very low to provide great returns going forward, which we've had over the last decade, extraordinary returns. Another simple example that I give is the period of the 20th century, the 1900s the UK economy grew 1.8% per year. Their GDP growth was 1.8% per year, and the US economy grew 3.2% per year, much faster growing economy, if you compound that out over the 100 year time period, the UK economy grew about seven fold. The US economy grew about 17 fold during that same period of time. During that period of time, the UK equity market returned about 10.1% per year on average, obviously, with volatility. During that same period of time, the US equity market returned 10.1% per year with volatility. So there really has been no correlation between economic growth and equity returns.

Wouter Klijn 29:53

You mentioned there as well that the important element in there is risk. Is it a case where. Perhaps people focus too much on on volatility as a measure of risk, rather than taking into account all the other elements, including valuation.

Gus Sauter 30:08

Yeah, I think people do do focus on volatility. And if you've got a long time horizon, you don't really need to focus on it. If you've got a short time horizon, I think volatility probably is important to you. If you need your money a year from now, volatility is definitely your enemy. If you you happen to get a bad return over the next year and take your money out, you've got less money to take out. So. So volatility is important, depending on your time horizon, if you're 25 years old, saving for retirement 40 years from now. It doesn't really matter if the market goes down dramatically in the crash of 87 or the the crash of the tech bubble or the global financial crisis. All that matters is where the market is 40 years later, when you you're retired. And actually, if you look at a the stock market itself. Look at the price levels of the stock market over the last 50 years, all of those market crashes look like a blip in the in a heartbeat. When you look at them, they're really nothing when put in a long term perspective. But so people probably do focus on volatility a little bit too much, but people tend to be too short term oriented, too they don't think long term.

Wouter Klijn 31:24

You are here in Australia, partly because you're an advisor to the Investment Committee of Sun super. How did you get in contact with them?

Gus Sauter 31:32

I retired six years ago from from Vanguard, and Sun super was a client of Vanguard. I had not actually had I spent a lot of time in Australia during my working career, because I did have an investment team in Melbourne. So I got here a couple of times a year, and did meet a number of clients at Vanguard's. But I don't believe I had actually ever met Sun super. Turns out, when I retired, Scott Hartley, who was the CEO of Sun super, was, I think, looking for somebody to lend advice to the Investment Committee of Sun super somebody who had perhaps a slightly different point of view. He was looking for somebody who could, I think, play a slight devil's advocate role, maybe offer a slightly different point of view. And while you know, investing is investing, and we've all had the same theory of investing, you do have a little bit of a different experience depending on your environment. So, you know, my work experience is probably different from what you might experience in Australia. And so I think Scott felt I might be able to add something at the margin to Sun super as either a devil's advocate or something that they just hadn't thought about.

Wouter Klijn 32:39

So did you have to play devil's advocate a lot so far.

Gus Sauter 32:41

Oh, you know, I I chip in every meeting, and you know, I wouldn't say anything earth shattering, just something that a lot of times there's perceived wisdom. And sometimes I question it. Sometimes I might even believe in the perceived wisdom. But, you know, I just want to be a hair shirt and challenge the thought, so see if people can justify the thought. So I, you know, I try to play a meaningful role without being obnoxious.

Wouter Klijn 33:13

So do you see a lot of similarities or differences between the issues that the Australian pension funds and perhaps us institutional investors grapple with…

Gus Sauter 33:25

I think the nature of superannuation is a little bit different from institutional investors in the US. So ultimately, Superannuation is about members, whereas institutions in the US frequently might be an endowment, a foundation, a defined benefit plan, a pension plan, and of course, you have those here as well. But Superannuation is not like that. Superannuation would be more similar to our 401, K plan structure, and where you're dealing directly with individuals and members. And so I'd say it's very similar to that, which is, in our view, it's a little bit more retail than institutional. But I'd say it's applied a little bit differently. Here in the US, it's typically stocks, bonds and cash, and here, through most superannuation firms that I'm familiar with, in addition to those big building blocks that everybody's familiar with, they also invest in private investments as well, and alternatives also.

Wouter Klijn 34:30

Yeah, I think in the past, you also have put a lot of emphasis on the importance of asset allocation within an investment strategy. And I think in Australia, there's still a lot of funds that have a static asset allocation, high percentage of equities, little bit of bonds. Do you think that makes sense, or should there be a more dynamic form of asset allocation to play into the different circumstances in the market?

Gus Sauter 34:56

Investing is a social science and not a hard science, if it were. A hard science, I would say, you know, you should be dynamically adjusting your portfolio given the circumstances. Unfortunately, if you ask 10 economists, what's going to happen in the economy over the next year, you'll get 11 answers and and that's the problem with with investing, we just don't know what's going to happen. I mean, everybody's got an opinion, but frequently the consensus is wrong. So if you were correct and knew that the market was going to go down, and if you're correct in that assumption, then yes, it would make sense to dynamically adjust your portfolio and lighten up on equities. Unfortunately, people overestimate their you know, their knowledge is, there's a it's called in behavioural finance. It's called overconfidence. People suffer dramatically from overconfidence, and they typically do the wrong thing at the wrong time. And so, you know, think to yourself, how many people do you know you've heard of that sold out in 2009 got out of the stock market in 2008 or nine after the market had crashed. And then, I mean, people were asking me, in 2012 When do I get back into the market? Well, the market was already up 100% by 2012 and they've been sitting on the sidelines. So that's the danger of trying to dynamically adjust your portfolio. It's just that we just don't know what's going to happen.

Wouter Klijn 36:25

Yeah, I think there's an interesting illustration of that in the annual report of one of the largest Australian super funds. And this is a super fund that has what I call a direct investment option, where they allow the members to manage or pick some of the investments directly. And you could see that over the course of the financial crisis, it's exactly what they did. They sold out at the lowest point and sold back in when already stocks had gone up for most of its recovery, and so destroyed quite a bit of value there, which I think everybody's prone to but it's an interesting question around these direct investment options as well.

Gus Sauter 37:05

Yeah, that's, that's, that's a tragic story. I mean, you know, that impacts people's lives and their, ultimately, their retirement. And it's, it's really unfortunate. There's been a whole study in finance called behavioural finance that looks at these issues, and hopefully in the future, we'll learn and be able to counteract them.

Wouter Klijn 37:24

Yeah, now throughout your career, you've seen a few crises. Is there anything that we can learn from them? Every crisis is different, but are there some shared elements that people can guard against, or is it more a question of sensible asset allocation?

Gus Sauter 37:42

You know, I think it does boil down to sensible asset allocation. At Vanguard, we always talked about stay the course. And the only reason for that is, as I mentioned earlier, because we just don't know what's going to happen. I think the crash of 87 I going into that, you know, I didn't think we were going to get the returns that we had gotten previously. I didn't see a crash coming, and it happened all in one day. And so, you know, it was too late to respond after the fact the tech bubble, actually, we at Vanguard were concerned about that. I mean, that's, to me, that's one of the most visible things that you could observe. I mean, valuations were just ridiculous, and we did. We didn't know how it was going to play out. I mean, we knew that returns were going to be less going forward than historical returns. We didn't know if it would just be you'd get 3% for the next 10 years, or whether you'd see a 43% decline in the market. Well, we got the ladder. Unfortunately, we didn't know that. The other, the other situation I saw that really, you could see, I think pretty plainly, was one I mentioned earlier at the bottom of the market in the global financial crisis, that equity returns were going to be good going forward. But usually, you know, in my career, the only two that really seemed probable to me was the decline of the bubble or the imminent decline of the tech bubble, just returns were just going to be less, and in financial crisis being an opportunity to invest at the bottom. But I didn't see the financial crisis coming. I mean, we knew there was a lot of turmoil, but I didn't see the destruction that we had. So, you know, you didn't have cash sitting on sidelines to bottom, anyways, if you didn't get it out of the market beforehand. So, you know, our view is, really, unfortunately, investors typically are best off if they stay the course. I mean, that's just what we observe historically.

Wouter Klijn 39:38

Yeah, and doing a bit of crystal ball gazing. Are there any sort of risks that you think people should look out for today?

Gus Sauter 39:45

You know, it's interesting. The markets have been, actually pretty, pretty reasonable, not, not too volatile. You know, we've had a few spikes here and there. But actually, if you're the last five years, historically, that's we've experienced low. Volatility. I think it's more of the same for the foreseeable future. I don't see what upsets the apple cart from an economic standpoint. You know, typically economic expansion ends when either the central banks are trying to fight inflation, which they're not. I mean, they're hoping we get a little bit more inflation, in fact, and the other would be when consumers are so stretched from borrowing that they just can't spend anymore. And while I am a little bit worried that debt levels have increased, I don't think they're at crisis levels, and hopefully we don't get to crisis levels. I mean that that's what happened in the financial crisis, but so I think it's a little bit more of the same kind of muddling along, probably okay returns in the stock market and slow growth for the next year or year and a half.

Wouter Klijn 40:50

And summing it all up, I thought I might ask you as well, looking back over the long career that you have, could you share some of the moments that you find most memorable of them as well, and perhaps some points where you said that was a hard period, but I learned a lot from it.

Gus Sauter 41:10

Yeah, well, there are so many things that I remember. I mean, you know, obviously the crash of 87 was really scary, and I was two weeks into my job, and I wasn't even thinking about, could I be fired or laid off, because all of a sudden we've got a lot less assets. But fortunately, we stuck with it. So that's certainly my mind. You know, reflecting back on my career, I think the most fun was actually the people relationships, the people I worked with, a great bunch of people still have very strong friendships. Going back, I also enjoyed talking with investors. For the most part. I was, you know, back at the office, overseeing the investment team, but but I would get out and talk with institutional and retail investors from time to time, and I really enjoyed that. And I guess a few particular instances, I remember one day Jack Bogle, early on in my career, coming into my office and standing in the doorway. We had just crossed $2 billion in our s, p5, 100 index fund, the only index fund at that point, and and he said, Gus, you wait some day. Indexing is going to be really big. We'll have $10 billion someday. Jack boogle was not really prone to understatement, but he missed that by by a bit, because he's now Vanguard has $4 trillion worth of indexed assets. But I'll always remember that one, and I guess that you mentioned something that I really learned from that might have even been a scary experience. The financial crisis was extremely, extremely scary, and I had the opportunity with our CEO, Jack Brennan, to speak with the Treasury and various regulators during that period of time trying to figure out what was going to go on. I remember driving in to work at about four in the morning, because that's when our opportunity was to talk with the Treasury. They were working all night long, and I was sleeping for a couple of hours, but it was pitch black out, and I was thinking to myself, you know, the world may have changed going forward, and that was scary. And, you know, I learned I don't want to repeat that one.

Wouter Klijn 43:19

No, I can imagine that. Well. Gus, thank you so much for this conversation, and it was a pleasure to talk to you.

Gus Sauter 43:28

Well. Thank you very much. It's been very fun to be with you.

In this episode, I speak with Michael Kollo, a return guest to the [i3] Podcast. Michael has recently published a book on artificial intelligence, called: Future-ready with Generative AI Skills, Mindsets, and Stories in the Age of AI

We speak with Michael about how he build an equity analyst AI agent in a weekend, how AI helps review your work and how you can get it to find solutions that are tailored to your style of working.

We also delve into deeper philosophical questions around the nature of language, how AI changes people's interaction with language and whether AI changes our perception of what is artificial and what is not. Enjoy the show!

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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 Michael Kollo

03:00 We, collectively, still struggle to have the right framing for what this kind of AI is 04:00 I wanted to write a book on AI from a white-collar perspective that was neither hype nor alarmist 10:30 You build an equity analyst in a weekend, using AI agents, which produces broker reports? 14:00 What good looks like is still very much an individual judgment 14:30 AI is a mirror to yourself 18:00 Students are very strong users of AI across many different disciplines. And they are symbiotically learning with the AI and are becoming natural users of it 18:30 One of the more powerful usages of AI is not to do a job, but to review a job 21:00 AI helps you to think on a meta level: what is it that you find interesting, useful and powerful? 23:30 Can you get an AI system to explain to you in plain English why a non-linear system works, test it in 10 different ways and write a research report about it? Yes, you can. 31:00 "I'm expressing myself in my adult language (English), but (AI) is taking it and swirling it into patterns of Hungarian (my childhood language) that are hitting me back at a whole different angle that I'm not sure if I could have done myself". 32:30 "Language was supposed to be this thing that was supremely human. It encapsulates all this weirdness and contradictions that is to be a human being. 34:00 An AI system is not an individual or a single entity that has a will or a desire. It is a field that you can land on and move from one place to another, as you will. 37:30 There is a danger that power users of AI might experience burnout, because they are constantly given things to review. 43:00 AI experts should not be asked about workforce impact, because they don't know enough about it

Full Podcast Transcript

Wouter Klijn 01:17

Welcome to the [i3] Podcast. I'm here today with a return guest, Michael Kollo. Mike, welcome to the show.

Michael Kollo

Hi. How's it going?

Wouter Klijn

Pretty good. Pretty good. So we're here to talk about a book that you wrote on generative AI. It's called Future Ready with Generative AI: Skills, Mindsets and Stories in the Age of AI.

Michael Kollo 01:39

Well, thanks very much for that. That's a bit of a mouthful. We kind of continue to expand the title. It feels it's coming out in the middle of March, so I think the 14th, 15th. It's being published by a publisher called Rutledge, which is a UK based publisher. So it'll be available here in the US, in the UK, all around the place.

Wouter Klijn 01:58

So what prompted you to write this book?

Michael Kollo 02:01

So look over the last three years and for years before that, but certainly the last three years, the topic of AI has obviously become very, very popular. Everybody's been thinking about it and talking about it. But one of the things I found through lots of presentations about 40 keynotes per year from all kinds of different audiences, from boards of directors all the way down to, you know, the average person kind of presentations is that we, we collectively, still struggle to have the right framing for what AI, this kind of AI is, and what it might mean for us. I don't think anybody has answers as to where it's all going, what will happen to the workforce or jobs or personal relationships and so on, but I think we have a pretty good inkling as to its capabilities and how fast it's moving. We have a pretty good inkling as to the different areas it might impact, but we don't have the right framing or the right thinking about it. So I was very keen to write a book that I could capture the imagination of a white collar worker in across any industry, just about to help them just understand what this thing could be and what it means, and get them to form their own view, but to form it in the middle ground, not to be hype and not to be alarmist. I wasn't keen on creating a book about how it could all go wrong and how it could be all terrible. And I wasn't also keen to create a book about, you know, the utopia that it could foreshadow in the future, but I was just interested in informing the average person how the middle ground could look.

Wouter Klijn 03:29

Yeah, so not hype, but you do call it a civilisation altering technology. What do you mean by that?

Michael Kollo 03:37

Yeah, so that's, um, so okay, there's a story behind that. Okay, so the story is the following. I, I was asked to give a brief testimony to the Senate, Senate hearing in Australia, and it was for the education use of AI within education. And so a lot of the speakers before me had come and talked about the dangers and the problems and so on. So I was really keen to try to counterbalance that with the significance, but in a positive light as well. And what I was trying to say with to that audience is that if we get this right in terms of how we teach the next generation, how we enable the next generation to reason and to think better, then we could bring about a whole golden age, a whole kind of new renaissance, I suppose, of reasoning and thinking, and this could be civilization altering. And so really, the context of it was, how do we use this technology to enable people to be their better selves, or to reason or to think better? It was a bit idealistic, absolutely, because we all know that not every technology, in fact, most technologies, arguably, and not always used for the betterment of people. There's a whole bunch of other negative things that we've had recently, especially with social media and the way that it impacts people. But I was kind of, I suppose, making a case for if we can use this properly, in a good way, that there's enormous an abundance of positivity that we could have for our civilization. So. I really was looking for a term that would say, actually, civilization materially changed with the printing press. It materially changed with a few other critical things we've done in the past, nuclear power, or electricity, or so on. And each one of these changes just brought about change. That's all it is. And this is one of those moments,

Wouter Klijn 05:17

And you explore that concept further by actually saying it's not just the technology. I think you describe it as: it's a system that helps you navigate uncertainty. Can you explain a little bit what you mean by that?

Michael Kollo 05:31

So this was one of the big challenges I had in the book, is I was trying to get across to people that they should not think about this as just technology, as data, as statistics, because for a lot of people, that alienates them immediately from the topic. They go, Well, I'm not about technology, I'm about people. I'm about conversation. I'm about artistic things. I'm about something else. And so for them, it pushes it away somewhere in the corner for someone else to deal with, and it's more comfortable that way as well. And so I was trying to find the right words or the right framing in this book by positioning it in as a companion, positioning it as a co worker, positioning it as a whole bunch of different kinds of things in the fiction and the non fiction stories. And I think in this particular case, it was somewhat of an abstract way of saying that if you think about this as a reasoning engine, as a thinking intelligence of some kind without will and without desire. So we take those off the table and we say it's just about that. Then it really is about how to help the average working person understand information, distil it, or expand it or manipulate it in different ways, and then ultimately, to deal with the core part of most jobs, which is dealing with uncertainty. Decision making under uncertainty certainly is really prevalent in finance and in financial services, but it's prevalent in many other industries as well. You have to make decisions. Do you write two two paragraphs or one paragraphs to your boss to explain what happened? Do you do you put in a big report or a small report? Do you go with one stock manager versus another stock manager? Whatever the decision might be, there's a constant set of understanding, evaluation, analysis that happens in our world. And this is a capability. I wouldn't even call it a tool. I'd call it almost like a companion to help with that.

Wouter Klijn 07:13

I think a lot of people are a bit concerned whether it's going to replace them or not. You say it's more of an analytical tool that helps you make better decisions. And I thought it was an interesting example that you gave in a book where you talk about a friend who is a programmer, and he basically recognised where his own input was when he asked it questions. And some of it was really relevant, but some of it led him down, you know, a deep rabbit hole that absolutely was not worth pursuing, but he recognised which one was, you know, the right path to follow. And that's when he realised, this is where I contribute to it. It will help me. But left on its own, it could easily descend into, you know, just time wasting, resource wasting. Do you think that that translates to other professions, and in particular our industry.

