Transcript
Note: This transcript has been edited for readability.
“The mandate we were actually given is to try to hit CPI+4.5% over the long term, and I think the normal way to get there would be to have a very heavily concentrated portfolio in equities. Obviously, equity risk premia is about that number. So, if you were just going into this thing blind, you’d probably have 100% equities. And so, we’ve decided that we can get there in a more resilient way by doing things a little differently, having a more diversified portfolio, obviously making lots of active choices and trying to gain excess returns at a lower volatility, which provides a more consistent way to get to, hopefully, our objective. So far, that’s been reasonably successful, but also, we think that’s getting harder.” —Ben Samild, Future Fund CIO
Jim Haskel
I’m Jim Haskel, editor of the Bridgewater Daily Observations. One key area of focus for us has always been working with our clients to help them address the vulnerabilities in their portfolios and engineer greater portfolio resiliency. We wanted to bring you, the listener, into what that actually looks and feels like by sharing a conversation with one of our clients who’s at the forefront of this type of research, and that is Australia’s sovereign wealth fund, the Future Fund. They manage roughly $300 billion in Australian dollar terms, and they’ve been a great client of ours for approximately 15 years.
They’re also a great example of the types of strategic partnerships we love to create, where, indeed, we’re learning as much or more from them at the same time they’re learning from us. So, we are delighted to bring you a recent conversation between Future Fund CIO Ben Samild and our own co-CIO Karen Karniol-Tambour, our Head Strategist Atul Lele, and BDO Deputy Editor Jake Davidson.
And Atul, I want to bring you in here to help our listeners understand the work we’ve been doing with the Future Fund and why we decided to record this podcast.
Atul Lele
Thanks, Jim. As you said, we were really glad to have Ben join us for this conversation. What has stood out over the years of working with Future Fund, for now 15 years—in fact, Jim, I recall that you were there right at the inception of that relationship—is that we’re speaking a very similar language in looking at the whole portfolio and trying to make it more resilient.
So, what we thought we’d do is invite Ben into a conversation with myself, Karen, and Jake. And we thought that discussion would be really valuable to listeners because this priority of resiliency comes against the backdrop of a shift in the asset allocation landscape, as some investors shift away from thinking about their strategic asset allocation and tactical asset allocation separately and move toward the total portfolio approach. And that total portfolio approach is something that’s really at the core of how Future Fund thinks about investing.
Jim Haskel
Atul, specifically, what did the conversation focus on?
Atul Lele
What we tried to do was get at how Future Fund approaches investing at the strategic level, and then get into the really challenging questions of what that means in practice.
So, listeners are going to hear Ben talk about Future Fund’s broad approach to the portfolio and how they manage that total portfolio approach as a whole. Then we go deeper, hitting issues like: are benchmarks relevant, and if not, how do you assess the quality of your choices? How do you assess whether you should keep assets in your portfolio that return less in recent periods? And at an even more foundational level, how do you want to design an organization with the right culture and the right incentives to get the outcomes that you want?
Then, in terms of portfolio construction, where does Future Fund think the world is likely to go, and what changes are they making as a result? For example, how do you pursue inflation protection in a portfolio? How do you determine how many illiquid assets to hold?
Jim, I thought the back and forth across these areas was really helpful—at least it was for Karen and myself and Jake—and I hope our listeners think so as well.
Jim Haskel
Great; thanks, Atul. I also want to encourage our listeners to leave feedback on this podcast with any questions they have on portfolio resiliency or the challenges they are wrestling with, because this is a topic we’re looking forward to covering much more in the future and, maybe, with their partnership.
So, let’s get right into the conversation with Ben Samild from the Future Fund.
Chapter 1: Defining Portfolio Resiliency
Jake Davidson
Ben, so great to meet you. My name is Jake Davidson. Thank you so much again for joining myself, Karen, and Atul for this conversation about portfolio resiliency and just sharing our thoughts on how we think of this important concept.
So, maybe to start, Karen, you could talk through what we mean when we say portfolio resiliency and how that connects to some of the biggest challenges you see our clients facing. And then, Ben, I want to turn to you and get some of your thoughts.
