Transcript of interview with Dr Raphael Arndt, Chief Investment Officer, and Alan Kohler, The Constant Investor

Alan Kohler here and I’m delighted to be talking to Raphael Arndt, who’s the Chief Investment Officer of The Future Fund.  They’ve been pretty good investors over the years, their 10 year return is 8.5% which well and truly exceeds the index and also their own benchmark at 6.7% and very interestingly they’ve reduced their exposure to Australian equities.  That’s where I start the interview – it’s a long, in-depth interview, well worth listening to or reading all of it, but we start with an explanation of why they’ve reduced over the past five years, reduced their exposure to Australian equities almost by half from nearly 12% to just above 6%.  Here’s Raphael Arndt, the Chief Investment Officer of The Future Fund.

Raph, I’ve been comparing your asset allocations now in your latest portfolio update with five years ago, a couple of things kind of jump out at me.  First, obviously, is the change in allocation to Australian equities from 11.6% March 2013 to 6.3% now and against that there’s a big increase in the private equity allocation.  Could you explain what’s the thinking behind the cut, the reason behind the drop in the allocation over the past five years to Australian equities?  

Sure.  I think the first point to make really is that we don’t build a portfolio looking at any sector in isolation, we look at the whole portfolio.  When we think about an exposure to Australian equities, we’re also thinking about our exposure to equities in general and the relative attractiveness of equities globally in different geographies.  Then separately we’re also thinking about the equity-like risk that we have in the portfolio and because we’re a long term investor we’re not too worried about shorter term market fluctuations at all and so the sort of things that make equities perform well: economic growth, liquidity and leverage availability, just the desire for asset, the risk premium that investors demand to invest in risky assets, those sort of things also drive the performance of things like infrastructure and property and private equity. 

In the last few years few years in general, what we’ve seen is that as the very low monetary policy rates across the world have started to take effect, the quantitative easing programs have worked.  They have been successful in pushing capital into riskier assets.  You might think of that as a yield compression type effect and relative to some of the more illiquid asset classes and certainly the ones that are more skill based, so the ones where you have to build a business or create value somehow through action as opposed to just buying a core asset or a bond and holding it.  Those assets in general have looked more attractive to us on a risk adjusted basis and so we have been reducing the equities exposure in general.

Then there have been some concerns during that period a few years ago particularly about the Eurozone.  If you remember a few years ago, there was some concerns about, I guess, the stability of the Eurozone until the ECB changed its program and also about Greece and what was going to happen there.  We thought that those risks weren’t necessarily adequately priced in by the market.  That led us to reduce equity risk exposure in the portfolio generally and so part of the reduction for Australia just came from a reduction in those types of exposures in general.  But what’s happened since then more recently is that if we go to the big picture themes we see in the world, we’ve got a big deleveraging cycle. 

We think that needs to happen because the amount of debt in the world has actually increased since the financial crisis, not reduced, albeit a lot’s gone onto governments and we’re only at the very, very early stages of that.  But here in Australia that hasn’t occurred at all, in fact households here are much more levered now than they were at the beginning of the financial crisis.  We’ve got factors in the world that are leading to us to expect lower economic growth going forward.  One is that deleveraging, a second one would be a reduction in the pace of population growth just through demographics. 

As countries tend to become more affluent they tend to have fewer kids and we’ve got a lot of the developed world now with slowing or even declining populations and that effect is starting to happen in China as well.  That just leads to a lower potential economic growth in the future and that’s not good for equity prices or other risky asset prices.  Then we’ve got the effect of the monetary policy which has really helped out your listeners, the people who own assets because asset returns have done incredibly well in that period because of this yield compression effect.  Those who have to work for a living, real wages, as we know haven’t really gone very far and in Australia they’ve actually been slightly better than other places.  Nevertheless, that’s led to this rise of populous politics.

It’s interesting, your allocation to equities overall hasn’t gone down that much, it’s gone down over the five years from 35.3% to 33.3%.  Your allocation actually to global equities developed in emerging markets has gone up.  The big kind of cut back in equities exposure that you’re talking about has actually been entirely focused on Australia.  I mean, I understand what you’re saying about Europe, but actually your developed markets exposure has increased.  I’m just wondering, is there something particularly about Australia that you don’t like?