Michael Kollo 08:04

Yeah, look absolutely so white collar work Financial Services is about navigating uncertainty. So as we just said, it's about creating analysis, thoughtful analysis. Some of the analysis is pretty scripted, cash flow modelling and things like that. It's almost like a task based thing. But then there's a lot of choices to make along that pathway. So if you're, let's say, doing manager selection, you might look at the track record, you might look at the data, you might look at the portfolios, but then you might also look at the character of the manager. You might look at the way they talk about the markets, and you try and anticipate how they will respond to certain market conditions, and you try to essentially understand their partner. So I think it's, it's, there's a lot of judgement that goes into these things. There's a lot of personal judgement that happens as well. And so when you're using these AI systems to analyse something, because you don't have a set path, you're discovering the path as you go, and you're using judgement as your compass. In a way, you're using these systems more or less as a transportation vehicle to get to where you want to go, but your compass is in your hands, which is your judgement and so but the speed at which you can get to those places is much, much quicker. So it puts some pressure on your judgement to be a lot quicker. Your Compass has to figure out where you are much quicker, because these systems can, at speed of light, create analysis in different directions. So I think, I think the first part is understanding the fact that you're in charge with that judgement, with that compass, with the where should you go? What does good look like, is entirely up to you. There's only a very few jobs where what good looks like is already scripted, that is already is written down in hard ways, and you're just executing that, in which case your judgement is anyway not in the picture. And so you would assume that for those kinds of things, that you'd almost happily hand it over to an AI system. But anytime it's up to you, and you understand the why something happens and why that your judgement works like that, you should think about these as just very rapid, iterative companions.

Wouter Klijn 09:59

It's. Yeah, but having said that, I do understand that you build an equity analyst in a weekend which can produce its own broker reports, and quite hard to distinguish from the human produced ones.

Michael Kollo 10:12

So this was a kind of experiment I did recently. We were just chatting about it before, but Okay, so let me describe what it does, and then let me describe why it still fits into my model, so I can defend my model, my mental model here. Okay, so in the first instance, what it does is it's a forensic accounting type system. So it takes financial statements over a number of years for a company, it then looks through them, looks for unusual attributes of the accounting that's been presented, the cash flow statements, the earnings, the accrual accounting, the way that various other things. It then creates hypotheses as to try to explain those particular anomalies, and goes out there and test those hypotheses. And it does so by looking at competitor data, by looking at product market fit, by reading the news, by looking at other contractual, other statements, and so on. So it covers a wide variety of different data sources from trusted places. But importantly, the way that it thinks, the mechanism of its reasoning is a very kind of stoic, kind of philosophical kind of reasoning. So observation, empirical, observation, hypothesis, test, confirm or deny. And it does that. And so it typically takes about 17 page, 17 minutes, excuse me to do something, and as an output, it gives me back exactly the investigation path. What is what is found, is unusual, where it looked and so on. When I was calibrating it, after a couple of iterations, I started noticing that I was guiding it more as to what is significant. So what is material? You found a bunch of things over there. It's actually, don't worry about that. That's it's interesting, but it's not material for what I'm trying to do. Or what does a hypothesis actually look like? Well, I want you to actually create very striking hypothesis. Don't want you to create an average hypothesis that says that the reason that that particular ratio is out of whack is because, on average, you know, cash flows are easy to do with something. I want you to create a punchy one that says it's that way because the manager is trying to do something bad. It's a governance outliers. Yeah, I'm looking for I don't want average explanations to average things. I want extraordinary explanations or extraordinary things, a combination of both. So what good looks like lay in my hands and my compass lay in my hands. And so from the outside, it looks like it produces five, six pages of beautifully written material, and soon enough, you'll have one, and I'll have one, and the person down the street and person listening to this will have one. But I want to distinguish what what makes it tick and what actually makes it good or not, will no longer be just the advent of that. There is five pages, because today, you know, there's lots of people that provide equity research, but not infinite amount, just a lot. Tomorrow, there'll be a lot more, but it'll be even harder to tell inside those systems what is the reasoning pattern being followed and why that's good, why your system of reasoning is better than mine. And so therefore, if I'm trying to evaluate which Equity Research AI I should listen to, I'm probably going to need my own AI that that, you know, I've calibrated that tells me this is actually a better way of thinking about it, and it will go and evaluate other systems so you can see kind of escalating. But the problem is, what does good look like? Is still a bait, at the moment, very much a source of individual judgement, yeah.

Wouter Klijn 13:20

And going into that a bit further, I thought one thing that was fascinating in your book is where you describe, sort of the the impact that expertise and training and just experience has on how you interact with an AI system. So I think there's a couple of stories that you tell in the book where people quite quickly recognise, okay, this is the path to go through, but to a degree, it also relies on how well they understand where their advantage lies. That can be sometimes a very tricky thing to analyse and to recognise.

Michael Kollo 13:56

I often, over the last years of working with AI, I found that it's most often a reflection on me, in other words, like it makes me question why I do that thing, or why I'm asking it that way. And so it's a mirror point to yourself, really, which is, again, a very unusual thing, this idea of meta Meta reasoning, or meta thinking. So thinking about thinking, when I asked that question of doing it that way for the equity research for example. Let's take that example. Why is the forensic accounting the right approach? Why is this kind of a hypothesis testing the right way of doing things? Are there other ways of thinking about value? Is there other ways of solving for this kind of problem? And I think knowing the why and owning it then becomes a very empowering thing. To go back to the AI system and go, Okay, I want you to look at these three other ways of doing forensic accounting. But ultimately, the aim is to do whatever the objective is, and you can rotate your lens around the problem, if you're comfortable enough to rotate your lens. Around the problem. I think for a lot of us, we become accustomed to doing things a certain way, and we haven't exercised those muscles of, why am I doing it this way? There's just a there's a process, there's a structure. I'm going to look at these five things, or these six things. I'm going to fill out the boxes. You know, I'm going to talk a little bit about it, but I didn't set up this system. I'm just executing it. I I'm just a custodian of it. I think for those kinds of jobs, companies are going to look at that and go, Well, if you don't, if you're just a custodian of this system, either you quickly start to own it and go, Why? And that becomes you, becomes yours and your manifestation of your will, or it becomes a process that's executed, in which case, why not bring an intelligent system to do it?

Wouter Klijn 15:47

Yeah, yeah. So often people think, Well, young people that are growing up in this age of, you know, a lot of technology, the internet, that they might be better equipped to work with AI. But it seems, from sort of this reasoning, that potentially more senior, more seasoned people could work better with AI because they know better questions to ask it or better give them better instructions.

Michael Kollo 16:12

I think so. I think I think there's, out of any problems that I can see, this is one of the biggest ones I can see, which is that we have many of our industries are set up in ways where younger people come in, they learn by doing or by osmosis, and then over time, they develop knowledge and they develop judgement, and then they manage others to do the same. And if AI comes in, hollows out that beginning part and basically says, well, we can kind of execute based upon your commands, dear senior person, and you're quickly going to get to a point where, which is what you're seeing today, which is that graduates are having a lot of difficulty finding work. They are possibly the cheapest resource, yes, but they also the ones that are most unproven in terms of their ability to add value. So for the average organisation, look at an AI system, and they go right, if we can basically scale the expertise we have in the senior people, maybe we can do that. I think that's one point of view. I think the other point of view is that younger resources are often more flexible in their cognitive capabilities. So they may not yet have worked out what they believe to be the best way of doing things, but that often means that they are open to different ways of doing things, and they're open to learning and so on. So normally, a lot of the younger generation that come across in universities are very strong users of AI across multiple different disciplines, and they're symbiotically learning with the AI system to use it better and become natural users of it, which means that they're able to question and iterate to better solutions much more rapidly than a domain expert who's just trying to manifest their own way of doing things into an AI system.

Wouter Klijn 17:51

It seems like an ideal tool to do like pre and post mortems of certain business cases.

Michael Kollo 17:57

It's so good. I mean, the one of the use cases that so often people start with AI going, why? I'd like you just to do something for me. Okay, write my report, or, you know, write a transcript of this podcast, or whatever it is, and therefore it'll just do it for me. Probably one of the even more powerful use cases is the reviewer. Is the review this for me. Review this report and tell me where the inconsistencies are, where the mistakes are. What's better way to frame this? When I wrote this book, I gave it to a number of times to be reviewed, and while it was complimentary to begin with, it was very sharp and very critical very quickly, about, you know, loss of tone, about consistency across chapters, about consistency of messaging. And it helped me to pretty high level, which I'm not sure I rose to, but, but it's, it was a, it was a really interesting thing where you put something that you feel like it's a part of you, like when you write a book, you inevitably put a lot of yourself in it, and it acknowledges that goes, thanks, Mike, yep, I can see this is you. That's lovely. Anyway, now you need to do these things. You almost like, Oh, it's right. I don't like it, but it is right.

Wouter Klijn 19:02

Yeah. So it's polite, but also, to the point, to a degree, it seems that what you get out of it depends a lot on how specific you are in what you put into it. And I think you gave this example in your book, where there was somebody in a financial services company who said, Write me a market update, and then that led to rubbish. But then, when you specified, okay, write a market update about volatility in emerging markets with, you know, an eye on the US dollar, then it came up with something much more interesting and much more to the point. To what degree is it like a matter of, like, you know, garbage in, garbage out, and just being specific about what you want,

Michael Kollo 19:46

it's all about that. So, I mean, there's a bunch of different ways I can say this, but let's say, for example, in this example, you said, right? Write me an interesting market update. Okay, so what does interesting mean? So this goes back to our meta conversation, right? So what makes interesting for you? Well, interest. For me, means sharp market movements with contradictory news or mysteries. Okay, great, so is a mystery. Is a sharp market move 5% or 10% Well, at least 10% okay, great, etc, etc. You follow this path and suddenly you get half a page of write for me, articles that relate to at least 10% market moves, accompanied by interesting news articles that point to x, y, z, etc, and you start to really define very carefully what it means. So you can't just look at something and goes, I'll know what it when I see it. And this meta thinking actually makes you again question, what is it that you do? What is it that you find useful, valuable, powerful, and so on. And these systems can take you anywhere. So one of the kind of visual metaphors in this book, which I quite like, is the is the kind of the Ranger metaphor. So imagine like an infinite woods in front of you with many, many clearings. And your guide arranger is going to take you to one of those clearings. And depending upon how you instruct it in terms of what kind of clearing you'd like to get to, you can get to beautiful oak trees and sunny whatever, rainbows and butterflies. Or you can get to dark, terrible things, or you can get to pretty average looking, or you can get to plasticky ones, or any proportion permutation of woods that are available to you. And the only thing that will take you to one place to another is what you whisper into that, into that Ranger, AKA your prompt. So if you just say to it, take me to a wood clearing, please. You're literally looking at any number of those that you could land in.

Wouter Klijn 21:34

Where are some of the best benefits you think can be had in our industry? And you know, we sort of discussed the analytical part of it, the decision making process. But you also describe in your book, where you make the comment, financial markets are not linear, and one of the things that we often hear about AI systems is that they can help find trends in nonlinear processes. Is that sort of another area where you find a lot of benefits in?

Michael Kollo 22:01

It's a good question. So people often confuse these terms. So with generative AI, and specifically with language models that this book deals with, it is very much the patterns and trends within language and expression and information. And so really, what you're doing here is you're intermediating your and another person reading of information. So if you're doing a report or analysis and so on, you're putting a system in the middle of that which is very good at reasoning, cognitive capabilities, but also speculative writing, creative writing, and so on, so on. Can you get it to explain a non linear system for you linguistically? Yes. Can you get it to recommend for you methodologies to tackle that loneliness, yes, can you get it to write the code and execute that nonlinear system to test it for that yes, you can. Can you actually ask it to test 10 different ways of modelling that weird nonlinear system, write the code, evaluate it on certain grounds, come back to you, write a research paper for you and explain it to you without the technical logit. Yes, you can. And so where we are today is this really interesting moment where, at the beginning of it, had we been having this conversation three years ago, I would have said to you, well, it's good for doing, I don't know, emails and reporting, but after that, you're on your own. Today. We're at this point where the systems can pick up skills, can pick up what this is a methodology from Claude. Can pick up, in this particular case, Knowledge Base. Can execute code, can test, can revise their hypotheses, can re execute again, iteratively learning and updating their hypothesis, all through the medium of language models. So language models become the controlling layer, and underneath that are these systems that are working not just to write code, but to execute and then learn from it. So again, two years ago, yeah, I would have said to you, yeah, just use it to write some code, and then good luck to you, Python or whatever else you want to do today, the system will write it and execute it and look at the results and to see whether it's actually what you want, and then go back and write it again, if it isn't all in a loop. And I think it's, it's a it's easy to lose track of how fast this progress is going. If you haven't looked at it for six months or nine months, you might go back and say, I tried that. It just didn't work. But I, and this is something I find often in LinkedIn, because I'm quite active there is that people don't understand that this is a very much a thing in motion. So whatever has you kind of characterise it as it's like that, or it's like this in six months time is no longer probably not true anymore, except, so this is one of the challenges of writing a book like this. I had to write in such a way that I try to pick out those eternal characteristics of the system. But I wouldn't be too much pointing fingers, going, haha, I can't do this, because by the time the book come out, it can do it just fine.

Wouter Klijn 24:47

But is there sort of a confusion, maybe sometimes, about what it does, because you take a clear approach that you look at, sort of the language, the large language models, but the language aspect of it, while, if you're. Looking from an investment side, you're probably looking more at mathematical trends rather than just language. Do people confuse that you think where…

Michael Kollo 25:08

Massively so right? Let's take a step back for a second so you've got basic statistics, econometrics, statistics that used to measure back test so on. Most of quantitative finance, if not all of it presently, is based upon econometrics and linear models. So standard linear models, little bit of exponentials, maybe a little bit of logit here and there, and that's about it. And so therefore those systems are input output equation go hypothesis testing, kind of methodology, then neural networks came along to finance, probably 2014, 2015, and people went, Oh, can I use this to do stuff, trading, liquidity management, high frequency, because it eats up data at higher rates. Can't use it for monthly data. So it's a very specific area. Finances started to think about using it, which is the higher frequency trading elements of it. Can't use it for macroeconomic research, because the data is to 60 observations, monthly observations to work with, or you got 600 it's just not enough. You don't have hundreds of 1000s. So the methodology fell by the wayside as a primary methodology to model financial systems at anything else but a high frequency range when language models came along, and this is a very specific area of AI or kind of neural networks. It said, Look, maybe we can model how language, or how words and tokens, in this case, come together. And it turns out it was quite good at that system, again, through the transformer mechanism, but that that mechanism didn't transfer. I can't put a stock price in there and go by the way, can you also tell me what's going to happen to happen to that? So it's much more along the lines of modelling language, and over time, it obviously got bigger and better to the point where now we can do 24 languages, but we can do number of programming languages, and we can do mathematical proofs, which was an unusual thing up until now because we thought, well, how can language models do maths that's kind of dumb. Maths is a whole other part of your brain and whole different ways of adding numbers together. And still today, if you ask a system to do math for you, it's more likely to write code and then execute the code and give you back the response than it is to figure it out directly. So when you're thinking about the difference between language models or generative AI versus modelling or forecasting the world, forecasting methodologies are often much more simple in their applications, with more limited data, with more speculative outcomes, but the difference now is that language models become so powerful that they themselves can do the testing for you. So it's not the case that the language model itself has a neural network that's specifically about stock prices, but the fact that the language model understands the fact that it can run a regression for you, test the results, understand what the results are, gives you back the results, or iterates over and over again. So it's a layer that sits on top of empirical testing, and does that testing with you, for you so on.

Wouter Klijn 28:09

Yeah. Because I think when you wrote this book, you can sort of get a sense that you get almost at a more philosophical level, where you start to ask what language actually is. And I think there's a passage in your book where you talk about beneath the surface of language, words and concepts in communication, there are deep patterns that represent common ideas, thoughts, impressions, emotions and experiences in life, where you basically talk that there's a lot of abstract commonality among different languages. And I think you gave an example where from your childhood, where you go back to Hungary, and it's a very different language. It's, I think you say it's more complex, but you realise that there is these commonalities underlying that. Can you tell me a little bit about how it has changed your concept of language. Doing this, doing this exercise,

Michael Kollo 29:04

It's a big topic. I think it's one of those things that is very personal to most of us. When I first looked at this, I thought that maybe language itself was a weak expression of an inner world. So you have this big inner world. Both of us have first language is non English, and so our we grew up as children speaking another language, and so maybe there's like this big inner world of emotions and so on that we try to squeeze through the keyhole of language into the outer world. And therefore AI is just that keyhole, or language model specifically just represent that keyhole, but they can't represent the entire inner world. I think as I got to know language models more, and as they kind of got bigger and better, I felt like there was more power and more things that linked us than not through languages, through the expression of language alone. Yeah, and that made me question about my inner world, whether my inner world was also a lot more linked to both language and maybe to each other and to other people and but I think just falling deeply into this idea of what can language represent about the mind, how much of your mind is imprinted into the words they use, and how you express yourself and so on. I think for me, has been an interesting journey. Again, being dual language, expressing my ideas through English, getting the system to translate into Hungarian writing music with that, writing poetry, with that, seeing the way that the words form around my ideal, of my thoughts in a different language, has been really humbling. There's this moment where you're like, I'm expressing myself in my today's adult language, but it's taking it and swirling it into patterns of Hungarian which then hit me back on a whole other angle that I'm not sure I could have done myself and and again, these are moments where you have these wow moments about this is more than a or, if it is a mirror, it's a mirror into humanity, as much as it's a mirror to yourself.

Wouter Klijn 31:07

Yeah, and you delve also into the concept, then what does it actually mean artificiality? And I think, you know, for me, it's very relevant, because as I starting to use it more, I'm starting to think, should I give chat GPT a byline or not?

Michael Kollo 31:24

Oh, interesting. I like it. I like it.

Wouter Klijn 31:27

But, you know, it becomes concluded where the system didn't generate it by itself. I didn't generate it necessarily by myself, but it was an interaction. So tell me a little bit about how you now think about the concept of artificial.