Karen Karniol-Tambour
Ben, the reason we’re so excited to have you is that we talk to institutional investors all over the world, and there’s a really wide range of circumstances, constraints, and situations they’re in. But what I think is broadly shared is an understanding that the last decade or so has been uniquely really good for being concentrated in equities and some sense of shared understanding of the mission and goals, as having a portfolio that is more consistent, more resilient through time, can kind of withstand different things.
But there’s a really wide range of ability to take that very broad goal and actually set up an organization to be able to live it out. And there’s actually a lot of constraints in how a lot of institutional investors set up that make it very difficult to think that way. I think Future Fund has been really uniquely at the forefront of challenging assumptions, thinking about things from a fresh perspective, and defining the goal and going from there.
So, I would say the way I would define the goal as clearly as possible is: you’re trying to make the highest return you can at the best consistency. That means you’re worried about tail risk outcomes, you’re worried about long periods of underperformance, and that, ideally, you don’t really care what else is happening in the world. You just want a consistent return at all times, and you want to narrow the cone of how wide that can get while getting the highest return possible.
In practice, of course, it’s hard to ignore what’s going on in the whole world, and that, if you’re going after the highest return at the most consistent slope possible, you have to ask yourself what drives variations. What creates the wide range of outcomes? That has to come back to cause/effect relationships; that has to come back to understanding what creates the asset outcomes that you see. And that lends itself to designing a portfolio, asking these questions and basically picking the assets—not thinking about every asset individually, but how they come together into one portfolio. I’d say that very high-level goal resonates with a lot of people, but what that actually means gets very tricky.
Chapter 2: Future Fund’s Approach to Investing
Jake Davidson
All right, Ben, let’s turn to you and get your thoughts. I think it’d be great if you could just introduce yourself and the Future Fund, and then maybe share some of your perspective on the goals that you’re trying to achieve and whether what Karen said resonates.
Ben Samild
Thank you. My name’s Ben Samild. I’m the chief investment officer of the Future Fund. The Future Fund is the sovereign wealth fund of Australia. We manage, give or take, $300 billion AUD in a series of mandates, the largest of which is the Future Fund itself.
So, look, I mean, it completely resonates. We were constituted in 2006 and started investing in 2007. And really from day one, the founding chief investment officer, Dave Neal, his observation was essentially that, as you were institutionally investing, [you were] heavily reliant—certainly in Australia—on a regulated strategic asset allocation model, which made some long-term actuarial sense but had very little to do with investing. And, more importantly, it had very little to do with the mandate we were actually given or the objective we were actually given, which is to try to hit CPI+4.5% over the long term, which we also needed to define.
And so, from day one, the construct was essentially: we’re going to try to achieve that mandate the best way we possibly can, with the best portfolio we can possibly hold today, and that might be different from the portfolio we hold tomorrow. That’s essentially a mentality of a blank canvas, and a competition for capital, and constant evaluation.
Jake Davidson
CPI+4.5% is a pretty ambitious objective to have to hit. So, Ben, I want to ask you, how do you think about managing a portfolio to achieve that? And how does the total portfolio approach that Future Fund is known for fit into achieving that goal? And that approach, as Karen said, is really looking at each asset and asset class, not individually, but as part of the portfolio as a whole.
Ben Samild
So, we’re thoroughly institutionalized and embracing the approach. So, indeed, it’s literally on our coffee cups. Initially, we had a concept of “one team, one portfolio” that’s evolved over time, but it’s more or less the same way we think about governance, our alignment, and our incentives.
Our objective is quite a difficult one; it’s a fairly aggressive one. I think the normal way to get there would be, as Karen opened up, to have a very heavily concentrated portfolio in equities. Obviously, equity risk premia is about that number. So, if you were just going into this thing blind, you’d probably have 100% equities. And so, we’ve decided that we can get there in a more resilient way by doing things a little differently, having a more diversified portfolio, obviously making lots of active choices and trying to gain excess returns at a lower volatility, which provides a more consistent way to get to, hopefully, our objective. So far, that’s been reasonably successful, but also, we think that’s getting harder.