Well, this populism that I was talking about, that impacts trade and Australia’s a very trade exposed economy and so if there are trade disputes between China and the US for example, although that’s more recent, then that’s going to impact Australia one way or another.  But I guess just continuing in effect, yes, the debt levels haven’t come down as much as other parts of the world.  The economy’s being resilient and I think to the credit of the policy makers and the breadth of the economy, different parts of the economy have stepped up since the roll off of the mining boom, but a lot of that is fuelled by the property market which in turn is fuelled by leverage.

Our banks which fund our economy are exposed to offshore funding sources and so the reduction in liquidity that we expect from the reduction in QE is feeling that too.  I think there were a few reasons why we think there are headwinds for Australia right now compared to some of the rest of the world.  Not to be too pessimistic but we’ve got rising growth in the US.  The real drivers of performance in the US and to some extent in China and emerging markets have been internet and tech companies or growth companies anyway and Australia doesn’t tend to have a lot of those in the equity index.  It’s dominated by banks.  Banks tend to not do so well in rising interest rate environments. 

We haven’t seen that yet in Australia but we’re certainly starting to see it in other parts of the world.  We would consider the change is a relatively small adjustment at the total portfolio level.  But it’s those sorts of things combined with valuations as well, so where are valuations?  And I think as we’ve seen in the last few years the Australian market has underperformed the rest of the market quite considerably.

Can you give us any detail on the allocations or your investments within the Australian market, within that 6.3% allocation?  Is it broadly like the index or have you got any specific kind of likes and dislikes?

Our investment model is that we invest through managers, so we don’t pick stocks internally.  We develop strategies but we don’t pick stocks.  And so, in terms of equities in general, we wouldn’t think of Australian equities separate to global equities.  It’s just an allocation within it and because we’re Australian and because we, like most Australians, get the benefit of franking credits and we don’t have to hedge the currency, it’s relatively more attractive to us than other exposures in other parts of the world, all things being equal. 

The exposure here for a large investor, even at a 9% allocation we’re well over a half a per cent of the market cap and so we do have to be concerned about the liquidity of the index and the concentration of the index, which means that we develop concentration issues.  I think you could assume that by and large the exposure is an index based exposure.

How do you go about choosing fund managers?

In equities in general, we have a combination of both active and passive managers and we have had both active and passive approaches in Australia in the past and we do a lot of data and analytics internally and one of the things we look at particularly on historic performance is what value are the fund managers adding relative to the index, firstly, to the market cap index?  But then secondly, are they just applying a particular style approach?  For example, value or quality bias.  Because these days using a factor based approach or some people call it smart beta – you can buy that extremely cheaply.

And so when we did that and we looked at the performance of the active fund manager universe in general, it’s really tough in Australia.  Because of the concentration of the index, these mainly just tend to be forced into making calls about the path of interest rates because that will dictate the relative value of the banks against the rest of the index and the path of commodity prices for the mining companies.  As a rule, we’re just not very good at predicting those things. 

In the last little what you’ll see because we publish our managers on our website, is that in Australia we no longer have any active equities managers.  We invest passively into the index at the moment although some of that is a modified approach because we want to take into account things like buybacks and franking credits and other things like that.  But we continue to actively research the market and as and when we see opportunities, whether they’re active or passive, if they stack up we would be happy to do them.

To be clear about it, you’re saying that your entire Australian equity investment portfolio is passive now?

It depends how you define passive but it doesn’t have an individual picking stock, that’s correct.

Wow, that’s amazing!  I had no idea.  Goodness…  And presumably you’ve got active stock globally have you?

We do, and I would just make the point that a lot of those mandates are not constrained globally so they’re free to pick stocks in Australia, long or short, some of them if they wish to, but we’re not directing them to. 

And do they?

I imagine they do from time to time, but with $145b portfolio I don’t look at every individual stock position.

Do you have any minimum investment or minimum allocation to Australian equities or Australian investments generally that come down from the board?

No.  As I said before, we look at the portfolio as a whole.  Our job is to deliver to an absolute return mandate and that’s built off Australian inflation.  We’re, for sure, predisposed to like Australian investments and we don’t have to hedge the currency, as I’ve said, but also the mandates, the Australian inflation.  The Australian financial markets and economy are pretty small in the scheme of the world and so to get a good level of diversification and also to place some of the strong themes we think are going on at the moment like a technological disruption theme which we think is really interesting and important.  We’re a global investor and you see that from our portfolio and we invest in Australia as and when it makes sense as opposed to because we have to.