Michael Kollo 31:43

It's so that I never liked the word artificial, because it there's always a tribalism attached to it. For me, like a separation. Artificial means not of Me, of over there, and that separation means that it's over there, and it's becomes adversarial eventually. And so I feel like we have lots of adversarial pictures of AI in our history, right? So everything from terminators to whatever, and they're normally just versions of ourselves to humans with more power, bigger muscles, you know, etc. It's always very amusing for me now to watch Terminator two back, which is an awesome movie, and go, these systems have figured out how they work time travel, but they don't quite understand language, you know, this kind of I think because, you know, language was meant to be supremely human. It was meant to be the thing that really encapsulates the weirdness that is and contradictions that is to be a human being. So I think, I think we're just in a very different world than we were back when those kind of systems were thought about. And I think AI really came from a world where technology and statistics and data were over there, and we with our humanity and our flowing and whatever were over here. And it was a very clean separation, and made us feel comfortable now that separation is not so clean anymore. Now these systems can talk to us, can modulate voices, can understand and reason and help. The number one usage for Claude is personal therapy, like it's it's going to be really so called, coming into this space that we, up until this point, we had thought about as purely human, and that's okay. That's not something to be concerned about that's more about a really interesting kind of self realisation about what it is that you bring to the table, versus what's another AI bring to the table. So to your point about having a when you set up a GPT or any kind of system, you'll say to it, this is what I find interesting, and what I don't find interesting, and you will embed a part of you into it, and then it'll run for a while. And if you allow it to continue to evolve itself, aka, based upon a number of clicks or readerships or your likes, for example, it will try and choose more of that or less of this. Again, it's just a ranger. An AI system is not an individual. It's not a single entity that has a will or a desire. It's a field. It's an S surface area, and it's a vast surface area that you can land on and move from one place to another, as you will, because you bring the will, it brings a surface area.

Wouter Klijn 34:16

Yeah. So it comes back to sort of this concept, the better you know yourself, and the better you know your skill set. You seem to get more out of these systems. Do you think that that will translate in how people, the people that will do it better, are a specific type of mindset and thinking, for example, about people whose jobs revolve around delegation. It seems that a lot what you do in interaction with language models is delegating them to do things right, and recognising where you come short, and finding solutions to that. Do you think there will be a certain subset of people that are just better in interacting with these systems?

Michael Kollo 34:58

It's a really interesting, very live. Problem, right? So lots of HR professionals are grappling with, what are the skills of the future? I think, being able to explain yourself and what is it that you want to do and why is absolutely a key skill. There's no question. Now. Full stop. Agree with you. Nothing more to add. There is a danger here. And it's a very funny one. So one of the things that you find when you work with AI too much is you get spoiled. You have this intelligent system that is only constantly listening to you, thinking about what you're saying, and trying its damned hardest to do how you want it to be done. As it learns more about you and learns about the background, how you like to do things, updates his memory, or your skills or whatever. Every conversation feels like. It's easier. It's like it's already a step in there. It's already thinking about it like that. You already find yourself nodding as it's finishing the note to you. It's very hard for humans to compete with that. It's very hard for me to walk back into room with four humans that I don't much work with and try to align them, to get them on my page, to get them understanding, to get them understanding. There's all the social cues, the etiquettes, the intentionality, the all of the things I've got to work past, then I've got to understand where you're coming from, then I've got to align you, and so on, so on. The gift for me is that I get to work with people, and that maybe one of you has a better idea than I do, and we make something better than so that's there's absolutely reasons to make that investment. But I think in many cases, people will go, why am I doing this? If I can just go to an AI system and it'll get me quicker, better, faster. This feels so slow, this feels so difficult, by the time I get around to it and so on. And so what I think this will kind of lead us to is a world where individual power users will be incredibly good at using AI systems, and their only danger will be, as I'm finding certainly recently, is burnout. Ai burnout, right? I work six hours, and then I my brain stops. I look at a blank wall. I can't really focus anymore, because the man of will and attention. It's literally like a room full of really smart people constantly giving you things to review, and you're constantly judging reviewing next, judging reviewing next. And as soon as you set another milestone, it's achieved and it's achieved and it's achieved and you're running at full speed, and I tend to be quite strategic. Think I do tend to think a couple of steps ahead, and even I'm like, Okay, so I've thought three steps ahead, and you've already got there, so I need to now think three more steps ahead and so on.

Wouter Klijn 37:36

Yeah. So in that context, like so we talked a little bit about this, this equity analyst that you created, and I thought one interesting aspect of that is that it came up with, I think you said, it creates a hypothesis, but then it spawned new agents to look in different elements of all of those hypotheses. So you get this sort of cascading effect and but ultimately it came back and gave you a report. But when you look at that process on itself, it seems like it's something very different than, I think, where people started out maybe two years ago, where everybody was expecting that AI would automate a lot of stuff. This doesn't feel like automation. What is your sense there that these language models end up more, as you say, reasoning agents for individual people, rather than straight through automation?

Michael Kollo 38:36

It's a good question. So I think we need to understand the category of use cases much better in organisations. So an organisation is a rich set of use cases, and then sub use cases tasks underneath them, and some of those tasks are about the movement of information. Reporting. For example, you're moving information from one system to another. Maybe you're combining it with few things. Maybe you're making a calculation. But then ultimately, so everything from your custodian to your fund, reporting to other things are simply linear movements, and what you're doing, in most cases is your search, retrieve problems. Where is my data? Where can I get it? Is it accurate? And then moving it from A to B? So that's fine. I think that's automatable, and it's automation friendly, and maybe up until now, it's been hard to automate because it was the data's been finicky. It's been all over the place. It's been messy. Now with AI, it'll iteratively search and find things for me and things like that. So that's better then you've got this class of discovery type problems, right? So discovery is, I don't know what I'm looking for. I just have a principle of what I'm trying to do. So in this case, the principle is, I think there might be something wrong here, but I don't know what it is, so I have to give the AI system breadth to explore that, and I'm going to lean into its intelligence to do that. So I'm going to lean into the idea that it can creatively create hypotheses, that it has the reasoning systems to test those, or to write code and so on. So I expect it to go widely in a deep research kind of way. So go. Wide and come back in again. Go wide, come back in again, go wide, and so on. And at the end of it all, I wanted to have covered a lot of ground, and ideally, hopefully it's figured out what relevance is, or I've given it good instructions as to what relevance for me looks like. So out of the 180 things are found, only 18 get mentioned to me, and out of the 18, only three are flagged for me to do, and again, for research purposes. This is an incredibly powerful tool. That's what you're seeing now. Physics Research people are talking about, or mathematics research being co done with AI at much faster speeds. I'm not giving you another example, Monash. I was at Monash, I think last year, I was giving a presentation to the faculty and a bunch of other quants in the room, and it was about using AI as a paper reviewer, as an article reviewer, so if you've got a working paper, submit it to a journal. Normally it takes six, seven months for you to come back, and then little bit back and forth, and then the next journal and so on. Give it to an AI system that goes out there, reads the nearest 20 other papers, figures out what your unique contribution is. Then reads the next 20, the next 20, the next he's read 150 papers and said based upon what you've done. And these 150 papers, I think these are the elements that are unique, or not unique, or these are the suggestions I would have, and so on. It can now do that within the space of 15 minutes or 20 minutes, and that's a tool that allows us to create much sharper research. But then you ask the obvious, the question, and you go, Well, why don't we just get the AI to do that the beginning of my research project, rather than the end? Before I even pick up the pen to go, what should I be doing? Let's go that way. So, a lot of different applications. But the bottom line is, the is, we're all discovering this idea of what it is useful for, because, at the moment, this thing called generative AI, and where it's put into agentics, or whether it's a chat bot, is is a raw material. It's like the genie flask with the genie coming out of it.

Wouter Klijn 41:52

Yeah. So in a lot of ways, AI helps to accelerate processes, rather than really replace entire functions. What do you think is, sort of, if we may do a little bit of crystal ball gazing, what is sort of the natural progression of that? I mean, as you said, there's only so many hours you can review, you know, all the things that come back at you and the information overload. Do you want to take a stab of where AI might take us in the next two or three years?

Michael Kollo 42:23

I don't actually, I'm going to plead ignorance, but you should definitely just read the book. No, it's, um, yeah, I have a bug bear about people that have expertise in one field being asked about a different field. I sort of often think that, you know, AI experts shouldn't be asked about workforce impact or things like that, because they just don't know enough about it. I don't think it's as Armageddon as everybody believes it is to be. I get the sense that, like with anything else, people will do very creative and interesting things certain Emperor's close moments might happen, things that you know, we kind of do currently, just because we think we should suddenly become not that relevant. I think there is reason to think that there'll be moments of disillusionment, perhaps in a sense of society will and unions and governments will suddenly go, Hey, this is happening way too fast for me. We need to slow this down, not necessarily for safety, but more for like protection, society, workers, those kinds of things. But ultimately, the there's a very small percentage of people in the entire world that will take this and will do incredible things with it. Will advanced sciences, biochemistry and physics, mathematics, hopefully economics, although I don't hold my breath much, much further, and I think everybody else will be struggling or a little bit trying to balance between the human rate of change that's possible, which is typically three, 4% per year versus the AI possibilities that will keep opening new doors every time that you're just about told your staff about what you think AI is another door gets opened, and in three, four months time, you need to tell them what else it is, unless we adopt it and use it, it won't have any impact on our society. So AI is not a weather pattern where you just sit here and it rains on you, and then it doesn't rather it is only comes about because somebody has picked it up and done something with it. And so innately, the rate of change from AI in the world is only manifested through the adoption of people, at the rate of adoption of people. And so that gives us a lot more time, I think, that more people believe when they just look at the capability and go, Oh, look, you can do this. So therefore tomorrow, it's only going to be done this way.

Wouter Klijn 44:46

Yeah. Now that's a fair comment. Well, Mike, thank you very much for this conversation, and thanks for coming to the office. It's fascinating.

Michael Kollo 44:54

My pleasure. Thank you. I look forward to the GPT, by the way, the [i3] AI column, I look forward to reading that.

Wouter Klijn 45:03

Yeah, I should have a few AIs writing for me that would be helpful. All right, thank you.

Greg Cooper is Chair of financial services giants Perpetual and Colonial First State, but is perhaps best known for his role as the Chief Executive Officer for Schroder Investment Management in Australia. In this interview from late 2019, only weeks before COVID-19 broke out, we spoke with Greg about whether public markets are broken, the state of active management and his interest in the venture capital space, topics that are still very much alive today. Enjoy the show!

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Greg Cooper podcast overview:

1:00 Starting out in actuarial studies 3:00 Focussing on Japanese equities 4:00 Compared to 1986, Japanese equities are still at the same level 5:00 What were some of the highlights of your career at Schroders? 6:50 We've moved on from strategic asset allocation 7:55 As a CEO, don't be afraid of what others think and try to draw out ideas 9:35 Are public markets broken? 11:00 Not having a well-developed VC industry means that a lot of good ideas get starved of capital and eventually go offshore 11:30 Will that change when the effect of QE goes away? 15:00 No investor is entirely passive. 16:30 Passive rose, because active had too large a share, but you can't have a 100 per cent passive investment market 17:30 Will value-style investing come back? 21:30 You have an interest in fintech and hold a board position at OpenInvest? 25:00 Joining the TCorp board and chairing the investment committee

Full Transcription of Episode 131:

Wouter Klijn 01:12

I'm here today with Greg Cooper. Greg, welcome to the podcast.

Greg Cooper

Thanks, Wouter.

Wouter Klijn

So can you tell me a little bit about how you started in the asset management industry. We had some former guests on there that started with, you know, creating banks at eight. What were you doing at eight?

Greg Cooper 01:26

I certainly wasn't creating banks. Probably more surfing and and that kind of stuff up on the beaches and the Central Coast than anything. I mean, my career in investment really started in the latter stages of high school. I was at one stage looking at becoming an accountant. And then my maths teacher at the time had said, Have you thought about actuarial studies? I didn't even know what one was at that point in time, and, you know, and so I looked it up, and things kind of sort of went from there so that, I suppose that was the real genesis of things year 11 and 12 at high school.

Wouter Klijn 01:59

So how do you transition from an actuary training to an investment career?

Greg Cooper 02:04

So I mean, I started out in the more traditional actuarial fields. I was working for Taos Perrin the time as a defined benefit actuary, and it was at the point in time, I was in the early 90s when the SG was just coming into play defined benefit plans, some were being wound down, but there was a lot of work to do in the DB space, but as SG kind of kicked in. Then there was a whole pile of, you know, actuarial work to do around, you know, justifying minimum contribution levels and so forth. And then, you know, one day, one of the investment guys had come over to in the investment asset consulting area, come over and asked me if I was interested in doing some research. And it was on Managed futures at the time. And, and I kind of said, I said yes. And and started doing and I really enjoyed it. And that was kind of the first foray into investment consulting. And so sort of from starting out in the actuarial field, I was lucky enough to get off at a roll up in Hong Kong with with towers. And I sort of took the view that the traditional actuarial work was, was, was a good mainstay, but was not likely to be a growth engine. And moving into the investment space was, was a lot more interesting, and it also worked from a commercial perspective.Wouter Klijn 03:15

Yeah, did you ended up doing anything with those managed futures research?

Greg Cooper 03:19

Well, apart from it was kind of the early stages of hedge funds, I guess. And it was at the point where saying, you know, alternatives kind of had a place in a portfolio that was, that was the primary emphasis of the research. So, you know, it's interesting. And obviously, you know, alternatives nowadays have become a much bigger, much bigger part. But back then, it was really just looking at that small hedge fund, like type diversifying characteristics and see whether they fit it in a portfolio.

Wouter Klijn 03:44

Yeah. And then from there, you went to Schroeder's and started doing Japanese equities. Why Japanese equities?

Greg Cooper 03:51

Yeah, good question. It was really partly as a function of the role that was there at the time and Schroeder's. I come out of asset consulting, I was much more interested in working in the asset management side of things, the role, while it was in Japanese equities, it was much more about the product side of things. So it was more like being in charge of the business, of running an asset management sort of sub strategy, if you like, rather than specifically worrying about, you know, Japanese equities or European equities. But it was very interesting, because at that point in time, Schroeder's was the biggest manager of Japanese equities. You know, you were just coming out of the 90s, which had been a bit of a lost decade, but, but in the latter part of the 90s, you know, Japan had taken off with the likes of SoftBank and so forth. So, you know, there was this real kind of boom happening, and it was just a really interesting time to be involved in, in in the markets, but particularly

Wouter Klijn 04:48

in Japan. Yeah, any views on Japanese equities today?

Greg Cooper 04:51

Well, it hasn't been a terribly good investment since that time. I remember one day sitting with one of the team, and he said, he said, Oh, you know, he said. I started in Japanese equities in 1986 and the markets pretty much at the same level it is was then. And I think we're always say the same now, so, but it's, you know, it's a very interesting case study in what happens in a deflationary environment. And, you know, when assets get overvalued, you know, you can have everyone thinks that equities kind of go and, you know, 10 years in equities, you'll make your money, but you'll make money.

Wouter Klijn 05:21

I was just about to say, Did I just hear you say that equities don't go up always. That's right,

Greg Cooper 05:25

so, you know, and it's a fantastic case study, but also one, I mean, sort of investment aside, it's a good one to think about, that, you know, despite, you know, the economic criteria not looking that good. You know, the social cohesion in Japan, everything else is held together very well. And so, you know, life isn't all about just economics. There's more to it than that. Sorry, all the economists.

Wouter Klijn 05:49

So you spent almost 20 years at Reuters, climbed up to be the CEO of the Australian business, and also had a global distribution role. What are some of the highlights you look back on your career. And also, do you have any tips for aspiring CEOs,

Greg Cooper 06:06

I suppose, in terms of highlights, you know, it was just, it was fantastic, and still is fantastic being involved in, in in sort of the dynamism that is the whole investment marketplace. I mean, in particular, just look at, I mean, not just Australia, look globally, but certainly in Australia, you know, the rate of change that's taken place with funds. And, you know, back in the late 90s, early 2000s you know, there was obviously a much larger number of very, very small funds. And you look at where we've come to now, I'm having conversations about internalising and, you know, financing specific assets, and you know, the size of the asset pools and so forth. So I would say, you know, over that whole span, it's just been a very exciting time, and I think that will continue. It's no less exciting looking forward than it has been in the past. But just the sheer growth of the industry has been fantastic terms of some particular highlights. I mean, I always quite enjoyed standing back and looking at sort of the way the industry was was developing, and coming up with suggestions for maybe how things could be done better, or where, you know, the industry had adopted certain practices that I didn't think were the right sorts of practices, and it was much more fun kind of standing back and trying to point those out and offer suggestions for better ways forward, rather than just joining the chorus of sales people out there.

Wouter Klijn 07:21

Can you give an example of that?

Greg Cooper 07:23

I mean, the key one that you know, and I write a lot of research papers around this, is the i concept of around, sort of objective Based Investing, and the idea that benchmarks and the whole strategic asset allocation process, which we've grown up with in the 80s, didn't always work. And you had in Japan is a great case in point, you know, a fixed, strategic asset allocation with a large exposure to equities through the 90s in Japan killed you. And so you know that that, to me is, you know, it's resonated very well in the industry, and I think it's a key part of sort of thinking about how to do things differently. And so, you know, sort of, it's not to say that strategic asset allocation is that that style of investing is bad. It's just to say that I think we've moved on from there, and there and there are better ways to think about this, and there's some consequences that come from that, and that's worth bearing

Wouter Klijn 08:07

in mind, the consequences. Yeah, so in your answer, it sort of shows that you, you've always been quite keen on fostering a culture where it's open for discussion, and there's pretty much no topic of debate. Why is that so important to

Greg Cooper 08:21

my mind. You know, we work in an industry where there are lots of really intelligent people, and no single person has all the right answers. So the more you can foster debate, and the best way to foster that debate is to have a fairly transparent and open culture, then ultimately you get a better outcome. And it might be sort of painful in the near term to hear, you know, if your particular idea shouted down or what you're doing, you know isn't you know doesn't resonate with everyone, but I think fundamentally, it gives you much better outcomes, and when, when people are, you know, more open, transparent, and in particular, prepared to bear criticism to their ideas. That's how you that's how you drive change and move things forward. So you asked about sort of tips for aspiring sort of CEOs, and that would be, you know, a very clear one to me is, don't be afraid of what others think and try and draw out that. And certainly don't create a culture where you know yours or a small number of views preside. You want to create a culture where you hear right through an organisation, because then, particularly today, like the world's changing so much, sometimes the best ideas come from, you know, some of your really junior people who are right at the coalface. So you want to, you want to make sure those ideas get aired and have as much resonances, you know, some of the more experienced ones.