Chapter 3: Building a Culture Around the Total Portfolio Approach
Atul Lele
So, Ben, much of portfolio resiliency comes down to assessing individual decisions in the context of the portfolio as a whole. You are really industry leaders when it comes to that. So, from here, I want to go into more detail about how you set up your organization to operate that way.
Just speaking anecdotally, we’ve often had meetings with Future Fund where we think we’re meeting with three or four people, and suddenly there’s something like 25 people in the room, and we think to ourselves, “Who are all these people and why are they interested in this specific topic?”
So, it’d be great if you could just flesh out what running a joined-up portfolio means from a day-to-day perspective for the team, and at the organizational level, aside from what I can imagine is just a scheduling nightmare.
Ben Samild
It’s definitely a scheduling nightmare. I mean, so much of everything that you’ve said really resonates. People might say that the biggest marker of a total portfolio approach is just the number of meetings and conversations you have to have to get to the assessment of the marginal impact of every investment decision you’re trying to make. And that’s only half joking.
So, tracking error, constraint—those words are just banned within our organization, so we don’t use them at all. And then there are periods of underperformance, and the challenges of holding your portfolio, and the constant need for communication and trust and whatnot—now, that plays out at multiple different levels, obviously. But, as you know, I used to run the hedge fund portfolio here, and for some years, I had to stand in front of all my peers, 100-odd people, sometimes more, and proudly tell them that, you know, this thing that just gave you a, whatever, 3% return this year—while equities did 25%—is an outcome you should be thrilled about. And, yes, it was really quite expensive to get that 3%. And as that persists, you know, 27% then, etc., that becomes quite difficult, right? And what I’m ultimately saying often, then, at the next level, is not only should you be happy about it, but given where cash rates are and volatility and equity prices are, you should probably be giving more capital over here.
So, if they just look back and say, “Hold on, you’re costing me my bonus, mate. You’ve just given me 3%, private equity has done a million whatever it does; how dare you.” If that was the attitude then, again, you couldn’t run this kind of portfolio.
Jake Davidson
I’m curious, Ben, does it ever work the other way around? Do you ever get teams that look at their opportunity set and instead of saying, “This is a good and diversifying asset and diversifying hedge, even if it’s not making as much as equities,” they actually turn around and they say, “You should take money away from me because I’m just not seeing very good opportunities.” Is that something that happens?
Ben Samild
Yes, so, I’ll give an example. We’ve thought the environment for credit investing was pretty poorly rewarded for much of the last, call it nearly 10 years. And we’ve had a very small allocation to credit because, frankly, we thought equity was favored through that period. That information on “this isn’t a great environment for credit” came largely from our credit team. So, it’s our credit team saying, “You shouldn’t be investing with us because we’re lending to those guys over there, and we’re lending on terms that I don’t like; we think that you should be buying the equity, not the credit.” How do I measure if that was a good decision? How do I reward them for putting out their hand and saying, “Please take money away from me”?
So, there’s just a forever cultural reminder that leaders at the Future Fund have to engage in to not have that culture devolve into blame—you know, “I’m all right, thanks, Jack” kind of culture. So, yes, you get 25 people on the call because there are representatives from all of those teams who are asking to understand how the world is today and how it might be tomorrow, and for that to inform both the diligence of their asset class and their understanding of everyone else’s problem. So that takes empathy, curiosity, and trust. And, like I said, it’s been that way since the founding; it’s an origin statement that we will try to invest toward our objective and not toward a series of benchmarks.
So, like I said, a predecessor said—and I’m paraphrasing—we’re not going to sit in the corner of our cot, sucking on the comfort of a benchmark. That’s just been very strongly embedded in our culture that we don’t invest that way—that we’ll try to do it in this joined-up, total portfolio way.
Karen Karniol-Tambour
That is quite a visceral analogy.
Chapter 4: Measuring Outcomes without a Benchmark
Jake Davidson
It’s a great analogy. But I think it also raises a question, which is how do you actually measure whether the portfolio is working well? Because starting from a blank sheet of paper, I think we’d agree—from a portfolio construction perspective—that makes sense, and being unconstrained makes sense. But you have to hold yourself accountable somehow, and benchmarks exist for a reason because they’re a very clear accountability mechanism. How do you determine whether you’re meeting your goals without a benchmark?