But we do like the Australian exposure, so we have quite significant exposures here, particularly in infrastructure, but also in property where those sectors are very well established here and equities, as you point out, we also have some private lending exposure, some interest rate exposure and quite a bit of private equity exposure.

On the private equity, I was interested – earlier on you talked a little about how you’re skewing your preferences, perhaps to more than active managers that are actually taking control of companies and so on, which is what private equity is about.  I can’t remember exactly what you said but it certainly made some reference to the thinking behind the private equity exposure that you have.  Can you talk a little more about that and why you prefer it?  Is it your preferred way of investing in active managers now?

I wouldn’t say there’s a black and white rule like that, but at the moment we would say that technological change is disrupting the model for active managers in the long only equity space.  We’ve seen long only fundamental equities managers at places like BlackRock and Macquarie – they’ve just closed that business and lots of other Australian multi-asset manager houses are questioning that business because with the technology now it’s quite cheap to access pretty similar styles of returns and in Australia in particular, because of the narrowness of the sector, it’s quite hard to be a competent active manager consistently through time after fees. 

But in other areas where there’s a bigger universe to play, for example, private equity, more active and growth private equity or in hedge funds or in global equities we think that equation works out differently.  More specifically on private equity, our view of the world is that economic growth going forward is challenged for a whole set of structural reasons.  I really talked about deleveraging the level of debt in the world, population growth and populism, all of which detracts from future economic growth. 

But we’ve also got this technological disruption which is going to change the world and it does mean the companies which we’ve invested in the stock market, which by definition are the ones from history that have done quite well to get there in the first place, need to fight or change to maintain their position in the economy and new ones will emerge and will seek to displace them, that’s just the way of the world. 

Then we’ve got a very profound generational change going on I believe where we’ve got the Millennials entering the workforce and Gen Z not far behind them and they’re going to be more than half the workforce in Australia in just a few years.  They just consume, interact by services very differently to Gen X and Baby Boomers and so they’re looking for different things.  We want to play those themes and it’s hard to play those themes through the stock market, not possible, but hard, because by definition the larger stocks that are more liquid are incumbent that have been around for a long time and they have to change their business models. 

We find private equity a really good way of accessing new ideas, that’s why we’ve got a very large venture program, certainly the biggest in this country, and why a lot of the rest of the program is skewed to growth equity which means it’s funding small and growing businesses that need capital to grow.  You don’t necessarily need economic growth to support those ideas.  They might be displacing existing ideas or just focusing on a traditional market.  The more traditional buy-out end, the mega buy-out end, tends to be much more dependent on leverage and liquidity and trading market cycles and after fees we don’t really think that’s something that will be a sustainable return generator for the risk that you take.  Therefore, we have very little of that in the portfolio. 

Our subscribers at The Constant Investor are generally obviously smaller investors.  You have a liquidity constraint obviously which is driving you away from small stocks on the ASX, into kind of larger private equity funds and that’s perfectly understandable.  But I just wonder, how do you think small investors could, in a sense, emulate what you’re doing and focus on the sort of disruption and themes that you’re talking about through private equity?

I think there are some simple things.  Firstly, I would say be aware that what worked in the past won’t necessarily work in the future.  Don’t just assume because something’s done well in the past it will continue to do well.  You have to look through to what is the strategy of the company or the business and how are they dealing with these issues?  Secondly, I would say flexibility in the portfolio is important because we cannot predict the future, there are too many things changing the world right now and so you’ll note that we’ve got a reasonably high cash allocation in the portfolio by some measures and we also worry a lot about the liquidity in the portfolio, as you also point out. 

That cash is quite valuable from an option value point of view.  If there are concerns about some political development or some economic data and the markets sell off to a point where they look attractive, we want to be able to invest into cheap assets, and so cash actually has a lot of value.  Thirdly, I think things that are uncorrelated to the broad equity market are attractive.  That just means having a well-diversified portfolio.  I think that there are various ETFs now that offer exposures to fixed interest and credit type exposures and other things that are worth exploring. 