Wouter Klijn 09:36

Yeah. So is that a matter of staying competitive, or is it also more generating sustainability within a business that you can see risks or potential challenges coming that are further ahead.

Greg Cooper 09:47

I think it's both. I think, you know, this industry is nothing if not cyclical. We see markets are very cyclical. You know, performance of asset managers is very cyclical. You know, the active industry is probably having a pretty hard time. Of it at the moment, I see that as a very cyclical outcome, and I just think that if you're not open to, you know, sort of change happening, then you know, particularly when times are good, and that's often the time when it's hardest to make changes in an organisation, because everything seems to be going well, but that is often and always the most dangerous time when everything's going really well, because you tend not to see the risk. So just trying to, yeah, it's not to say you get it right all the time, definitely not, and it's difficult, absolutely. But at least, you know, keep your eyes open.

Wouter Klijn 10:30

So one of these big topics we've recently spoken about is the functioning of the public markets. And we see that more companies stay longer private. There seems to be a bit of a challenge in raising capital through the public markets. What is your view on that? I think you have a bit of an idea that maybe the public markets aren't where

Greg Cooper 10:50

they used. Yeah, look, I think I wouldn't say the public markets are broken, but, but I do think there are some real issues in the way public markets are functioning. And if one goes back and sort of says, Well, what was the point of a public market? It was to allow capital to be held in the hands of a very, very heterogeneous group of individuals, and for new capital formation to happen. The way the broader investment market has changed is you've got a smaller number of very large holders, and almost by definition, those holders end up becoming more passive in their equity holdings. They have to become much more active in a governance sense to compensate, but they become much more passive in terms of their equity holding, just because they have to be so I think that that has changed the way you know public markets function, and will continue to change them. And at the same time, you know whether it's regulation or other things sort of driving, you know how new capital gets formed, people are more prepared to sort of keep their companies private and accept some of these large investors because they just don't need to go to the public markets. And the private markets tend to give them a bit more flexibility. So I think that's changing the whole dynamics of it. Where I see a real danger is in the smaller end of the corporate capital formation process, where how do new ideas get funded? And I think in other jurisdictions, particularly in the US, where they have a really well formed venture capital industry, we don't have that. And I think there's a danger in Australia that not having a well formed, or even a barely call it embryonic VC type industry means that there'll be lots of good ideas that get starved of capital and potentially go offshore, and that's bad in the long term for the economy, and bad certainly for those funds in the long term.

Wouter Klijn 12:38

So to what degree is this also the influence of quantitative easing, because you could make the argument that, well, it's easier to raise capital from the private markets when capital is so cheap, but once that goes away, then perhaps the public markets start functioning, and the way they should be, well, there's

Greg Cooper 12:54

certainly more capital around. There's no question about just given what's happening in terms of QE. But but whether we have QE or not, you will still have larger asset pools. So in a relative sense, you know, you just have to look at the Australian market. You know, the top 10 asset pools, you know, represent a significant chunk of the Australian equity market. So that feature occurs no matter what, with or without QE. So I think, I think QE has pumped, yes, more capital in the system. But I wouldn't blame QE for where we are. And I don't mean blame in a negative sense. I mean it's just where we are is a function of the rise of large asset pools. And that's that's not a bad thing by any stretch. It probably leads to, you know, better overall capital allocation decisions, because they've been made more professionally, rather than by, you know, a vast number of more amateurs, but, but it does have that consequence of potentially, certainly in Australia, starving the more junior end of the market of capital. The other

Wouter Klijn 13:54

consequences is that there's more money flowing into passive and you've did some research around how this could potentially also distort markets, especially the public markets, where they come up with all sorts of different flavours of essentially similar indices, but it also then channels potentially funds to, particularly a couple of companies that occur often in certain indices, and basically get funding on the basis of that, rather than of their fundamentals. Yeah.

Greg Cooper 14:21

So I thought, like any, any capital allocation process that's rules based is prone to, prone to some form of danger. So if you just keep following those rules blithely, and the whole, remember, the whole point of passive was about allocating, you know, in a in a certain way, a market cap weighted sense, across the broader economy, almost. And it works when you've got very large and diverse equity markets, but gradually, as the proportion that is passive becomes larger and larger, and indeed, in fact, in certain markets like Australia, where they're sort of more concentrated, that can have a consequence that it starts to distort certain companies in the way that they're weighted. In the indices. And then, I think the rise of passive as a sub. Don't use the word asset class, but, but where you get, like, you know, sort of a passive exposure to a certain thematic that then overweights the companies with no real bearing on their economic impact, and and you just get this weight of money. And then the other passive money comes in and has to allocate more to it, because to it because it's got a higher weight. And so you can end up with a with a disproportionate allocation in certain companies. And you've seen that, I think, in some of the tech names and even some of the dividend payers, whenever a thematic comes through, it gets a lot of money, and then, by definition, those companies get pushed up in price and get overvalued.

Wouter Klijn 15:42

Yeah, yeah, yeah. I can remember that at one stage I saw there was a sushi ETF coming out, and I was wondering if that's really a product The world needs. Yeah.

Greg Cooper 15:51

I mean, those are, those are marketing concepts. You know, the idea is that passive was meant to be low cost exposure to a broader group of investments. And I think that's been sort of slightly skewed when you start talking about real flavour of the month passive strategies.

Wouter Klijn 16:04

So the other argument for passive investing is that it's simple. It simplifies the investment process, and often, when there's too much complexity in a portfolio, it's hard to keep track of it all and also to basically communicate it to stakeholders. How do you look at complexity? Are we giving up too much by just having passive strategies?

Greg Cooper 16:24

Look and passive has a very good place in some portfolios. And bear in mind that actually the bigger investors, as we just talked about, have virtually no choice but to hold passive or quasi passive exposures. The point that I would make about passive is that no investor is truly passive. You have money coming in if you're in your accumulation phase. You have money going out if you're in a decumulation phase. So you have to manage the cash flows and where you allocate capital to and take it from. Shouldn't be entirely a passive decision. You should have some view on where you know what price you're paying for assets you know, and particularly when you're allocating amongst equities, bonds, property, cash, whatever you should have some bearing. So you can't be entirely passive, I think, in a total portfolio context, and even where you are, those big passive holders have to take a much more active role in a governance sense. So, you know, to me, passive is just, you know, it's a it's a simple way of implementing a certain part of your investment strategy, but it's not your investment strategy. It's just a way of implementing a piece of the investment strategy, and as long as you bear the total portfolio in mind and your objectives and all that kind of stuff, passive has a has a place to play in that, but it's but it's not the answer to everything.

Wouter Klijn 17:40

So you're not concerned about the predictions that I think it is by 2021 we will see more money in passive than in active,

Greg Cooper 17:46

Not at all. And I think, again, I would, I would sort of come back to the point about markets being somewhat cyclical. And I think the passive will rise just because active, you know, probably had proportionately too larger share. But there's a point where passive can't, you know, you can't have 100% passive, or the markets don't function. So, you know, and whether that, I don't know whether that numbers, you know, 40, 5060, whatever. And I kind of almost, you know, it's not that relevant, because we'll never get to really high levels, just because something will happen that causes a change and the cyclicality will kick in.

Wouter Klijn 18:21

Yeah, you mentioned that cyclicality, looking at investment styles, value hasn't worked for probably the past decade. What are your thoughts around that? Is that something that is structural, or is that cyclical?

Greg Cooper 18:33

You can make an argument for both. I mean, I've seen plenty of arguments about it being structural just because of the way value is defined. And I think, you know, if we think about value in a, you know, sort of booked value context, or, you know, or in businesses which, have, you know, high tangible assets and low intangibles, then certainly there's this, you know, that's, you know, there's a change that's taken place in markets where intangibles are now, you know, of extreme importance. And so how you define value, I think, has probably changed over the course of that, but, but, you know, value as an investment philosophy is, you know, a very sensible strategy buy things that are cheap. I mean, like, it kind of makes intuitive sense, and I don't think that will ever go away. I'd be far more concerned about buy things that are expensive, things that are cheap, but values also had, you know, it's had long periods where it doesn't work again. That's the cyclicality of markets, yeah,

Wouter Klijn 19:28

but it is within these big technology companies, where there's so much depending on the IP that arguably, it is harder to value what an IP is actually worth and when it's at a discount

Greg Cooper 19:38

or not. So I agree. I think that's the issue. Is, is the definition of value, and how do you how do you place a value on certain of these organisations? Is the more difficult thing, but also too. I mean, I think certainly at the moment, markets have gotten a bit carried away. And whether it's QE or, you know, the some of the passive bits that we talked about, or just sort of momentum. Generally encouraging more investors to invest in it's could be a whole combination of things, but it's quite clearly that there are some levels of what I would call exuberance in certain parts of the marketplace. And while that hurts in a value context, you know, value is always going to be or any investment style hurts the most at its peak or at its trough. I should say, you know when the when the alternative is at its peak, that's, that's the point of

Wouter Klijn 20:27

maximum pain. So do you think that the process of value can be adjusted to reflect the current market conditions, or do you get very quickly to a point where you basically have style drift? I think I'd

Greg Cooper 20:40

be very careful about saying current market conditions, because, because that that I think does infer style drift, I think it's more about, you know, making value work for the nature of markets, and recognising that the term of value, and particularly getting this rise of intangibles on the balance sheet requires maybe a bit of a different way of thinking. But I'm sure there's plenty of value managers have already all over that and captured it, and some of these things probably still look really expensive. So, yeah, I think, I think again, styles are cyclical, and value and quality in particular. You know, if I had to have a bias in my portfolio, would be slight advice to value and quality than I would be to certainly to momentum.

Wouter Klijn 21:17

So one of the things that you, you're interested in is more in this private market aspect. Can you tell us a little bit about what you're

Greg Cooper 21:24

doing there? Well, it really comes back to the whole sort of VC space, and how do you encourage better capital formation? And particularly, as I said, in Australia, I think you know, you've got a well established VC market in the in the States, potentially, sort of, as the assets have grown in that space, probably, you know, managers charging too much for the for the service, much like, sort of what happened, I think, in private equity. But in Australia, we don't have it. And I just think that there's, there's really something that can be done. And where you've got a small number of large asset pools, you know, we really should be looking for ways to allocate capital to that space and try and generate some sort of venture capital ecosystem, albeit without necessarily, you know, I think this is our chance to kind of invent that space without imposing, you know, a more traditional third party fee model over the top.

Wouter Klijn 22:16

Now, one of the activities you do is, you're a director of a FinTech company. One of them is open invest. What is your interest there in this particular space?

Greg Cooper 22:26

So that was much more specific in the asset management space, and we talked about some of the issues that active asset managers, or just asset managers generally, were facing, and the rise of large asset pools, particularly in Australia, making the institutional market less of a source of funds for them, but at the same time in the, you know, what I'd call, sort of the retail and wholesale markets, you've seen this, this real explosion in SMSFs and and so forth. And I would say, actually, a large amount of professional or non professionally invested assets. And so the idea behind open invest is to have a simple mechanism through which people can allocate to a diversified portfolio and get a lot of the benefits that come from a more traditional portfolio structure, but build it very cheaply. You know, one of the things that gets me is when I look, sort of, you know, all the regulation, other things that have had gone on in Australia, in the retail marketplace, Royal Commission and so forth. You know, the cost to member hasn't really gone down. And it's like, well, you know, surely we can build things, particularly with technology, that deliver professionally managed portfolios to individuals at a much cheaper cost. And that's, that's the concept behind open investor.

Wouter Klijn 23:38

It's an interesting model, because I think it shows what a lot of FinTech companies trying to do, in the sense that you have sort of a traditional model, where you have a distribution platform, you have the asset manager space, but then there's elements incorporated of social media, like features, so you can like things, you can share things. In essence, what is happening there is that you try to create communities around certain products or services. Is that sort of what interests you, or is it more directly coming from?

Greg Cooper 24:09

Yes. So the point to me is really about, you know, simple, well designed portfolios being delivered to the general public in a relatively cheap format. And I think that's, you know, we were great at creating themes, and, you know, charging, you know, probably excessive fees for that as an industry to individual consumers and trying to stir up, you know, momentum around those particular themes or concepts, whereas actually, what I think we really should be doing, particularly with a more fiduciary type of mindset, is simple, you know, typical balance type portfolios that are well diversified and well structured and delivering them at a pretty reasonable fee, and that's the concept. And you know, with that, you need to have things like content layer. That sort of give you all of the right sort of behavioural impact with your customers and so forth, and deliver the messages out there in the right way. But the real premise is you have to do all that sort of stuff to deliver a simple, well diversified, professionally managed portfolio at a cheap cost.

Wouter Klijn 25:17

Yeah, absolutely. But I was also thinking about that struggle for getting people's attention, and it can be very powerful to have something that's just sitting on your phone, and you can talk to other people, and you basically can go there without necessarily having to invest in a fund. You just you can just check up on it. That must be a very powerful

Greg Cooper 25:36

feature, I think. So, yeah. I mean clearly that, you know social media, more generally, is changing the whole way in which consumers interact with each other, way in which they interact with third parties, and that will continue. People come up with new ways of delivering content to the end customer. You know, things like web 3.0 and things blockchain and so forth, could even mean that, you know, some platforms are no longer the right delivery mechanism for for all sorts of content, because it becomes much more individual to individual. But I but, yeah, I mean, I think what you're seeing is an explosion in the way people want to interact. And definitely have to look at my kids, you know, they spend an awful lot of time looking at their phones and interacting through their phones, and it's just, it's the norm. Yes.

Wouter Klijn 26:23

So you just mentioned the fiduciary side as well, and you've joined the asset owner side as well with T Corp. Can you tell me a little bit about how you came to T Corp and what your role is there? Yeah.

Greg Cooper 26:35

So I've joined New South Wales Treasury Corporation as a non Executive Director. I was lucky enough to get approached by them in my sort of last few months at Schroeder's, when it was, you know, all very public that I was retiring from executive life, and I think it just turned out to be a good fit. I mean, T Corp is a fantastic organisation that's going through some pretty fundamental changes, particularly in the investment model as a result, you know, of the merger between what was workcovers, now I care state super and the original T Corp portfolios. And now it's, you know, looking at a an asset size in excess of $100 billion and needs to be managed in that form. So it's a really exciting time to be there. The team's been built out. It's, it's, it's a great role. So as well as being a non exec, I'm also chair of the board Investment Committee.

Wouter Klijn 27:29

Yeah, the executive team seem to have a real drive to build us out into a global quality asset management firm, coming from sort of that more sleepy government organisation, probably. But yeah, I probably but, yeah, I probably wouldn't

Greg Cooper 27:41

describe it necessarily as sleepy, but, but certainly quieter, and the asset size was significantly smaller if you go back five years. And I just think that that, you know, we've seen a pretty fundamental change in their business, or driven by the right sort of economics and and that's a great time to be there and be involved in the transition. There's also, you know, it's a very interesting business, Teik court, because it's also the government's debt issuing authority. So it's got a very large, you know, issuance side to the to the balance sheet as well. So it's a fundamentally different organisation to most asset owners in that you've got, you know, these two fairly large parts to the business.

Wouter Klijn 28:22

So it took a while to get your head around all the different moving parts. I would say some of it,

Greg Cooper 28:26

you're still getting your head around. You always are. But I think, you know, that's the that's the great thing about, you know, these sorts of roles and the challenges. And, you know, particularly in moving from a third party asset manager to an asset owner, there's, you'll learn new things all the time, yeah.

Wouter Klijn 28:40

So what else is on the agenda for you? So you have directorships? Can we see you at any other roles?

Greg Cooper 28:49

Well, I think in terms of sort of building out a portfolio, you'll see me pop up, I suspect, in one or two other places, as in a non executive or advisory type capacity, as well as that, I've got some personal business interests with the family, which, which keep us occupied for a little bit of the time. And as I said that, you know, the whole thing we talked about in terms of the venture capital space is something that interests me in terms of helping, you know, build out that ecosystem in Australia. And I think, you know, it's, it's a, it's a really exciting time in my career to be involved in a whole range of different things, rather than, you know, sort of singly in one sort of more commercial type arrangement.

Wouter Klijn 29:30

Yeah, yeah. Excellent. Well, Greg, thank you very much for your time. It was good speaking to you.

Greg Cooper 29:36

Thanks, Wouter, that's great.

In this episode, I'm speaking with David Walsh, who is the Head of Investments of RQI Investors, a First Sentier fund manager. And we delve into the concept of a Quant Winter.

Some market participants argue a new Quant Winter is in the making, since growth and momentum factors are compounding with limited breadth, driven partly by the promise of AI. This can lead to distortions in the market and the collapse of quantitative models.

David has tackled this topic in a recent paper, called 'Lessons from the Quant Winter' and we discussed what it is, how likely it is another one is coming, the impact of monetary policy and innovations in quantitative strategies through machine learing and AI.

For the full paper, please see here: https://www.firstsentierinvestors.com.au/au/en/adviser/insights/latest-insights/lessons-from-the-quant-winter.html

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Overview of Podcast with David Walsh, RQI Investors

04:00 From engineering to investing

09:00 What is a Quant Winter?

11:00 Is a Quant Winter a form of mean reversion?

15:00 Do I see another Quant Winter emerging? Probably not. What we are seeing is an anti-value period

18:30 On average value should beat growth, because the market is behaviourally tilted towards growth and overpays for it

20:00 In a high volatility environment, a rotation towards quality is sensible

23:00 A good quant portfolio is not just about established factors, it should be much more about finding idiosyncratic sources of alpha

25:00 You don't want a 100 signals in your portfolio; you want them to be able to breath

26:00 Machine learning let's you build models in ways you couldn't in the past

28:30 How to deal with cost in implementing non-linear signals

31:00 Higher dimensional portfolio optimisation through quantum computing

33:00 Quant Winter versus a recovery

38:00 Is AI in a bubble? "My guess is that the air will come out of the balloon, rather than it popping"

41:30 The extent to which passive or passive-enhanced money has affected the market structure is definitely an issue that has been arising in the past five or 10 years. You can broadly read that the market is becoming less efficient

Full Transcript of Episode 130

Wouter Klijn 00:00I

Welcome to the [i3] Podcast. I'm here today with David Walsh, who is the Head of Investments for RQI Investors. David, welcome to the show.