Ben Samild
So, it’s one of those things that requires—this goes back to the sort of empathy, trust, and communication. So, we’re constantly communicating to our stakeholders what we’re doing in the portfolio and why we’re doing it, and the ramifications of that, so that we’re owning those outcomes together. It’s their portfolio that we’re advising on.
That’s actually really important because if we can’t get that governance layer right, then you’ll default to a benchmark and accountability model and that’ll drive your incentives and your process and you’ll just be in a very different place. That’s not to say whether that place is good or bad; it’s just different.
Now, as to the specific way we try to assess if we’ve added value, we have lots of ways. But essentially, we say, well, here’s the portfolio that we could invest with these risk settings. Then we say, here’s a slightly more complicated portfolio with a mix of different liquid betas that looks more or less like ours, over time. Let’s hold that static and let’s see how that does. Now let’s move it the way that we have moved it over time and see how that does. And we build that up and say, well, here’s our portfolio and, I think, we can more or less say, all right, this is where value has been added over time, this is the value of sort of the asset selection, the way we’ve moved around the portfolio, different decisions we’ve made. We can compare that to the risk we’ve taken, the risk of equity markets, peers, whatever, and get to a nuanced conversation about the value-add of my team and our model. This is all the different ways we could do this.
Karen Karniol-Tambour
Can you talk a little bit about how you boil it down to what the risks are, what aspects to look at things, or how do you actually look at an investment and even compare it to other investments and think about how it relates to a total portfolio if you’re not in asset allocation, “I have benchmarks” land? What are you looking at? How are you assessing what’s good, what’s bad?
Ben Samild
So, that’s where the rubber hits the road; that’s the forever challenge. Because on any one day, I might have, I don’t know, scarce capital—we have no inflows. And I might have a potential hedge fund investment and a potential bridge in some far-off country, and an office building in another far-off country, and a bunch of sheds in Europe to store whatever. And I have to now try to line them up against each other and make some sort of fist of what the risk is, what the potential return is, obviously, but what portfolio features they are capturing—is that complementary to our existing portfolio? Is it better than what we already own? And ultimately, is it consistent with how we would view what we call our secular horizon?
So, we start with how do we think the world looks over the next X years—3, 10? We set that up in a sort of discounted probability way. Once we’ve done that, we try to imagine what capital market outcomes would look like under these secular probabilities. Then we try to understand our vulnerabilities and opportunities within those secular narratives. That gives a sort of framework for assessing the relative attractiveness of the different features for every marginal investment that comes afterward.
Chapter 5: Building a Resilient Portfolio
Karen Karniol-Tambour
How do you know something is complementary? Because I think in our view, that’s a little bit the Holy Grail, right? The Holy Grail is you have investments, you like them, and now you have something that actually is complementary—maybe it will do well when they do poorly. It’s the hardest thing, but how do you basically know if you’re there? How do you assess if it is actually complementary?
Ben Samild
We try to drill down into the features that it has. So, there are really obvious ones, where I guess, in one of those examples, we’re buying a bridge in, whatever, Spain. So, what’s that giving us? That’s giving us some equity at some level that we try to ascertain, probably some credit, probably some duration. It’s giving us a currency. It’s giving us exposure to policy within that jurisdiction. It’s giving us probably some inflation exposure, again, to that economy, to that jurisdiction, and a few other things. We would then take a look at that and say, well, how much of those things do we already have? Do we want more of them, given our view of where the world’s heading? And then we penalize, essentially—we change the cost of capital for things that are complementary versus things that are just additive.
In terms of—I think you’re asking, essentially, how do you evolve the portfolio toward something more resilient, and what does that journey look like? So, essentially, it goes to constraints and how you define “resilient,” which you both mentioned earlier.
So, we go to our board and we say, look, here’s our view of the world, roughly, and here’s our probabilities of those outcomes. If it turns out in these ways, this is what we think will happen to our portfolio. Obviously, most of the time, it’s vaguely normally distributed. What we said last year is more or less what we believe this year, and it’s “as you were,” and there’s these tail probabilities. We will do bits around the margin, but we can’t manage to those tails.