At the Future Fund, as I’ve said, we’ve got quite a big exposure to venture capital and hedge funds but there are other emerging small companies that are listed that are active in that space and I think if you think they’re in a space that has a potential and that they know what they’re doing and importantly, that they have enough income or cash reserves to fund themselves into that space, then that might be something worth exploring.  Lastly, I think just a basic rule would be, think about does this company add value?  How do they add value?  Are they creating a business?  Are they growing a business?  Or are they just buying and flipping and putting leverage on things?

Because I think that style of investing worked through the 80s and 90s because debt was getting cheaper and cheaper and there was strong economic growth supporting a continued increase in asset values as well, but those days are unfortunately behind us. 

If I add up your allocation to private equity infrastructure and alternative assets, it’s actually about 35% which is more than your allocation to listed equities.  I’m just thinking, a lot of individual investors in Australia kind of jumped on Blue Sky alternative investments because it was a way of, in a sense, doing what you guys do, which is to invest in alternatives and private equity and venture capital and so on, but in a way that you can do as a small investor.  Then that’s blown up on them, so I’m just wondering, what do you do as a small investor?  I mean, perhaps you don’t have to have 35% of your portfolio into alternatives and private equity and so on, but I mean that’s clearly worked for you and I just wonder how do you do that?  Are there ETFs for it?

There are ETFs for a lot of things but I think people need to understand what’s underlying them before they invest in them because some are more liquid than others in terms of the underlying assets.  But a lot of the large private equity companies globally now have listed permanent capital vehicles offshore and these days it’s quite easy to buy offshore shares from Australia, it’s not particularly complicated to do that through the online broking accounts. 

But also, the wrap accounts that a lot of the banks and other asset management businesses have do include quite a large range of options, I think, in the private space if people are willing to take some illiquidity in order to put their capital to work.  They’ll have to do their own assessment on the quality of the managers and whether the fees are worth taking, but I think those options are available to people.

On your website you’ve got a section called investment beliefs, which is quite interesting and there were a couple that I wanted to just get you to explain perhaps.  One of them is risk management should emphasise qualitative considerations including a deep understanding of the investment environment.  Qualitative measurement is important in supporting and testing this process.  Could you just explain what that means and how you approach risk management?

Sure.  I guess the key point is quantitative risk management, by and large, is based on models that we build which seek to predict future market behaviour based on past market behaviour.  For example, a bank might have a valuer risk model that looks at historical correlations of assets and drawdowns and extreme events and then seeks to project that forward and say, well we’re okay because this thing would only blow up in a way that would impact us 1 in 1,000 years or something like that.  Those tools can be useful but I think for the reasons I’ve already described, we think it’s very dangerous to assume that markets will behave in the future the way they have behaved in the past.

The data that goes into those models has been collected pretty much over the last 15-20 years and over that time period what we’ve had is a demographic tailwind following the baby boom after world war 2, a big rise in global leverage, fuelling economic growth and bringing forward consumption and investment patterns.  The compression of discount rates because of people’s increased comfort with risk taking.  Those things just don’t exist any more as tailwinds, in fact many of them are headwinds now and so it’s not necessarily sensible to assume the correlations between asset classes will be the same going forward.

What we do is we try to think just from first principles, what could go wrong?  We’ve got these exposures, we seek to understand what we own and we look into the portfolio and try to build this exposure lens in different ways.  For example, I was saying before, we know that property and infrastructure and private equity to some extent are going to react over medium time periods in a similar way to equities because if there’s economic growth or leverage available or those types of things then we’re going to impact all those asset classes.  We don’t assume that they’re uncorrelated for example. 

We also try to think through what are the plausible economic scenarios that might occur going forward and what might that mean for the future pricing of the various assets that we own.  Then look at if that scenario plays out, even if it’s not very likely, where would that leave us.  For example, right now we know that actually a stagflation would be probably the most damaging scenario for portfolio returns, because a high inflation, we’ve got a real return mandate, that would impact bonds, that would impact asset prices.  But if there was low economic growth, if there was a high inflation because of some supply shock in commodities like what occurred in the 70s, or even because here in Australia there was some significant depreciation of the dollar for some reason importing inflation, then that could cause the reserve bank to need to increase interest rates and have inflation occurring but without domestically generated economic growth.  Thankfully, we don’t think it’s very likely and we certainly don’t think it’s very likely in the near term.  But nevertheless, we think through the portfolio construction to say, well is there something we should do about that.  