David Walsh

Thank you very much. Great to be here.

Wouter Klijn

So I understand you studied electronic engineering before you got into the investment industry and specialised in reducing circuits and chips, is that correct? And optical communications? So how do you end up in the investment industry after that?

David Walsh 00:28

Yeah, well, that was the topic du jour when I was studying my electronic engineering, way back a long time ago, the idea of what was called, at the time, very large scale integration, which was the idea of taking a circuit board or a chip design, and shrinking it down as small as possible had a lot to do with the way in which the mapping of the transistors on the chip worked, the material science underneath which materials you're going to use. That was very interesting. Also worked and looked at optical communications quite an early part of that industry. A lot of the talk about the fibre technology and loss rates and speed rates and bandwidth and so on, are quite interesting topics that were quite topical at the time. Emerging industries, the material science and the optical technology side, were very interesting, and clearly emerging technologies that have gone a long way since then. I took that and worked in power and mining engineering for a few years after I graduated, not directly in those topics, but used a lot of the ideas and instrumentation design and the like when I when I was in the industry, it doesn't naturally segue into finance, but it's important to think that a lot of the problem solving techniques that you get from being an engineer or training as engineer, the way you approach problems, the technical issues you use, the things you realise you're missing, apply themselves pretty well to a finance study as well. So when I, some sense, moved careers from engineering to finance, a lot of the skills came with me.

Wouter Klijn 01:49

So when you talk about shrinking circuits and chips, is that related to like Moore's law, where, you know, trying to get more and more things on the chip and making them smaller, and then that would increase the computer power. Or is that totally off?

David Walsh 02:05

Yep, no. Same field, pretty much. The idea there is you can only shrink them down to a certain size, beyond a certain size. It's impossible to to get the chip widths, the better the actual tracks you use for transmitting electrons around the circuit. You can't get them any smaller than a certain size. So there's that sort of limit, physical limit. There's been a lot of work since then. That's a long time ago. A lot of work since then, that's evolved that technology. But the idea was, how far could you get it down before we started to impinge on on issues regarding impurities in the material, in terms of the track sizes, in terms of the transition times, in terms of getting things out of sequence. So the design was really important in that sense, that was kind of the the intuition behind it.

Wouter Klijn 02:44

Do you sort of with that background look at today's, you know, development around machine learning and AI and like this need for chips and the dominance of AMSL, with that background, does that surprise you? Sort of where that has gotten to?

David Walsh 03:02

Not at all. No, I think it was a natural evolution. We would see of the of the the technology was growing back in the day when I was again while studying it a long time ago, the evolution of the technology was, was clearly progressing towards faster chips, greater memory, better software and the like. It's pretty early days, but you can see the trajectory it was moving on. A lot of discussions at the discussions at the time not about where the hardware or software would go, but how the usability of those technologies would move. And really, even then, artificial intelligence was a concept. At some point the industry expected to get to the point where it could replicate some kind of human behaviour, not to the scale we see it today. But certainly there was trajectory. I don't think it's been much deviation from that. The only real direction I think has been interesting, and I don't really understand this properly yet, is the idea of quantum computing, which gets away from the original idea of logic gates being zeros and ones to an issue where to a logic gate or a bit can have both zero and one at the same time based on some probabilistic distribution, which I can I've studied Quantum Physics A long time ago. I kind of understand basically the principles. I still don't get quantum computing the way I'd like to.

Wouter Klijn 04:04

Yeah, no, it's a fascinating topic, but very complex indeed. So that engineering background you now work as a quantitative investor. So you know that engineering background was that sort of a natural progression to become a quant, rather than, say, a fundamental approach?

David Walsh 04:21

Yes. So I transitioned across to finance academia first. So I was doing a higher degree in Finance as part of my studies, further studies. And I liked it, and transitioned across at an academic level, mainly because I liked the idea of research and pushing the ideas of knowledge and challenging myself. And I liked teaching. I like communication side. Did those skills necessarily move them across to quantitative investing? The answer is yes, I think fundamental investing has changed quite a bit since I've been in the industry. There are a lot more quantitative skills being used, but it's still not disciplined in a way that a quantitative investment process is. So having those tools and techniques that I'd learned as an engineer were not. Really directly applicable, but the discipline around problem solving, the idea of numerical optimization, the idea of constructing a problem in a certain way, those things lend themselves very naturally to quantitative investing,

Wouter Klijn 05:11

Yeah, but you're not getting to a stage where you built your own computers and systems for backing up the quant strategies?

David Walsh 05:18

No, no. There are many more, many people in the industry, including people that work with us, who are much better at that than me, my skills, are more around I think thinking about how the evolution of information works in markets, what things get priced in, what don't, what drives volatility, what events are happening that will perhaps override those that sort of quantitative discipline applied to the investment market. So it leads us on, naturally to where I've sort of come from in my come from in my industry, rather than going back to the technological side.

Wouter Klijn 05:46

Yeah. So part of the reason to do this podcast is because you wrote a paper that was talking about the quant winter lessons from the quant winter, which is perhaps not the topic you expect from a quant, because, you know, always works, doesn't it? What is a quant winter?

David Walsh 06:02

So quant winter was a term that was coined by a couple of industry people back in about 2020 also 2021 to reflect a certain period when a lot of quant factors didn't work as expected, both not in terms of factors not working, but in terms of the complementary factors that usually work not working either. So I went to almost a drought. So you could call almost a winter or a drought would be sort of either terminology. I don't like the winter term very much because it tends to mean that there might be seasons in quant behaviour. There's a spring and a summer. Yeah, that's not really how you want to think of the world, but a lack of of drivers of underlying fundamentals that have worked for a very long time, that certainly reflects a more wintry period or more drought period in terms of those factors. So it wasn't coined by me, but it's become a bit of a topic, particularly more recently, with some of the quant factors behaving in, again, peculiar ways, particularly for the last year or so. That suggests that maybe there's been some discussion, maybe there are reflections of that quant winter appearing now. Winter appearing now. Are we still saying the same things? Is it going to happen again? The Quantum winter itself probably can't be defined easily as being a single period, although it does tend to reflect times when certain style factors didn't work as expected, and the other factors, as I said, which were complementary to those didn't work as expected, either, and that period of nothing working was a winter or a drought.

Wouter Klijn 07:25

So what is, sort of the fundamental driver behind that? And as I was reading the paper, I got a sense that it points out that people were paying more for sort of the same earnings growth, that there seemed to be a bit of a mean reversion element to it, where you know that trend of paying more for the same earnings growth is not sustainable, so at some point that will break. Is that just mean reversion, or is there something else going on?

David Walsh 07:51

Yeah. So you don't want to try and bet against the markets when they're doing things which appear to be irrational. We all know that those sort of expressions, but what appeared to be happening was a narrow part of the market became more and more expensive after a long period when value was hadn't worked for about 2011 to 2017 or 18, value had been in a difficult period, low interest rates, low inflation and stimulated growth. Companies had driven a lot of the AI boom. A lot of the technology around that was developed in that period because it had a runway. A lot of investors were buying in to that period, what we saw from about 2017 or 18 onwards was a strong period when value underperformed, because that narrowness of growth continued very strongly and went upward. So in a sense, it's mean reverting. It kind of is a precursor to a mean reversion. I think that's why it's thinking of it. So in other words, markets became more and more expensive during that period, with the inevitable outcome that eventually it's going to be a reversal, which we saw in 2021 so that you get a reversal. And that was, in some sense, the main reversion that you speak of. But what was interesting as part of this was there was no way probably you could really have predicted or changed your position accordingly if you want it to be tilted towards value, you couldn't change that value characteristic. But normally, in an environment we know in quant investing, if value is not working, which is associated with mean reversion, trending signals like growth or price momentum tend to work, they didn't really work either. So it's because the market was so narrow, in the sense of a handful of stocks that were running, you couldn't really pick up a growth story unless it was very much a tech, US tech, expensive US tech story. And that's not usually, that's too narrow a bit for most investors to make. Certainly, for quant investors to make.

Wouter Klijn 09:34

So in this quant winter, a lot of factors are not working. Some factors are, I think, distorted a little bit in how they perform as well, when you look at that, is that mainly a problem from the perspective of a factor neutral investor, because usually, then you sort of don't want to take a bet on one particular factor. You try to have a broad spread that if one doesn't work, hopefully some of the other ones work. So is it mainly a problem from that perspective, or just did nothing work at all?

David Walsh 10:05

So if you were to bet on tech, as I said, I mentioned earlier, so if it was a tech bet, you're willing to buy expensive tech, expensive tech growth in the US, then you didn't have a problem. You were going to be overweight those names, and you'd do fine. But most managers weren't willing to pay up for the excessive earnings multiples, because the earnings had not yet been realised, even though the valuation is reflecting those earnings. So you're getting stocks trading on 30 and 30 plus times forward earnings. Those sort of numbers are pretty big for anybody to own. So that was a difficult thing to swallow, and that was what was driving the market lot of the time. That concentration was driving it. So in a sense that if you have a diversified factor model, like an alpha model, the quant model shop like us would have, you'll find a lot of things wouldn't work. You wouldn't necessarily be penalised by them, per se, on average. But in this case, we would have been, because we've been underweight a lot of those, those tech stocks. But generally, those sort of factor models would be have an alpha drag because of those. In fact, any model would have an alpha drag unless it had those characteristics that we talked about. I'd be, I'd be thinking that it's kind of a binary bet. A lot of ways, you either buy that story or you don't. And if you don't, no matter what your investment style is, you're going to be underperforming, whether diversified quant or a style risk premier capturer or a fundamental investor, the same thing will apply.

Wouter Klijn 11:23

Yeah. Now, you mentioned earlier that there are some people that saying maybe we're facing another quant winter. And to a degree, it does sound familiar, the concentration in the technology stocks, we do see that it impacts how momentum and growth work, because sometimes they seem to get a bit concluded in this narrow market. What is your take? Are we facing another quant winter?

David Walsh 11:47

Yeah, again, I'd push back a little bit on the term quant winter, although it's an easy thing to say, I get it, and it's catchy, isn't it? It's very catchy. And I get the point. I think probably the more the story that we are so uncertain of the direction, there's a lot of volatility in factors. There are periods and pockets when things are working. Things are working more quickly, perhaps, than we might have expected. Things which are in the past have worked aren't working. That sort of lack of product predictability probably isn't quite the same as a quant winter. It's more about an excessive period of volatility and uncertainty in the market, and so you're getting a lot of policy decisions, a lot of directions of the market, which are probably not what you would have taken as your bet being longer term, certainly. So do I think, to answer your question, do I think we're seeing a another winter emerging? Probably not. I think what we're seeing is an extensively value, anti value period in concentration and in expensive stocks and in tech unwinding. We are seeing that at the moment, and that unwind I would expect to continue. I don't think I would see a period where everything goes flat. More likely we'll see value continuing to do well, as we've seen over the last few months, after a period when it didn't do well, momentum will have difficulty. Growth stories, which are very uncertain in a higher inflation, higher interest rate environment, are difficult to pick. So some of those factors that have worked for a little while are not going to work. Would have called a winter No, I'd probably call it more just a high volatility. In fact, there's a lot of factor risk going on. So perhaps in an environment when someone like like us, who's investing a lot of these contractors, needs to be very cognizant of those. Probably would like to take some risk out of them, out of the process, or have it taken out simply because cross sectional deviation has gone up this uncertainty we're seeing. Yeah.

Wouter Klijn 13:34

So how do you prepare for that? I mean, the increase in volatility, does that also provide opportunities?

David Walsh 13:42

So yes, um, if it's cross so usually, quantitative models work better in environment when cross sectional dispersion opportunity set is bigger. Yeah, no question about that. So, so yes, you're exactly right. That's what you'd expect to see. So bigger dispersion, more likely opportunity set, provided it's the right sort of dispersion that you would see. So on average, that's true if it's macro factor risk or thematic risk that you're not normally betting on or is driven by factors you wouldn't normally see. What happens then is those factor opportunities don't appear. Contra sectional risk increases, and the model automatically adjusts itself by shrinking its positions and holding more names. That's part of the rebalancing process. When you use a risk model that we do, you tend to hold more names in period when cross sectional variance is higher. That's kind of what we're seeing at the moment. Volatility has been up a lot more uncertainty, and we tend to see a more of a risk averse process falling through. But we still have great conviction in our ideas. Longer term. You know, we were happy with those things. There's nothing in there we want to throw away. But it does seem to be that a lot of volatility in those factors and a lot of factor risk, which is not part of the normal Alpha factor risk that we need to take into account.

Wouter Klijn 14:51

Yep. So you mentioned the value factor there, and you said, well, that underperformance is sort of unwinding, but you don't necessarily. Expected to outperform going forward. What is your sense there in terms of, you know, the role of the value factor in portfolios? Because we've seen a long period where it pretty much did nothing or underperformed, then it started working a little bit again. But it's, it seems that you saying, well, we don't expect that to continue for a long time?

David Walsh 15:21

No, no, I think what I was saying was the value factor probably should continue to work for a little while, but the growth component of that probably, the growth factor probably would not so Okay, so I'm more of the view that historical evidence associated with value is going to continue to be true. We've gone through some periods when it didn't work. As you noted, 2011 2018 1020 period value was a struggle. It's rebounded strongly, given back some it's come back again. More recently, on average, value should beat growth, because the market is behaviorally tilted towards growth and overpays for it. Yeah. So you tend to get this bedding up of growth and then disappointment. The market sell off, you get glamour stocks, which are sold off, and you get under unloved stocks being sold off too far before that and bouncing again. That value premium has been shown many times through history. I would expect that to continue in the future, but longer term, but with volatility being as high as it is and uncertain drivers that we're seeing, macro drivers, thematic drivers, as well as these sort of factors which are highly volatile. I'm not going to say that we're going to have a period over the next 12 to 24 months when value is going to shoot the lights out, but I'd certainly expect it won't underperform by anywhere near as much as it has done during the period we saw prior to that.

Wouter Klijn 16:31

So it's not time to throw value out of the portfolio just yet, because it seems that when you look at sort of asset owner portfolios, that some of them have migrated from a pure sort of value exposure to more of a quality exposure, and basically, don't have a lot of exposure to it, to a pure value factor.

David Walsh 16:53

That's that's a good point. I think the the idea of a rotation towards quality measured however you can measure it, quality is a bit of a slippery concept, but, but measured however you measure it, that's sensible, because in a higher risk environment, you know, more likely better quality stocks, again, however you measure them, should outperform. But we would make the case pretty strongly that it makes sense to have a style balance for asset owners. They should be having quality in their portfolio, certainly, perhaps a little bit more of that, if that's their view, but you're going to be buying growth, because growth is where a lot of the returns are going to come from, and so you need to buy growth. You generally have to buy good quality, bottom up stock picking growth managers understand those companies, understand where growth is going to come from, not just narrow in tech, but more broadly than that. But that gives you a risk. You get an expensive growth e portfolio, particularly with the quality side that sits out there on its own without a balance now that stops paying off, you can significantly underperform. So we find, not only does value outperform over the long term, we like to think of value as being an insurance policy against those and then in client portfolios, we've had just a few clients have told us this. They like a low turnover, transparent, robust value process to balance out the styles they get from their other managers. So it's almost like a risk management tool in some for some clients, it certainly is. Others buy the value story and will own it longer time as a longer term as their core there's no question about that. But certainly for some larger asset owners we speak to, it's a balancing item. It's almost insurance policy in some ways. Yeah.

Wouter Klijn 18:25

So one debate in the quantity industry is focusing on, you know, how many factors are there, actually? And the answer, I find sometimes, ranges from three to five to like, 1000s. Yeah, sure. Where do you sit?

David Walsh 18:41

So there's a lot of discussion around what the academics called the factor zoo, lots of ideas and many, many different anomalies and factors in there. We tend to break it down, sort of at a high level, in terms of what we call composites or families of signals which follow certain themes. When it comes down to it, there's going to be themes which are, at one end, very risk based. So for example, volatility type signals, which will pay off over time. If you're tilted towards low volatility on average for the long term, it should outperform. Or there are periods, as we know, but it doesn't work. But that's quite a simplistic implementation. You just tend to buy low vol, low beta names and lab perform well, there's not much science in that, a little bit. And if you did build portfolio, build portfolios properly, you'll certainly see that that tends to act more like a risk premium. So you're picking up risk, and you're being rewarded for taking on that risk, risk associated with low volatility. You might do the same thing in taking on risk associated with value. For example, if you believe value is a risk, or if you believe that quality is a risk, you might find those as well. So at one end, you can think of these high level factors as being risk premia. I think any good quantitative portfolio should have a component of those within them, even if it's seeking idiosyncratic alpha, simply because we know that risk premia. Listing works on average, but your portfolio shouldn't be all about that. It should be much more about searching for more idiosyncratic sources of alpha and building those in. And that's when we get into this factor zoo issue that a lot of academic evidence, a lot of practitioner evidence, finds things that work, that perhaps worked thematically at the time, or perhaps based on a certain data set, or perhaps we're not able to be replicated, because this is replica replicability issue in finance academia, as is in every industry built you to do the same thing over again. That chasing of that next big idea probably is not really the way that you'd like to build your your alpha model, right? So I'd like to have, I'd like to think of our model as being a balance between risk premia, not too many of those, a small proportion of those that give you that long term risk premia harvesting issues associated with behavioural in markets, certainly behaviour in terms of the way in which investors work, the way that markets are pricing things in the data complexity issue is one that's really important. So issues around complex data models and how hard it is for individuals, or even invest many investors, to process efficiently and ingest that level of data. And I think those things, and I guess and limit, as well as some things associated with an inability to price in these things simply through mechanical issues, whether it's a short selling constraint or trading issues or institutional things that prevent you all of these things lead to various types of what I'd call idiosyncratic Alpha sources. Now, if you were to build a model that was a range of all of those things, you could end up with hundreds, as you said, of factors in there. The danger with that is you just squeeze out anything, you overfit. You end up with it with it, with a model which is very much data driven, can't be replicated in the future, no individual signal gets any oxygen. So as a balancing act, a little bit of art in building a model that says, I want enough alphas in now, have enough conviction over that are spread across a number of different insights that consistently work. So how many do you have? Well, 10 is too few and 100 is too many. It really depends on the alphas that you actually have, yeah. So really, it depends on the research you do. And that leads a little bit to the nature of, sort of the differentiation between quant managers that comes a lot of the time from the way in which you research and build those models, I think.