More recently, what we’ve been saying is this is now a very flat distribution, and we think it’s almost equally probable that there’s a kind of pernicious outcome versus an “as you were” outcome. And we feel like we need to start changing the portfolio to reflect that. Then we present, so here is the very pernicious outcome, and here’s what we think will happen to capital markets, and here’s the portfolio we would have to hold to meet our mandate in those circumstances.
As you can no doubt imagine, that is a pretty extreme portfolio. The problem with that portfolio is it’s completely irresilient to the world doing OK. And so we say, I don’t think it’s advisable to hold this portfolio—because that would be an extraordinarily arrogant thing of us to say we absolutely know how the world’s going to play out and so therefore you should hold this upside-down thing. So, we’re not going to do that. Then we step it back and say, here’s our portfolio today, and here’s how we think that would perform in these various things, and here is a series of levers that we could pull to evolve the portfolio toward some things that essentially are a constant—like, we’re trying to minimize the cost and maximize the resilience.
Again, there are some things that are relatively easy, and you do the minimum-cost things first. And then as you step through, there’s more and more cost involved, and there’s a bigger trade-off, and you’re now involved in sort of a constant discussion with your stakeholders about where their level of comfort is.
Jake Davidson
Ben, can you actually talk through some of those levers that you could pull? Then I’d be curious, Karen, Atul, how that compares to how we think about managing a resilient portfolio.
Ben Samild
So, I would say that there’s an infinite number, but broadly, there’s all the large beta levers that should be obvious to anyone, so you just change your asset allocation. So, basically, how much interest rate risk do we want to take? What kind of currency risk do we want to take? How much currency risk do we want to take? How much equity-style risk do we want to take? And then where do we want to take them?
The second one is what I would broadly call sector strategy—the things we buy and then the way we buy them, so what we choose to own within sort of broad asset classes. So, with infrastructure, do we have a whole lot of nonregulated, market-facing infrastructure with lots of market risks and no sort of policy risk? That would be one way to do it—highly competitive field with lots of price competition. Or do we shift toward something that’s quite regulated, has a much more consistent contractual inflation pass-through, a lower expected return, much narrower fan, take on some policy risk, and then we decide where we do that.
So, you can change within asset classes, equities—we don’t have to invest to the MSCI World or whatever benchmark. We can say, all right, here’s what we hold in the illiquid space, here’s what we think would best complement that within our listed portfolio; let’s think about our equities portfolio from that construct. What can it add that we’re not getting elsewhere?
Then I guess the third one is just: can we somehow add excess return through our own investment activities, all through, obviously, the managers and partners that we trust with our capital? For us, that’s actually a bigger part of our total expected return than I think most asset owners. We really lean heavily into alpha, as it were, as kind of a relatively low-volatility way to get to our return. And if we think risk premiums are expanding, then that’s going to be a bigger part of our total return over time anyway.
So, there’s all sorts of detail within all of those levers, but they are plentiful.
Chapter 6: Identifying Portfolio Vulnerabilities Today
Atul Lele
One thing, even before getting to the levels, that’s frankly a bit of a challenge is for organizations to actually identify where the vulnerabilities are, because there are always going to be a lot of vulnerabilities. And it’s actually saying, “OK, before I even deploy these levers, which vulnerability do I want to go after? And then, which environment do I care about?” We use growth and inflation and sensitivity to discount rates and risk premiums. But there could be different environments. There could be plan-specific environments. You could have plans that are very exposed to an economic downturn because of what the goals of the plan are, what the purpose of the plan is, and so on and so forth. And so, even before you get to that point of talking about levers, stepping back and actually saying, “Which vulnerability do I want to go after?” is a really important consideration before getting the levers. And then, what environment are you going to be exposed to?
Jake Davidson
Just along those lines, Ben, I’m curious, when you look at the secular and also the cyclical environment, are there particular vulnerabilities that you’re worried about and watching that you’re trying to make the portfolio more resilient to?