That change in the environment you talk about from the tailwind demographics and in particular, credit build up – and you’re saying that that’s finished now – I mean, you look at the MSCI global index on an accumulation basis including dividends, the past 20 years it’s returned 5.3% per annum.  Are you saying that the next 20 years on that kind of measure of global equities is going to be less than that? 

Certainly a lot of people would say that.  I think whether you agree with that or not will depend on things like your view on a productivity boost.  I think there are some people who might argue that the tech innovation wave that’s underway right now actually is leading to a productivity boost that we may not be measuring effectively.  But if we go by just that sort of normal…

What do you argue?

Well, I think there’s a chance that that is occurring but I’m not arrogant enough to think I know.  I think that is just one of the scenarios that is out there that we think about.  I think there’s a lot of reasons to think that equity markets will deliver lower returns in the next 10 years then they have in the last 10 years, for the reasons I’ve explained already.

And if that’s the case, what’s the best way then to maximise your return?  Is it just through picking good managers who know how to pick good stocks?

No, I think that’s part of it, but good stock selection will only get you so far if the index as a whole isn’t going well.  I think, one, stay flexible.  Things will be volatile, regimes will change – economic and political – and that will create buying opportunities, so having the firepower to do something in that environment rather than just being stuck in it and I think for those who might consider leveraging themselves into risky asset positions through margin loans, I would think that it’s not a particularly good time to have that type of strategy for example, which magnifies the volatility on your portfolio. 

Then secondly, as I was saying before, just find businesses with good ideas generating value.  I’ll give you an example in how we invest.  If we take our unlisted property exposure, we’re not particularly excited right now about buying retail shopping centres or office buildings around the world at cap rates that might be 3-4%.  And I think residential property in Australia might be yielding even less than that after proper costs are taken into account.  You need a lot of things to go right for that asset to deliver a reasonable return in the future if that’s what you’re buying it at.

But I think strategies which take skill and create value are potentially interesting.  What does that look like?  We’re doing some multi-family developments in the US which are essentially building condominiums in places next to universities, next to hospitals, in areas where people want to live but they’re not necessarily well served yet by enough capital stock and leasing those assets up and creating what I might describe as a core asset which are very attractive and going at those very high prices and then selling them.

And so I think the people with the skills and the energy and the capability, those sort of strategies exist here in Australia too.  The sort of changes I was describing in demographics and generations also impact asset classes like property because people want to live in different places and different types of accommodation.  And so being able to meet that market and provide something that the market place wants is a way to keep creating value even in an environment where the broad backdrop of asset returns isn’t that attractive.

Your 10 year return is 8.5%, which compares to a benchmark target of 6.7%.  Do you believe you can continue to get 8.5% over the next 10 years?

Well, I would like to think we can but I certainly can’t guarantee it.  I think it’s going to be harder over the next 10 years than it has in the past.  If you’re looking at our return profile I think the key thing to understand is, what is the risk we took to get that return?  Because anyone can generate a high return by taking a lot of risk and being lucky, it doesn’t tell you a lot about their investment style.  We look at something called the information ratio, which is really the ratio of returns to risk, measured by volatility.  The information ratio in the portfolio over that time is well above 1, which means that the return per unit of risk is pretty efficient we would think.

And as you pointed out before, we’ve got lot equity risk and we’ve got a fair degree of cash and compared to a lot of other funds which would load up on risky assets like equities, we feel like even if it’s a slightly lower return over the long run, the risk we’re taking in getting that return is very relevant.  Because as you point out, out job is to just make the mandate return target.  It’s not to shoot the lights out if markets are strong but very risky, nor is it to lose a lot of money if markets are week, but we do better than the average. 

How do we calculate an information ratio?  I’ve never heard of that, that’s great.

I think we publish that information in our annual report – I can check that.  It’s essentially just the return divided by the volatility.

I’ve taken enough of your time, it’s been really interesting talking to you.  Thanks very much, Raphael. 

Thanks, Alan.

That was Raphael Arndt, the Chief Investment Officer of The Future Fund.

This interview first appeared on The Constant Investor and has been republished with permission.