Wouter Klijn 22:15

And has that changed with the advent of machine learning in its current form, because you're basically looking with some of these risk premium for trends that are replicable, and machine learning gives that extra element where it can find nonlinear trends, so it potentially opens up a new source of factors. Is that how it works?

David Walsh 22:40

Or, yeah, very close to that. I think the there's a bit of a misnomer with AI, which I don't like the term artificial intelligence very much anyway, or machine learning, then it's going to find the answers for you. It's not really working that way. The insight, the understanding of economics behind it is really much more associated with what drives good returns machine learning tools, and has been a strong advance in many of these machine learning tools over the last three to five years, as we all know, let you explore those ideas in ways you couldn't in the past. It lets you pick up data sets you couldn't in the past. It lets you test things and build models you couldn't in the past. That's where a lot of the innovation comes from, not from finding new ideas, there's a little bit of that, but then taking old ideas and making them implemented, implementing them more efficiently. I think a lot of the ideas associated with machine learning allow you to extract those. I can give you an example. A lot of models that you might have in quantitative investing look at peer relative valuations. So you look at a peer group and you say that company is expensive compared to that company. So I'll go overweight, the cheaper one underweight, the more expensive one in that peer group. The question then is, how do you define the peer group? Do you talk about a sector? Do you talk about common geographic revenue? Do you talk about same customers? How do you do it? Well, in some sense, the machine learning tool in the past, you would have done that. You would have specified it that way, the machine learning tool has the ability to, in some sense, learn what the peer groups are over time within which your relative valuation signals can work. So while in the past, you might not necessarily have been able to pick up what those peer groups look like, now that relative valuation signal can be applied within peer groups that are determined by the machine learning tool. That's a really nice innovation, and much more powerful than a simple sector relative PE, for example, yeah.

Wouter Klijn 24:30

But do you find that that that group, that it then identifies, that that is a stable, permanent sort of group? Because sometimes you think that they find trends, but yeah, it might be a moment in time.

David Walsh 24:44

Yeah, really good point if you tune your model in us. This is part of the use of machine learning. If you tune your model in a certain way, you can find at that point in time the perfect peer group. And then tomorrow it doesn't work anymore, and yesterday didn't work either. Depends on how you tune it. If you. May tune the model too slowly, those peer groups don't evolve quickly enough. Which case you're lagging. So it's a question of how you build your machine learning model, how you understand it, and then the interpretation of what those peer groups might actually mean. So you want some kind of level of stability, but you want to be adaptive as well. And that comes down to the machine learning tool you use, the way in which interpret the evidence, the way you measure the importance of the input factors. All these sort of things matter.

Wouter Klijn 25:22

And the other thing that matters as well, and that is, I think, cost, because, from what I understand, that some of the non linear signals that are found by machine learning that they're real, they're sort of sustainable, but if you don't manage your cost properly, then get eroded away very quickly.

David Walsh 25:41

Yeah, two levels of cost for that. One is the trading of them. You can wear a lot more market impact by turning these things over much more quickly. So it's got to be an integral part of your process for testing and implementation of quant signals. No question about that. But the second thing is the cost involved in processing these things earlier on. When you do the analysis for these you're requiring fairly sophisticated tools that need to run for some time, and conventional computing hardware and systems are quite often not built for it. You need to be able to use much more scalable processes to be able to do a lot of the work that you need to do now. So cost in the sense of fixed and variable, cost of the hardware and software you use, as well as the trading costs associated with implementing them.

Wouter Klijn 26:19

Yeah. So we started off talking about a quantum winter, where you have certain factors not working. You got some distortion with factors. Do you think that machine learning can also help in sort of managing the risk, in the sense that it would pick up these signals earlier from distortions taking place?

David Walsh 26:36

Yes, indeed. So there's two strands. So that's a really good question. There's two strands to that. One would be trying to assess the way in which these signals are being implemented, sorry, being priced in. Now, what we've seen particularly at corners in the market. In Australia, we saw this in October and November. We saw sharp sell off and then rebound. A lot of factors behave very differently around those corners. Now, could you have a machine learning tool that allowed you to adaptively pick up what the factors are being priced in and change your model accordingly. Yes, of course you could whether that generate you get your original question, which is another good one, what about the cost involved in this? If you're turning over your portfolio too quickly, is to chase these things. Does the net reward? Is net reward positive? After costs, you might generate turnover. You burn it all up in transaction costs you earn you nothing. So you need to be able to assess those in history to work out whether it cost you when the time comes. But the answer is definitely yes. Machine learning tools could do that. They can also adaptively weight signals through time. So you need a machine learning tool that tells you what the best trade off between returns and risk and cost might be in terms of the mix of signals you use. That also is something that tells you in the normal run of things, rather than actually in terms of more in more volatile times too. So I'd say definitely, machine learning can help you in terms of portfolio construction, in terms of model selection and in terms of adaptability in the market. One thing I'll get back to a moment. I read an article this morning on quantum computing, again, trying to understand it, which I don't one of the tools that's being used there is for much more higher dimensional or granular portfolio optimization. So it's actually applications of that that apparently are toy examples that are being used at the moment that demonstrate how a much more efficient portfolio potentially can be built, not by changing the machine learning tool, by changing the particular application of a technology, the hardware you might do give much more space to search that space more efficiently than you're otherwise able to. So not just a machine learning tool, it's a hardware solution.

Wouter Klijn 28:25

Yeah, so with your background, then you look at quantum computing, and it's sort of a high level. Do you think that the gain there is mainly in faster computers, or could it also be that the fact that I work differently allows for a different type of software or program to be implemented?

David Walsh 28:44

I think the first one, again, I put the condition on that I'm still learning this stuff slowly, and I couldn't profess to be anything like an expert in what they do or how they might implement it. However, I think it's much more associated with the the selective problems it can address that current technology can't address. It has ability to compute many more computational cycles in a more complicated way than current computer. Computer literature, sorry, computer architecture can solve that particular problem. Lends itself very nicely to quantum computing, and I think that's where a lot of it will happen. I don't think quantum computing will come up with new ideas, as in the first pass it might, because of the machine learning tools you can evaluate on that lead to more things, but as a solution to a problem. At the moment, it's addressing problems which current hardware cannot really address because they're too complex or too big. That's where it'll probably come through, in my opinion. Anyway, my unlearned opinion.

Wouter Klijn 29:41

Yeah, interesting. So I think what part of the reason that you think it is not a quantum winter is because you talk about a sense of recovery, that we're in a stage where actually quite a lot of factors are working. There's some exceptions to that, maybe a low volatility. Not as robust at the moment, but it's basically a period of recovery, rather than a period leading up to our problem. And then I thought about that, because in the context, as well as the broader sort of monetary policy, we had a period where there was very loose monetary policy. It basically prevented the recession. That was the most widely predicted recession we were going to have. Is there an element there where perhaps there is the system had didn't have the time to flush that out, and there's a bigger crisis building because of that, the monetary policy has basically prevented the crisis from happening.

David Walsh 30:41

Yes. So there's probably two strands, if I can answer that in sort of two different ways. There's always been talk post any kind of major sell off or major economic disruption, and the support that's provided by by government institutions like quantitative easing, post GFC that prevent the natural run of capitalism, the creative destruction of capitalism for taking place. Yeah, really, companies that should have should go broke. I mean, should have been allowed to go broke. And we didn't get much of that. We had Lehman Brothers, right, but that's pretty much it. And Bear Stearns, obviously. So there's, there's that issue. I think there should have been. I mean, nobody wants to see this sort of thing happening. But in practice, if you believe in a capitalist system, that's a natural result. And things go wrong. Things are not working should be stopped, and things are working should replace them. Now, the creative destruction idea that wasn't really allowed to happen through implementation of lower interest rates, deliberately low inflation, productivity was very low. That stimulated a lot of and simulated a lot of growth in some areas, which turned out to be good, but prevented others from recycling the capital being recycled into more efficient places. So definitely, that's, that's an issue we've seen. I think, I think that probably explains a lot of the, or some of the growth we've seen in tech, in particular, a long runway of low interest rates of the market getting used to low interest rates and willing to buy longer dated cash flows and earnings that's certainly been built into the prices for a lot of tech companies in environment which is much more strict and higher interest rates and short term, it's unlikely that we've got the same runway that they've had. So you can sort of see that they would have performed the way they've done, and it's been great for a lot of reasons. Do I think a sort of thing is going to continue? That's really a different, much more, much more interesting and complex question, because I don't. I think in an environment we're seeing higher interest rates. Inflation is sticky. Despite posturing, interest rates are probably going to stay higher longer term. Certainly in Australia, we've seen that that's an inflation story, as much as anything else that will probably tend to play out in in a slowdown of growth plays nicely to value style. Getting back to what we talked about earlier doesn't mean it's building up something else to happen. To get into your question, I'd probably think that one of the the main things we've seen associated with the results of those long, long growth those companies didn't go broke. They probably should have. We've seen that in the past, but also the exuberance we've seen in Tech has played itself out in excessive spending, both in the past and into the future, on CapEx for data centres and for growth of hardware, extrapolating into the future, things which probably shouldn't be extrapolated in the way that they have been, and I'd be quite suspicious of that can't be continued, particularly the capex side, which just seems outrageous and unlikely to be able sustainable both, not just from environmental perspective, something from terms of finding the cash to invest in these for the return on invested capital you expect you probably won't see. So my expectation is a lot of those things will be scaled back, that those those dreams will not become reality. We won't have data centres in space, none of that going on, which I found also hilarious when I heard Elon talking about it. I think it's much more that those things will be scaled back. We can't have a sort of CapEx, we currently can't live with the depreciation that comes from that capex, in accounting sense, into the future. So I think those things be scaled back to be more reasonable. A lot of those businesses we're talking about do generate cash. They are next generation. They will be there in the future in some sense, perhaps not those companies, but the ones that come after them will be around. It's no questions technological shift, but it won't play out the way it's playing out at the moment.

Wouter Klijn 34:22

It doesn't seem at the moment, though, that they're scaling back, because I think they recently announced a combined US$600 billion in more capex that they're planning to spend, yeah, and at the same time, people have sort of said, Oh, it's not so much of a problem, because these companies, you know, the cash flow positive and have a lot of equity. So it wasn't, you know, a debt fueled spending, as some of the crisis have been in the past, but some of these companies are now starting to raise debt.

David Walsh 34:48

Yes, yes, that's right. There's 100-year bond or something that was Google listed the other talked about the other day. There's certainly been some debt fueling, I think a free cash flow for these companies is not as high as they thought. Open AI is a good example. Microsoft has plenty of cash, but the free cash flow, since companies is falling at the same time as the capex is increasing, the only way continuing to capex is to raise capital through debt or equity, and debt being the way they're talking about I'm confident or respectful of the market mechanism here. I think the market knows this, and it's already starting to price in some of the issues associated with this, this exuberance we've seen that's been going on for some time has probably rationalised itself a little bit, and I think it's more like that. These plans will simply be scaled back. There'll be some remnants of it. There are large data centres in the Midwest of the US and so on, which are being built now, and probably will continue to be built, some sense. But that long term growth of CapEx to solve a problem which doesn't yet exist simply to serve these things seems unlikely. So my view would be, it's more likely the air would come out of the balloon rather than a popping.

Wouter Klijn 35:47

So this type of big, you know, more macro orientated developments, how does that feed in with sort of your quantitative process? Does do you build signals on the back of that, or is it more it informs the broader portfolio.

David Walsh 36:01

Yeah, so it's more. It will not really find its way into portfolio construction wouldn't really find its way into alpha generation unless we can find something which we believe will consistently work through the cycle. It should really be kind of all weather. If it's thematic change that's happening then, then it's less likely to find its way in, it'll be more noticing what the risks are, understanding the processes and the outcomes that we see. And then when clients are curious, we can inform them. Team members are curious, we can inform them and understand how it works, because we know we can't predict the market well enough to understand a lot of these sort of underlying moves that take place, and the impact they can have on on returns, on portfolios. So just as being informed about the market, rather than making changes to the process, what we do in the process should be longer term. I don't think there's any real need for us to try and implement macro factors directly in, on thematic grounds like that. If we find something that's useful, very happy to do it. But I don't think there's going to be macro factors. There's too few macro drivers to make enough breadth in the portfolio decision making to allow you to put them in as an alpha factor. One thing I would talk about which has spurred some research that I've been thinking about more recently has been this capex idea. So there are certain regulations which are used around the world, accounting standards regarding revenue recognition, when you recognise revenue, and how you measure that. And it seems to me that revenue recognition is an area which is not well understood in the in the technology side. And if you recognise revenue at the right time, then you probably are understanding much more about the underlying development of the company and the quality of the company that goes with it. I don't think revenue recognition is very well understood in the IT sector at all at the moment, and how it's actually working. It's just a exuberance pay for the future growth story. So that leads me to think, How can we better incorporate revenue recognition more broadly across the market, across the portfolio, not just in tech.

Wouter Klijn 37:53

Yeah, yeah. Interesting. We looked at this quantum winter concept, and that's more about, you know, how different factors behave at the same time. Do you also keep an eye on sort of market structure at sort of a higher level? And the reason why I'm asking is because we've seen, especially in Australia, because of changes in regulation, because of mergers and peer awareness, that funds have been using more systematic strategies passive, but a lot of the time it's more passive and enhanced. So there's more money flowing in that side. Does that create distortions that sort of affect your process?

David Walsh 38:33

That's an open question, a good one, and an open question, the extent to which the growth of passive money, or very low risk, active risk, funds, ETF flow, retail flow, the impact that has on overall market structure and the pricing in of of ideas and what's driving them. That's definitely an issue that's been emerging, particularly in the last 45 or 10 years or so, and more recently, with the growth of index portfolios. The flow into index funds and the flow into benchmark hugging funds has a number of different effects. You'd imagine. One of them would be that conventional things, which we priced in, are now being priced in by fewer investors. Which case it should create an opportunity. There's less efficient markets. You'd think that's possible. One answer. The other reason these things never get priced in that no one buys them because you think it's a good idea, but people stop buying that because just go to the to the index, which case you're betting on the wrong horse. And that's possible, too. The emergence of these sort of things causes distortions, a lot of inflow, a lot of capital chasing fewer names. Market goes up and up on the back of these pricing issues that we see, this, this sort of flow issues we see, I can't see that changing, and it's definitely going to have an impact. It's just very cloudy as to what the impact might actually be. I think you can broadly read that the market becomes, as I said, less efficient. And there's an argument, also an interesting argument is. Well that it actually becomes potentially better for investors in an environment like this. And the reason for that is goes like this. If your index funds are growing, it means that the ability for stock to be borrowed is increasing. So if you're going to borrow stock and short it, you can now do more of it. So availability of shorting is higher, which means bad news should be priced in more easily. See the logic. So that would suggest that the short sale constraint and the ability to borrow is being reduced by the growth of index funds. Now, whether that's be true or not, I haven't seen any evidence on that, but you can kind of get the get the logic behind it. So it's too many things at play at once, on average. Definitely, it's been a change to the industry. It's not going to go away anytime soon. I would say that it's going to make everyone's investment processes more difficult, because less is being priced in by the things we used to get priced in by and more as being simply just buying at the close to meet a benchmark.

Wouter Klijn 40:51

Yeah, yeah, yeah. Fascinating. So if I might end up with a slightly tricky question, because we talked about the quantum Intuit. You don't like that term because it implies cyclicality, yep. So we get it, it's not cyclical. But we did recently a poll at our equity conference, and quite a few quants in there as well, and said, if it was to be divided in four seasons, if it's not winter, where are we at? And we got the majority that actually said, summer. Oh, right. Where do you sit?

David Walsh 41:21

Yeah, well, I think we've definitely come out of a period when quantitative investing was not front and centre with a lot of asset owners allocations for a variety of reasons. It could have been the performance from way back during the GFC. It could have been through some more volatile periods. It could have been quant winter that inverted commas quant winter period. But we certainly seen a lot of factors working at once, and a lot of emergence of quant businesses over the last few years that have really driven good performance have gained great reputation and have shone in the light of or perhaps in the lack of light from other managers who've struggled to perform. Deep failure, managers haven't done so well. Strong growth, managers haven't done so well. So that emergence, along with the idea that machine learning and data becoming more available, lends itself more towards popularity for quant investing. Are we in summer yet to use your analogy? No, I don't think so. I think we're in the upswing. I think there's still a lot of scepticism about the long term performance of quant factors have with quant models, have? We've certainly seen strong demand in our quant processes, consultants, clients have been very interested. I think what that means a lot of people is from one person different to another. You know what that quant process means? So some think of it as being very idiosyncratic factors that are all quite unique and different, and all driven by AI and black box and who knows? Others think of a simply risk Premier. And that variation probably won't resolve itself, but it also tends to lead to a lot of uncertainty, what, whether you're where you are, in that, in that, in that, in that seasonal period. Yeah, we're talking about, I think we're not there yet in terms of summer, but we're certainly growing towards it. Quant performance has been good. The risk controls are important. Technology is driving a lot of it. I can definitely see it being a, being a strong period for quaint investing for the next, certainly, next few years.

Wouter Klijn 43:17

Yeah. So spring, perhaps?

David Walsh

Let's say spring.

Wouter Klijn

Let's say spring. Well, David, thank you very much for coming to the office, and thanks for this conversation.

David Walsh 43:24

Oh no, that was fantastic. Thanks.

In this episode, we go into our archive to October 2019, when we interviewed Fiona Trafford-Walker. Fiona was one of the key consultants behind the success of Frontier Advisors and spent 25 years with the asset consultant, advising many of the largest funds in Australia.

She has been named several times among the most influential consultants in the world and was a driving force behind the fight for equitable fees in the industry.

In this interview, we delved into the changing role of asset consultants, questioned whether too much time is spent on manager selection and examined the struggles of value-style strategies.

Fiona has since retired, but is still active in the industry through various director roles, including for Victorian Funds Management Corporation, Perpetual and as a member of the IFM Real Estate investment committee.