Ben Samild
Absolutely, and we’re being quite public about it. We’ve released a series of discussion papers over the last few years to speak to how we think that the world is changing and what the challenges to our portfolio construction are, given that thinking. The big changing thing—from our minds anyway—was inflation and inflation volatility.
So, very clearly, we came from nearly 40 years of a very supportive regime where there were falling interest rates, more macro coordination, less volatility, inflation became an incredibly consistent variable in most places—certainly in developed markets. Unlike almost every other year, including sort of 2008-09, when we went through that process of “How do we think the secular environment looks today although it could look all sorts of different ways? But, you know, highest probability is it looks much like last year.”
For the first time, we said, “Oh, actually, we think it’s quite probable this looks different.” It’s very common and oft repeated, and I won’t bore anyone with the reasons why. So, some version of inflation and the type of inflation was the main portfolio vulnerability that we perceived. And then it came, and it came much more quickly and more strongly than perhaps we could have guessed. Obviously, we would have loved to have done an awful lot more immediately. But it was hard to convince ourselves and stakeholders that the world was going to significantly change more or less overnight.
As one example, I was just looking through some of our climate-integration work this morning, and we identified 16 major factors from physical risk, and policy, and other things. We view 14 of those as inflationary. That’s really important, and it goes to somewhat explaining our incentivization around marginal asset allocation.
Jake Davidson
You said you didn’t want to bore people, but I don’t think people would be bored to hear your thoughts. What are some of the things about the environment in particular that you feel are so different than the past, and why that leads to a more inflationary environment?
Ben Samild
So, a unipolar, dominant hegemon, laissez-faire world with ever-increasing integration was a world that had built up over, call it 40 years. We felt very strongly that that world had reached—that that rubber band had been pulled as far as it was going to be pulled, and it was going to start coming back in the other direction. The changing geopolitical environment, which was going to lead to a changing domestic policy, environment change priorities, and these are all the deglobalization, reshoring/friendshoring, strategic competition, demographics, competing industrial policies, more dirigiste governance—you know, all of these things that have played out a bit and now you can’t open your first page of Bloomberg screen without being drowned in this stuff. These were things that we identified as important, I guess, change agents back in 2020 of what we saw as the secular horizon then, and we still do.
Karen Karniol-Tambour
Can you talk a little bit about what you do about those? Because I find that a lot of them are in the category where investors feel almost powerless. It’s like, I’ve identified that there’s going to be big geopolitical problems. I’ve identified there’s tension with China. But that feels like that leaves me with just fewer options of what to do rather than knowing where I should go shift my portfolio.
I find that the most common conversation I have basically is, “I know that I shouldn’t bet on the prior environment returning. I know it doesn’t take a huge bet on the world to say that the future is going to look somewhat different than the past, and the past is already in the prices for the future, but I have no idea what I should actually do about it. What else is there really to buy?”
Ben Samild
It’s a really good observation. So, I can’t remember the exact number, but we made circa $100 billion AUD worth of changes to our portfolio between 2020 and today—between the time, essentially, when we thought that the world has changed and the secular environment is likely changed and would become more inflationary in particular, and different changes to growth, and countries would hold different levels of risk to our dollars than we had previously assumed.
Obviously that’s not any one thing, you know? We dramatically shifted our duration exposure. We actually took more risk, which was hard to do, and hard to convince stakeholders of at a time when they’re locked up and everyone’s screaming that the world’s ending. We put a higher price on our liquidity and flexibility, we made opportunistic things, marginal changes to our sector strategies to prioritize different features within the assets we were buying or selling.
And we think all of that—we know all of that—led to better performance. We think more importantly, though, it has led to a more, to your point, resilient portfolio to multiple potential environments.
Chapter 7: Finding Inflation Protection
Jake Davidson
Ben, one thing I just want to follow up on is you mentioned shifting [the portfolio], wanting to protect the portfolio against inflation. But I think everyone wants to protect against inflation. That’s often the biggest vulnerability that a portfolio has. And it’s not so easy to do it. So, I’m curious how you approach getting that protection at that total portfolio level.