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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 Episode

Overview Fiona Trafford-Walker podcast:

2:30 I'm an accidental asset consultant 4:30 You're named as one of the most influential asset consultants in the industry. What makes a good asset consultant? 5:35 You have to be willing to collaborate 7:00 Technical skills are very important, but equally important is time in the markets 7:30 The changing role of asset consultants over the years 9:30 As asset consultants have increased their senior staff, have conversations become more focused on strategy? 10:30 There is still the need to have a blend of specialist and generalist skills 11:50 Are we already heading to having a panel of asset consultants? 13:00 Is there a good balance between the time spend on manager research and that on asset allocation? 14:30 What type of data should inform changes in asset allocation? 16:00 There is not much you can do about geopolitical risk; predicting what politicians are going to do next is pretty hard. 16:30 But trade wars are a real thing that have an effect on markets 18:00 Are the struggles of active managers, particularly value managers, structural or cyclical? 19:00 There seems to be a need to tweak the value process to allow for the new capital-light business models. But at what stage do you get style drift? 21:30 Frontier Advisors took the decision to build a platform with all their research on it, quite a brave step in an era where softcopies get distributed easily. 26:00 You spent some time arguing for lower fees in the industry. Are we at the right level? 27:30 The real change has been the internalisation of asset management by some funds. 29:00 Can internalisation refocus asset management on the long term? 30:00 Bottom draw mandates 31:00 To what extent should asset owners engage with the companies they invest in? You are on a number of boards and see both sides? 33:00 Governance certainly has changed as asset owners realise they are the beneficial owners 35:00 To what degree can you divest from companies as a fiduciary? 38:00 The challenge of developing retirement products 41:00 At the moment, the willingness to do things together [as funds] isn't there. 42:00 What is next in store for you? 44:00 What issues come up in mentoring new asset consultants?

Full Transcript of Episode

Wouter Klijn 01:12

I'm here today with Fiona Trafford-Walker, who is a director with Frontier Advisors. Fiona, welcome to the podcast.

Fiona Trafford-Walker

Thank you. Walter, happy to be here.

Wouter Klijn

So 25 years of Frontier advices, has it gone quickly, or do you think it's a long time ago since you started out?

Fiona Trafford-Walker 01:28

I think the answer today is both, when I think back that it's been 25 years, I feel like, wow, that's such a long time. It's about half my life. And if I think about it like that, it feels like it's a very long time. But also, I think it's gone very, very quickly when I think of what it was like to start the organisation with Ray King, obviously he was very integral to starting the asset consulting business inside industry fund services, which became frontier. And I remember very clearly the first day walking to the office in Carleton. There were two of us in this room working out of there. And then I think of how, you know, we grew over the years. Some terrific people came on board, and then all of a sudden, it's 25 years later. So in some ways, it feels like it's a long time. Otherwise, it feels like it's gone very, very fast.

Wouter Klijn 02:13

Yeah, if I can take you back a little bit to the start of your career, I read this funny quote one time that you did an interview with The Sydney Morning Herald, where they asked you how you became an asset consultant, and you sort of made this comment where you said, yeah, it's not really something that you aspire to in university. It sort of happened. Can you tell us a bit about that?

Fiona Trafford-Walker 02:33

Yes, that's definitely true. I'm a great accidental asset consultant, I think, for a few reasons. One, it's not something back, you know, 25 years ago that people really knew that much about it was a relatively new career. Back then, the asset owners were much smaller. The system was very different. And I was interested in financial markets research, and I grew up in North Queensland, where the career prospects for that sort of thing are obviously relatively narrow. So I knew I had to move, and I knew it would have to be Sydney or Melbourne, and so just applied for a number of different jobs. I remember going for my interview again with Ray King, because he has employed me twice now, and sitting in the office at Towers Perrin in Sydney. And you know, Ray was asking me all these questions, and I couldn't answer most of them, and I thought I'd completely mucked up the interview. And next thing you know, they're offering me a role. It was a research role, and it was in the investment consulting business in towers parent, but sitting alongside that function, and my job was to do specific research that might help the consultants provide advice to their clients. And there were two of us in what we called the Global Research Unit, which I used to think was kind of ironic, given there were two people in Melbourne in a global unit. And after six months, the person I reported to Ron Bird, decided that he would move into funds management. And so I think they looked at me and said, Oh, well, we'll just move you into the asset consulting business. So I moved in, and I was there at Towers Perrin for a couple of years, and I just really, really enjoyed that work. I think what resonated with me was the chance to do research and practical research that could then be used to influence client portfolios and then outcomes for members. And I think I just not made that connection well enough before in those first six months. So I moved into the asset consulting division, and then in the middle of 1994 when Ray left to start industry fund services, I moved over with him, and the rest, as they say, is history.

Wouter Klijn 04:32

So you've been called one of the most influential asset consultants in business. What makes a good asset consultant?

Fiona Trafford-Walker 04:40

I get asked that question a lot now, and I think, I think what happens as you get older, people ask you all these questions, and so I've had to actually think quite a lot about it, because it was not something I ever thought about a lot beforehand. For me, I just did what I thought was the right thing, and it sort of happened to work out. But as I look back, I think. There's a few key characteristics. One, I think, is you have to be able to listen to people, and not only listen, but you have to hear. So listen to what they say. Sometimes their words aren't exactly what they mean. So you have to be able to read the room and understand what a question really means, and then you have to answer it and be clear in your answer, depending on the audience, use the right kind of terminology. So for example, in a trustee meeting, where you might have a lot of people who don't have an investment background, speak in very plain English so that people can understand what you're recommending that they do equally. If you're speaking to a much more technical audience, for example, internal team, then you tailor the way you speak to answer the questions and have the discussions. So listening and hearing and communicating, fundamentally, I think, is really, really important. The next thing I think you need to be really good at is collaboration, because as an investment consultant, asset consultant, you're giving advice, and a client may or may not take that advice, so you have to be willing to work with them to get a good solution that works for them. And sometimes you might go in with the best of intentions, the best advice you can possibly develop, but a client might say that doesn't work for me for these reasons, and so you have to always collaborate and move and shift and evolve your advice to make sure that you can continue to influence the clients. I think also, there are some fundamental skills around you know, the technical skills you really need to have, and they have changed over the years. So, for example, when I first started, I think we still use lotus, 123, but I'm not actually sure, because we didn't use it very much. And then we graduated to excel, and when we were interviewing people, when, for example, about 15 or so years ago, we'd interview people, and we used to do these tests in Excel, and they would have to do a VLOOKUP and those sorts of things. Whereas the technical skills nowadays, not only in the use of various pieces of software, but also the financial technical skills, are much, much stronger, and we see the young people coming through. They've clearly exceptionally skilled. And for people like me who don't necessarily have all of those technical skills, it's about other experience and skills you can bring So, experience with clients, time in the markets, I think that makes quite a big difference. And I look back now over, you know, nearly 28 years of of being in the markets and seeing things, and I think having that perspective is also something that's quite valuable. So you

Wouter Klijn 07:23

show that have there have been some changes within the essence consulted industry, and I think some of those shifts have been quite big. As the pension funds become larger and become more almost financial services companies. How does that affect the role?

Fiona Trafford-Walker 07:42

It's had a very profound influence. And if I think back over the various phases, so the first phase, when I first started, you would be the expert in the room. You would take your papers, the clients would thank you. They would pretty much do everything you said, and you would go away again, and then you would come back to the next meeting. And as those businesses became more sophisticated, they employed their own people. The work shifted. So some stuff that we used to do, they then took on. And at first it was some of the more straightforward things, for example, processing applications and letters and those sorts of things. But increasingly, you've seen a lot of skill developing in those internal teams. And so the role of the consultant now is very much to work alongside those teams in what I think is a very complimentary manner. Because if you think about it, and the way that I think about this, and I know that I'm absolutely biassed in thinking this is that I think there's always value in an external perspective. But clearly I'm biassed because that's what I've done for 25 odd years. But I look and think if you want to really kick something around, you know, getting people who are working for you, inside your organisation also working for you, but from the outside, you're all still working for the same reason, the same purpose. So I think working alongside those internal teams has meant, though, that the level of skill, the level of experience, the specialisation, has really had to change in asset consulting businesses. So your business model has gone from one which was probably a more typical pyramid, where you've got a few senior people and many more junior people, to being like an inverted pyramid where we've got many, many more senior people now who all can have a counterpart type relationship with the other people in the funds. And sometimes I go to some of those meetings, and they are talking at a level that is really, really deep. These are highly specialised people, and that's one of the most profound changes. I think.

Wouter Klijn 09:35

So does that focus in the discussion then also shift to a more strategic type of discussion where you talk more at a high level about decision making, rather than the implementation.

Fiona Trafford-Walker 09:45

Yeah, it varies. So some of those discussions, if it's specialist to specialist, they go so deep that I can't follow them, particularly on some of the newer areas, and that works for them. And that might be about a technical. Matter. It could be about implementation operations. It could also be strategic, if you sit alongside that. Though, when I think about strategy for the funds, I think that there are a group of people who can step back from that specialisation and bring what I call a truly generalist perspective. And it used to be, everybody was a generalist, and then everyone said, Oh, you've got to be a specialist to be successful, whereas now I think you can be successful and be either, or, some lucky people are actually both. That's pretty unusual, though. So people who can sit at the really the CIO type level, to sit back from the portfolio, to think about how the whole thing fits together, that's where a lot of the strategic discussions still occur. And those skills are not as common in the industry as they were perhaps, perhaps 10 years ago, as people have changed and people have left, but there's still that need, I think, to have the blend of of the generalist and the specialist, so you can have all kinds of conversations about how you make money for your investors, how you protect their returns, or, you know, whatever your goals are.

Wouter Klijn 11:01

Yeah. Now a number of years, I did an interview with Damian Maloney, who was then the CEO of Frontier Advisors, and he sketched a vision where, or a vision a future where he thought assets consultants will no longer have this exclusive role with one particular fund, it's more likely that it becomes like law firms, where there's a panel of different asset consultants and they specialise in different things. How far along are we in that? Do you think

Fiona Trafford-Walker 11:28

We haven't got in our client base many of those kinds of relationships we tend to rather than working in a panel? And it might be because there aren't that many consultants you can actually put into a panel, we tend to work with the internal teams who might then go and get specialist advice from someone for a particular reason. So for example, if they're doing an infrastructure deal, they might go and work with a traffic consultant or an airport consultant, something like that. But the concept of a panel where you have panellists who might be doing similar things. We haven't quite gotten to that, but I think broadly, there is a sense of a panel where the internal teams that are very active internally and, you know, and that's not the majority. At the moment, there's still lots of funds that are, you know, run very, very leanly with a lot of outsourcing, but those internal teams, I think, are increasingly surrounding themselves with expertise as they need it. And then, of course, the trustee surrounds itself with expertise as it needs it. So we have relationships with internal teams and also with boards and investment committees. So you're seeing a little bit of the panel approach in that sense, but not where you kind of line up and you go and get one report from one another report from another. It seems to be much more targeted.

Wouter Klijn 12:41

Sometimes, asset consultants are seen as gatekeepers, probably especially by the fund managers want to get on the approved list. When you look at the dimension of the time spent on manager selection and, for instance, asset allocation, keeping in mind sort of the research that's done on the impact of asset allocation. Do you think there's a right balance there, and to what degree, if you do focus a lot on asset allocation, can you be dynamic in that?

Fiona Trafford-Walker 13:10

Yeah, look, I've never thought that there was the right balance we you know, one of the very first papers that I did was really to try to replicate some work done in the States, about, you know, where do returns come from, and particularly where does the volatility of returns come from? And there was some early work done which showed that particularly the volatility of returns came from the asset allocation, and within that thinking about your strategic allocation, because that was the nature of that paper back then. This is what this is, 25 years ago that has evolved to being around strategic and dynamic asset allocations. That said, the role of active money management in that can still be really value additive. You know, it can be the cream in the coffee, so to speak. And so anything that helps you get you where you need to go is worth looking at. So for me, it's about the balance of time. And I think that over the years, you know, we would always have been better to have spent more time on asset allocation, like, what's going on the world? How do you position your portfolios? And for some reason, it was just never really seen by the industry as something where you should spend a lot of consulting dollars or internal dollars. I think that's changed now with some of the numbers are coming out, and you can see the difference in performance. That said, my personal perspective is there should always be room in your portfolio for good money managers who can make money over time for their clients. And I think that the time on manager research to find those firms is well spent, but probably we, collectively as an industry, spend too much time trying to find out who those firms are when. If we could deploy some of those resources into working out what's going on in the world and how to set your asset allocation, and I think dynamic is a really, really important dimension, then that probably would be better over time.

Wouter Klijn 14:57

So what should inspire some of these. Changes on the dynamic asset allocation. And I think particularly about we did a poll recently amongst investors and asked them what the top risks are from whether you're going to make your return or your liabilities. And the number one concern was geopolitics. And I can sort of understand from there could be a tail risk potential event. But then, when we asked if anybody made any changes based on geopolitical events, there were very few that actually did. How do you incorporate it and what should inspire changes in an asset allocation?

Fiona Trafford-Walker 15:35

Geopolitical risk, I think is really hard. I mean, I feel quite lucky. I work with some terrific people, and particularly the director of investment strategy, Chris Trevilian. He runs our Capital Markets team, and they think a lot about some of these tail risks, not only some of the structural changes in markets and in economies and in the world. So for example, things like demographics and climate change and others. Then you do have things like geopolitical risk. You've got quantitative easing and these sort of weird things that create enormous amounts of noise, and they do change the way that market and market participants respond to things. So we look at geopolitical risk and we think, well, we can't do much to manage that like it exists. We have to think about, how do you defend against it? Diversification is a good way of defending against it. But if you're trying to predict what politicians are going to do next, it's pretty hard. But then sometimes those risks creep into what I've loosely called real things, like the trade wars, for example, now that that is a real thing having a real impact on markets and on economies and on exchange rates and and and on people who are fundamentally affected by what happens in, you know, their own businesses. You know, small businesses in rural USA, for example, and businesses in China, and increasingly, businesses here. So we try to put the things we can understand but not control into one area so the least we know what's going on, and then we try to work out how might that squeeze out and affect the advice we give clients. And geopolitical risk has featured in a lot of the quarterly market outlooks that we do, but we try not to set portfolios based on things like that. But you have to have an eye on it these days. It's a brave new world, I think.

Wouter Klijn

Yeah, that said there's an argument that, you know, fundamentals should come to the fore at some point, like at some point, but it's been a bit of a long time now.

Fiona Trafford-Walker

So, you know, the rubber bands getting longer and longer, but we are in very unusual circumstances, and I've spoken a lot with investors about the absence of value working in the markets for at least the last 10 years, and there's a number of changes within the market that could make the argument that this is a more structural development. One is, of course, the capital life model of technology companies. There seems to be also more stricter regulations on how much management of a company can tell a fund manager without having to disclose it to the rest of the world. So there seems to be a number of elements that are not really in favour of active management.

Wouter Klijn

Are you concerned that this is a structural issue, or do you think this is mainly still a tale from QE and cheap money.

Fiona Trafford-Walker 18:21

I think it's probably the latter for the most part. But I do think that, you know, there are some structural changes going through markets, and I think technology is one of them, and understanding the impact that that will have on, for example, people who work in organisations and the work that they do, and how that might be displaced and what happens with them. So I do think there are some fundamental changes coming through, really, on the more of the social side, and that will change the way that companies operate, the way companies think, and also, I think the what asset owners and shareholders think and expect. So we did quite a big paper a couple of months ago just looking at active management, because the last 12 months was really, really terrible, and I think the worst year in the last 20 so it's really easy to look at that and go, Well, it's broken. But I think again, if you look through the fundamentals and think good active managers, if they're doing good research by good companies at decent prices, then the value style over time, to me, still is something that has a lot of merit, but, you know, maybe there's an openness to something like, you know, a new value style that does allow for some of these structural changes. And I think that technology, and, you know, machine learning, robotics, AI, those sorts of things are complicated, and they will change business models. And I think being open to that is probably the best defence.

Wouter Klijn 19:43

So there might be some changes within the investment process, within value. To what degree can you adjust that process? And at what point do you say, wait a minute, you got style drift going on here?

Fiona Trafford-Walker 19:57

Yes, the old style drift used to be something that fund managers were hung, drawn and quartered for. I don't hear people talk about style drift that much anymore, to be honest with you. I mean, maybe someone like Fraser Murray, who runs our equity research might hear that more than me, but certainly when I used to do manager research, that was something we were very vigilant to look out for, mainly because when you're putting together portfolios for clients, you have managers playing certain roles. And so if one manager you think is going to do something, but they creep to do something else, it does cause you problems with your overall portfolio, because you end up with too much of something you might not have wanted. That said, I think that it's always healthy for any firm, not only a money manager, but even our consultant as well, to say, well, is the way we do things still sensible? And so if you are going to have any kind of drift in your business, and we are drifting now, maybe called pivoting, I don't know, which is a very cool thing to do, you talk about it and go and engage with your customers and clients and say, look, we've been doing things this way for such a long time, but we think the world has changed, and we're going to evolve to do something different. And I look at the business model at Frontier, for example, and the work that was done, you know, when Damian was a CEO, which is going back to 2011 around technology, we were always way behind on technology. And He came in and sort of had a look again, the value of an external perspective coming in and saying, we need to really wrap that up. And would have been easy for us to say, well, we're a consulting firm. You know, technology is not our thing, but in fact, that's been incredibly empowering for us. But you've got to take your staff and your clients on that journey so it becomes something you can do together. And I think it's the same philosophy about money management and styles.

Wouter Klijn 21:45

Yeah, the technology platform, in a way, was quite a brave step, because I remember that when it was introduced into the market, and the idea that clients could log in and see research there, that they thought, well, if they see it on that system, then it's very easy to print it out and it gets all spread around and lose IP and but I think at the moment, it's actually turned out to work quite well. What do you think made it work?

Fiona Trafford-Walker 22:13

Oh, look, you're absolutely right. When we first talked about doing it. And, you know, back back then, the way that we used to think about consulting, and I think all the other firms would have been the same, is that you that you, you had your processes and people and everything, you developed your IP, and you protected that very zealously, and that's what you sold. You sold time, and you sold IP, and that's all you had to sell. So when Damian came in and said, you know, we should actually put this on its head, we were like, wow, we're going to be kind of giving IP away. Is that? How's that going to work? I think the philosophy that we had was that if we shared it, we would back ourselves to continually develop fresh IP and fresh ideas, and that people, in seeing how open and transparent we were, would say, well, these are good people. They do good work. I want to work with those people. So the sharing of IP was something that was that Damian drove back then in a very different way to the way that we used to collaborate and share the IP. It was one of the hardest transformations in the business, though, for a few reasons. One is we did actually have a database, which we affectionately called the prober, because we would be out there probing managers for for information about their processes. And the prober was just a an Access database. It was a very internal database. It was full of typos, grammatical area errors, inappropriate things that should never have been written. Thank you. Mike fish, and so we we decided we needed to go back at least three years to build something that people could see what they were going to buy. So we printed off all the notes for the last three years, and a number of us then went through and actually edited every note. It nearly killed us. It was just it was very difficult, but we ended up with something that has, I think, become, if I do say so myself, I think it's become the standard in the market for you know how you communicate with clients, how open you are, how how you can prove the value that you add. And I think that then led to being not only an internal system, but an external system on manager research, but now increasingly on capital markets research. So all the asset allocation we do is all done through the system, and that system is being enhanced all the time. So it was a very big transformation, and it was not easy, and it really took probably about five years from when we started to getting to the end and saying, I think this actually works pretty well now, but it was a very significant change and and it's been very, very positive, yeah, and it's enabled us to get efficiencies which we would never have been able to get before. So the concept of productivity actually is now quite a valuable one inside, inside frontier, whereas before, we just could never work out how to be much more productive, other than getting other people to do the work. Now we have this major tools.

Wouter Klijn 25:01

It's very important. So in a way, it motivates people to constantly look for new ideas and new research and produce that

Fiona Trafford-Walker 25:09

Yes, yes. And if I think back to one of your early questions about what makes a good consultant less so individually, but as a as a firm, you know you have to think of new ideas for your clients, and you don't need new ideas all day every day. You really need a couple of really great ones each year, maybe even one a year. I'm not even sure the number, but if you know you have a process that develops IP good ideas for clients, then the clients will look at you and say, Yes, I want to deal with those people because they're smart. They'll help me do my job better. So I think that that has enabled us to think in different dimensions about development of IP and ideas.

Wouter Klijn 25:47

You've also been quite active in the whole debate around fees and been driving funds to look at those arrangements. Can you tell us a little bit about how you think where we ended up is the right space? Because partly, there has also been a large unexpected impact from regulations with the introduction of my super.

Fiona Trafford-Walker 26:06

Well, not only my super but things like RG 97 and other things. So if I think back and it's 10 years since I wrote that first paper, and 10 years since Ken marshman, who was my counterpart at Jana at the time, and I sat down and had discussions about this as an industry issue, and the perspective we always took that did get a little bit lost at times, was it was always about net returns. It was just, what did you pay to get those returns? And was there a fair and transparent sharing of the, you know, the economics? So we developed six principles, which were very much around fairness, transparency, the right to commercially negotiate, all those sorts of things. And I think, though, as I look back, and I'm actually very close to finishing a paper that sort of updates on where we are 10 years on, I think on some measures, it's been very successful. It's made people think about just how much they pay for what they get, and is it worth it, and some things are worth paying for. You know, there are some terrific firms out there that do great work. It's research intensive. They deliver for their clients, and yes, you should definitely pay for that. But there are others where you sort of think, well, does that really a good sharing? And I think it's enabled a lot more discerning, I think, between firms that are worth paying for and those that possibly need to just sharpen their Proposition A little bit more or think about the products that they offer. So I think that's helped the biggest shift, though, I think that has caused real change in the funds management community is the internalisation by the asset owners, and that had sort of been flagged by a few some, in fact, some did manage money internally back then, but it wasn't a very public thing, and it's been increasingly flagged by some of these very large asset owners. And I think that as that became a lot more prevalent, I think the funds managed community look, looked and thought, well, the money is going to flow from us to them, and that's exactly what you've seen. And so that, I think, has made people sort of sharpen their thinking about, not only about their products, but about, you know, the economics, the prices they offer. But it's pretty hard to compete, in some cases, because the internal model is a relatively cheap model. I think what I would like to see in the next five years is full transparency from the asset owners who do manage money internally, just to be clear, that they're the same standard is being applied around the search for excellence. You know, by whether you're in an inside an asset owner business or you're outside, in many ways, what you're really doing is transferring risk from outside to inside. So you just want to be clear that that turned out to be a good thing.

Wouter Klijn 28:44

Do you think that there are any concerns over whether the standard might slip? You could also, because that's a discussion that's often had where you say, well, it's very hard to fire the internal team because your colleagues work with them and they have influence. But you could also think about it. Well, the industry has for a long time been focused on very short term results, and maybe this will enable to put some strategies in place that are much longer term, that look more at buy and hold type of strategies, and potentially drive also some change there.

Fiona Trafford-Walker 29:18

Yeah. Look, I really hope so. I think that you know the certainly institutional investors like super funds and other long term investors, that the one major advantage they have is time. And if you have time on your side, then that's an incredible opportunity you can exploit. And a big way to exploit time is to be a truly long term investor and to ride the cycles of business out. If you've got a company going through a tough time, understand it, but don't bail because your tracking error has gone up, or you've got a report to provide to a trustee, or something like that. And so in many ways, it's not completely fair, because, you know, that's not necessarily the way that an external money manager gets treated somewhere. I think it depends on how well they sell their story, but for the most part, the focus on the shorter term numbers, I think, has not been a positive thing here. I do think with internal money management, that it's a great opportunity to enable true long term investment to occur. And I used to call them bottom drawer mandates. And my idea, like in the mid 2000s was you would just go and buy chunks of businesses and literally stick them in the bottom drawer, good quality businesses just doing their job, performing well, clearly, if there's some kind of event, yes, you need to get it out of your bottom drawer and have a look at it. But otherwise, it seemed to me that the ability to provide capital for such long periods would be very positive, not only for capital markets, but for the community, society. For business, this flow on effects are quite significant. If businesses know they can truly invest for the long term, then it's just a win win for everybody. So hopefully we'll see that. I think increasingly we are seeing in the processes being developed by the asset owners, that definitely is something they're capturing. So that's really positive.

Wouter Klijn 31:04

So with the internal teams investing, they're closer to the market as well. And one of the things that is interesting, I think, there, is that they become much more aware of their responsibility as an owner of these assets, and engage more with the companies. To what degree do you think that that's desirable? Should they engage and try to get better outcomes in as far as they can? Or should I just leave companies to do that?

Fiona Trafford-Walker 31:32

Well, for me, it's about responsible ownership, and I think, I mean, I see these things from two perspectives now, because I'm actually on two company boards, and I'm also on the board of another investment organisation, and so I see a perspective I didn't have before, which has been really, really valuable. I think companies need to be allowed to just get on with the running of their businesses, just in the same way. Our Super Fund is a company, and should be allowed to do the same thing, but at the same time, they need to be accountable for what they do. Need to be transparent and to move with the times. So, for example, the shareholders are saying, What are you doing on climate change? Well, answer that question. Be clear about it. Commit to being responsive if if they have questions about, How do you treat your workforce? Well, answer those questions. And I think there's a bridge to be made between the asset owners and corporate Australia. I think it's they still have to work at how to kind of operate with each other. That said, I don't think that you want the shareholders kind of sticking their noses in too much, and vice versa. We have to learn to coexist. I think,

Wouter Klijn 32:47

Yeah, I think it's interesting, because in the recent years, we have seen more emphasis on governance, and sometimes it can be a bit vague in what exactly people mean by that, but at the same time, there's some real consequences to ignoring that part. So this morning, we just had news come out that some of the pharma companies are now being held accountable for the opioids in the US, and I think Johnson and Johnson has to pay more than 500 million and but there's another company, and that has apparently offered a 12 billion settlement to settle all of the cases that are against it, that's that's obviously having a real life impact on these companies. How do you look how that has developed over the course of your career? Is that really true, that there is more emphasis on it, and is there a clear way of doing this?

Fiona Trafford-Walker 33:40

Yeah, oh, there's definitely more emphasis on it. I think, I think, like when I first started, the fund managers couldn't, you know, had the relationships with companies, and they decided how they would vote and and that was something that was highly delegated. But as the the asset owners got bigger and bigger, and they realised, well, we're the beneficial owners of these shares, we ought to decide some of these things or be part of that conversation. So they started voting their proxies, but that typically was around things like remuneration, or a director standing, or something like that. Then the next wave, though, has been, I think as responsible investment has become, really quite a powerful movement, I think, for one of a better word, where they're saying, hang on a minute. There's a lot more going on in companies, and we own large chunks of them. And you know, for example, many have signed up to the United Nations Sustainable Development Goals, the United Nations sponsored principles, responsible investment. And that means you have to do something. You have to ask questions, put your money where your mouth is, literally. So we are seeing significant change, I think now, particularly by the big asset owners, to think about where they put their capital, what businesses are they supporting? We have a number of clients who think a lot about the just transition in a climate change context, because. Because clearly many of them have members and employers who might be affected by that so thinking, Well, how do they participate in that process? So might not be something that happens quickly, but something over time, and how can they help them make that transition as effectively as possible? So that is much more powerful today, and I think that's entirely appropriate when you are the trustee of multiple billions of dollars of other people's money, you have to think about, you know, how you how you invest it, where you put it, what you expect companies to do with it,

Wouter Klijn 35:32

Yeah, in the local context, we've seen a lot of emphasis being on cutting out tobacco companies from portfolios. And it seems that the next discussion is focusing more on a low carbon environment or portfolio. To what degree do you think that these types of actions align with the fiduciary responsibility as well? Because yes, there's obviously great risks attached to it, but there's also a point where you say, Okay, you can't just keep cutting out chunks of portfolio. How do you deal with that?

Fiona Trafford-Walker 36:05

I find that one really tricky. So I, I would always rather engage to help improve something. But there are some businesses. So for example, tobacco is one is they're always going to make cigarettes or vaping or whatever, and other things called so they're not going to fundamentally change their business model. You have to decide, do you want that in your portfolio or not? And some of those things, for me, anyway, get into kind of an ethical debate about whether that's good or bad. Some of it, though, is more tangible. So for example, you know you can point to, you know, things like lawsuits and, you know, future lawsuits. And so it can become quite a real thing. So it goes from being ethical to being actually something much more financial. Tobacco, I think, is in that category. But most, most businesses, it's not that straightforward. It's so for example, AGL is one I think, that got a bit of press a couple of years ago, where the easiest solution would be to say, well, we don't like what you're doing with coal, so we're just going to divest. Whereas a better solution was, which actually, I think, is what occurred, is to say, how are you going to transition? And they committed to a transition plan. And so, you know, you've made an impact there by saying, all right, you know, how do we help this company transition over some reasonable period so that we get where we want to go, and we've influenced the business. To me, that's a good use of that, of that power, and that, you know, the votes. But I think it's from a governance point of view. It used to be, it had to be, you know, members best interest, and a very fiduciary duty. And I think that has morphed a lot. So the concept of fiduciary duty, I think the lawyers would say it's still the same, but there's now community expectations, and there's a bigger overlay on that now that I think has made some of those decisions a bit easier than they might have been, but I'd always rather engage if you can, some companies don't want to engage, or if they do, they decide they just don't want to listen, in, which case you just invest somewhere else. There's plenty of companies, companies companies to invest in.

Wouter Klijn 38:03

Another problem, or more of a challenge that industry is facing today is the development of retirement products. Now, apart from sort of the product issue that there is investment challenges as well to it, why do you think it has been so hard to come to a solution to this? I mean, people have been retiring, right?

Fiona Trafford-Walker 38:22

Yes, yes. I think what I put it down to is we all got so excited building what I think is fundamentally a really, really terrific accumulation system. I mean, I think it's easy to beat ourselves up, and you could always do things better. That's definitely true. But fundamentally, the system we have here is really, really good. It's sort of one of the top three or four in the world, as assessed independently, many, many more people today retire with much more money and therefore dignity in retirement than they would otherwise have had. The coverage is much better in terms of the workforce and in terms of women. So I think we kind of got a bit excited building that that we sort of thought, well, we could just take those concepts and apply them in retirement. So, you know, the easy solution was, well, the money was small, so we'll just do a different tax assumption, and we'll put some products that work. And I think we always knew, or the industry always knew, that that was just a bit of a band aid solution. And though, as people think about it, I think the real challenge, though, is in retirement, you need to have much more fun consideration of your individual financial circumstances. In accumulation, you don't necessarily need that. You need to know a small number of things about someone. They choose the right option, they build their pool. But in retirement, you need to know, for example, any other money? Do they own their home or not? Are they in a relationship or not? All those sorts of things. And most people don't go and get financial advice. And so how do you help them in retirement? Build something that I think is the industry calls sort of mass customization. I think that's really hard. That said there. A lot of really smart minds working on this. Now, the money in the funds in retirement phase is growing rapidly, so the Critical Mass is is being developed. And so I think it will not be too long before we see some really, really good products coming out. But yes, I think you're right. It's definitely underdone.

Wouter Klijn 40:19

It's an interesting sort of issue, because we had the my super legislation come in, and so there's now this sort of legal definition of what a default option should look like. And I think sort of that concept was taken then, oh, let's do that for retirement. But you can't necessarily do that because of the vastly different circumstances that people are in. Do you think that one solution should be more that it's based on a concept or a platform that has then multiple different solutions hanging under it, or is it possible to have a my pension default?

Fiona Trafford-Walker 40:53

Well, look, I think also all those things are possible. I do think that to build some kind of platform, you do need quite a lot of collaboration to get critical mass across some of the funds, to make sure you can do things like pooling for longevity and all those sorts of things. And I think at the moment, the willingness to work collectively and to pull money doesn't necessarily seem to be there. I think the lot of the funds are trying to really do their own thing. So I think there's an opportunity to do something along those lines. I think possibly it's technically a lot more complicated than then it might first appear You're right. You should be able to have, well, we have my Super Why can't we have my pension? And I think it's probably quite technically difficult compared to an accumulation phase. Then again, as I said, so many smart people in the industry are trying to work out how to continue to look after members. I think we've looked after members really well until the point that they retire, and it's that next phase when, arguably, they actually need You more. You know, I think, because that's a can be a tricky time for a lot of people. And as they retire, then, as they age, thinking about, how do they get health care advice? How do they get aged care advice? It's this, we don't necessarily look after people at that point very well at all. I think so.

Wouter Klijn 42:10

Fiona, what's next in store for you? I think you recently have relinquished the role of director of consulting and taken on a few board positions as well. What can we see from you in the future?

Fiona Trafford-Walker 42:25

Yes, you're right. I am. My role has changed. And so I handed all of the consulting responsibilities and practice responsibilities over to Kim by water in 2017 and as I mentioned earlier, Chris took on investment strategy and and other people took on other things. And so I've been really excited to see how well they've done and how, you know, they've made their own mark, and they've thought about what the company should look like and what those roles should look like, and I think they've all done a terrific job. And so my role has moved to be more strategic. And when I can't do it on this, on this, because I'm not on a video, but whenever I say strategic, I do the bunny ears, because no one exactly knows what strategic means, but it's turned out to be things like working with clients on governance issues or investment issues or behavioural finance issues. It's helping them think about what their internal team should look like, what their delegation model should look like. I don't do a lot of can. I don't do much Consulting at all anymore. On the client front, I mentor some of the staff inside frontier, which has been great. You know, they're a fabulous bunch of people. And I'm on the investment committee, so I think more of that kind of thing is, is really interesting, and I really enjoying that corporate work as well. So that sort of you know that balance would be good, but I'm one thing I have learned over the last 25 years, it just doesn't pay to plan too much. And people often say to me, or did you? Did you plan this? And I'm like, No, I didn't plan any of it. But as opportunities come to you, be open to them. And as I say to people, you just got to be yourself and back yourself and have a go and you know, so I'm open minded to things, and I'll just see what happens.

Wouter Klijn 44:07

So you mentioned the mentoring element. Are there any specific things that you see in this new cohort of asset consultants that stand out?

Fiona Trafford-Walker 44:18

The biggest thing that I talk to the people that I mentor about is it's their own confidence. And I'm not sure if this is necessarily the people that come into the asset consulting business or whether it's just the people that you know that we attract at Frontier or not, but a lot of the younger people, I look at their CVs and their skills, and they're so, so incredibly capable, but they're also just a little bit uncertain a lot of the time. So I spend a lot of the time talking to them about how to get their capability and their confidence in line with each other. And a lot of that is just helping them think about, you know, as you do things, think, okay, yeah, I did that, and I might not have been able to do that. I. Month ago, and now it's all fine, and you sort of build this on this bedrock of capability and confidence. So that is something that I work with them on. I think that technical skills are exceptionally strong, and I think the key though will be to take those technical skills and turn them into consulting skills, because consulting is a funny thing. It's, you know, it takes time. Some people are naturally good at it. Some people it's not their thing. And in firms like frontier, now there's lots of opportunity to do lots of different things, so you can focus on consulting and research and other things. But it's you turning that capability, the technical capability, into something that you can go to a client and the client goes, Yeah, I want to hear what you have to say, because you're really smart and you've really thought about this, from my point of view. But I think they are very purpose driven. I know that that's a stereotype of, you know, the Generation Z and the millennials, but they are very purpose driven. That's it. I think a lot of people at Frontier repurpose driven as well, so we sort of blend together well, I think. But they get terrific bunch of people, and it's, it's, I really enjoy working with them, and I really enjoy learning from them as well. Because sometimes, as a mentor, it's easy to sit there and, you know, tell people I did this and I did that, but that's not that helpful. I like to hear what what they're doing, what they're worried about, what are they thinking? What's their experience, actually? And, you know, it's big difference. Sometimes the age difference is 25 years. So their world is very different to my world. Yeah.

Wouter Klijn 46:35

So next generation is ready to take on the challenges.

Fiona Trafford-Walker 46:39

Absolutely, I think they are ready, they're capable, they're willing, and I think, you know, they're excited by the opportunity, but the firm in the next 25 years will look very, very different. I think, you know, changing, evolving, continually evolving, is really, really important, and that flexibility and resilience will be important skills. And I see lots of evidence of that,

Wouter Klijn 47:01

Well, Fiona, it was great having you on the show.

Fiona Trafford-Walker 47:04

My pleasure. Thank you.