Ben Samild
Again, there’s no one magic contract you can buy that just gives you this thing. It’s clear you have to think about it through the total portfolio and try to measure it through the total portfolio—measure your vulnerability through the total portfolio, which we do. We try to understand almost like an inflation duration concept and how that’s changed over time.
But the question’s really hard, right? Because it’s whose inflation? Where inflation? What inflation? What kind of inflation? How does that bubble up? So, I know lots of folks say, “Oh, inflation is scary. We looked at the ’70s. We should buy commodities.” And maybe that’s perfectly sensible. But maybe not. That was a specific kind of inflation—a supply-constrained world. Maybe massive fiscal expansion gets us to a demand-style inflation, and that you want a different portfolio and commodities aren’t going to help you at all for that.
And so, we’ve tried to be thoughtful about the kind of inflation we’re concerned about, what we can do, how much of a cost we’re willing to bear, what event-style issues that end up leading to inflation. We aren’t going to predict and we’re not going to manage the portfolio too specifically, but we would just want to make sure we can survive them and ideally thrive on the other side of them.
Jake Davidson
It’s interesting because we wrestle with many of the same nuances you’re pointing to. Karen, anything you’d add to what Ben said in terms of our research on how to build portfolios resilient to rising inflation?
Karen Karniol-Tambour
I think in line with what you’re saying, Ben, inflation protection is one of those things that, at this point, is more recognized as relevant to portfolios but is challenging to do. I think in the public markets—you also pointed out this—it’s worthwhile to think about what kind of inflation matters to you and recognize that not all inflation is the same. That commodities are really valuable because they do really tend to capture a certain kind of rising price, but you can get inflationary problems that don’t end up focusing on commodities. And you do have idiosyncratic issues in commodities, and increasingly, you do have tough questions about which commodities are going to be significant in the global economy.
So, to answer what commodities are relevant becomes trickier and you’re also really beholden to what happens to trade, right? Like, steel is widely used and is not a very liquid market outside of China. So, I think it’s a very useful tool, commodities and commodity producers, but it doesn’t answer all the questions.
Then I think gold is quite helpful in the context that you can get a certain kind of monetary inflation and that inflation is driven more by geopolitical challenges. We’ve already seen that tend to show up in gold, partly because players like the Chinese and whatnot, if they want to diversify out of the dollar, they don’t have any options. So, it’s easy to get gold inflation when that happens.
And then I definitely find the inflation-linked bond markets being underutilized and less attention paid to them. Many times, it feels to me like if you have the ability to do it mechanically in terms of implementation, it almost feels like a free option value to move your fixed income to just get the option of what if inflation ends up being higher than priced in when the pricing is so moderate. But of course, a full inflation-linked bond does have embedded in it all the duration pressures, so you can’t think of that as just that option value on its own. The inflation swap can do that for you.
Then I think people have often pointed out that public markets do give you the limitation—some things can be done inside of private markets that can’t be done [in public markets], particularly the ability to structure your own assets and get long-term inflation protection tied to whatever you think is most relevant. And our main thought on that is that conceptually, it’s a great idea. In practice, it requires teams that actually go after that in their private choices, with the best example that I have really being infrastructure.
We see lots of people share publicly why they hold certain assets and whatnot, where their board, investment committee, whatever it is, discusses or has this specific goal in mind and says, “You know what, I really want to do infrastructure because I’m going to structure it for inflation protection.” But then when you actually look at what they then ask the manager to do, they never mention inflation protection again. They just say, “Go make me a return,” which could easily end up not touching inflation.
So, we did this analysis basically saying, “Let’s look at a lot of infrastructure assets,” and it’s all over the map. So, it does exist, but it requires thinking and governance. And so, when I step back on all that, our view is: there’s not one thing you buy that has solved your inflation vulnerability. It’s a thing that takes thoughtful management and a recognition that there are many different types of inflation. But because it’s so challenging, there’s almost no portfolio I’ve ever seen that couldn’t use more inflation protection.
Ben Samild
So, obviously, we agree. But I’m curious as to your perception or understanding of the potential synchronicity of that inflation. So, we have a specifically Australian inflation objective, and I think investors have become complacent about just talking about inflation like it’s one thing and that it happens in the same way. It occurs globally, largely because that’s been the macro integration of the world. But that’s less clear to me today as I look forward than perhaps it was 10 years ago. I can definitely see environments where Australian inflation looks very different from US inflation. Now I’ve got to be a bit more careful, again, in this thing that’s already hard; it just got a lot harder.
To your point, the Australian inflation-linked bond market is de minimis, so I can’t just go out and buy those things. I can go out and buy US inflation, but that might not actually be matching my mandate.
Atul Lele
You’re already seeing a world that has been essentially synchronized for the better part of at least 20 years, if not longer, go to a world that’s less synchronized. You saw that really coming out of the pandemic, where you saw the US and the majority of the West going into this more inflationary environment as a function of the policies that they introduced that stimulated demand, that exceeded supply. And you saw very, very different outcomes, for example, in China and the economies that were linked to China. And so, you’re already seeing it.
So, that to us is something that is likely to continue because you’re getting these different poles of the world operating on different cycles, more domestically driven, policy makers responding to those domestic challenges, getting different types of outcomes. It also impacts pretty significantly when you’re thinking about how you protect yourself against, to your point, Australian inflation going a different way. You saw that really going back over the last few years. We used to be able to take inflation-linked bonds from the US, hedge them, for example, into RMB, and get you some protection, from a Chinese investor’s point of view, in terms of those global inflation pressures. That didn’t really work going back over the last few years because you were getting very different inflation outcomes.
So, I think it’s something that you’ve already seen take place. It’s something that we think is likely to persist and actually you’re going to see the world go more into that multipolar state. And it has pretty huge implications for how you think about getting protection against that.
Chapter 8: The Role of Liquidity in a Resilient Portfolio
Jake Davidson
All right, Ben, one last topic I want to cover, and it’s something that we hear a lot of clients wrestling with. That’s the question of liquidity. I think it’s especially relevant considering that a lot of the risks you mentioned might require a certain amount of agility to handle. And also liquidity is just, in general, obviously less plentiful than maybe it used to be. So, how do you think about the balance of illiquid versus liquid assets in your portfolio and the trade-offs that come with those less liquid holdings?
Ben Samild
So, there’s always been a reasonable amount of exposure to illiquid assets. The total amount is, give or take, call it a third depending on how you define illiquid, frankly. But let’s call it a third. There is some science to why we settled there, and that changes over time. But we think that’s about the right balance to best achieve our mission.
Every marginal extra dollar of liquidity impacts obviously our flexibility, impacts our balance sheet. That impacts our ability to respond to volatility and market downturns and whatever. And that has a real cost.
If you read the academic literature, you pick up an illiquidity premium as if it’s this magic thing that you add monotonically to a risk premium, and you earn it by just being in a different investment structure, you know? So, that’s always seemed a bit dubious to us. There is a real cost to the portfolio for holding these assets. Now that can be extraordinarily valuable. Obviously, there are real advantages to being in those structures often, and you can pick up exposures, which you otherwise don’t get, from illiquid exposures. By the way, it’s been a very successful program for us, too. So, it’s not to say that we don’t think that there is an illiquidity premium, just that you’ve got to be very thoughtful about what that is, why it exists, where it exists, does it change over time, are you getting rewarded for it today in this structure, given this macro environment, given this policy environment, etc.
And then, are you getting rewarded well enough for taking on this illiquidity risk in a world where the option value of cash or flexibility we think is going higher? It’s gone up. And for reasons that I won’t get into, this is particularly important for Australian dollar investors. So, we think about this an awful lot. In fact, I’ve got four kids, and if you ask them what they thought my job is, they’d say “something blah blah blah liquidity.” They think that’s all I do and all I care about, and that’s not so far from the truth.
So, this is the first, second, and third part of any investment conversation we have, which is what structure should we do it in? If it’s illiquid, are we appropriately rewarded for taking on that risk and why? And how does that feel against everything else we currently own?
Jake Davidson
All right, I think let’s leave it there. Atul and Karen, thanks so much for joining me. And Ben, thank you again for being with us. It was so great to hear your perspective and look forward to talking with you soon.