Raphael Arndt – The Death of Traditional Portfolio Construction? (EP.365)

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2:31Hello, I'm Ted Seides, and this is Capital Allocators. This show is an open exploration of the people and process behind capital allocation. Through conversations with leaders in the money game, we learn how these holders of the keys to the kingdom allocate their time and their capital. You can join our mailing list and access premium content at CapitalAllocators .com. All opinions expressed by TED and podcast guests are solely their own opinions and do not reflect the opinion of Capital Allocators or their firms. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions.

3:11Clients of capital allocators or podcast guests may maintain positions and securities discussed on this podcast. My guest on today's show is Raf Arndt, the CEO of The Future Fund, Australia's 200 billion Aussie dollar sovereign wealth fund that his team manages alongside 55 billion Aussie dollars of other sovereign pools of capital. Raf assumed the CEO seat in 2020 after serving as chief investment officer for six years. Our conversation from five years ago about the fund's total portfolio approach is replayed in the feed. Our conversation focuses on the significant changes in the Future Fund over the last few years.

3:53Raf and his team spent a year analyzing changes in the global economy, demographics, and markets, and concluded the Future Fund needed substantial turnover to prepare for the coming period. We discussed these changes in the external environment and the governance and culture internally required to do something about it.

4:24Before we get going, what you just heard is my son Ryan's response to my asking him to create a guitar riff for a new intro for Capital Allocators. We do bring some heavies on the show, and he's definitely got that heavy metal vibe. So I'll leave this one up to you. Next time you're chatting with a friend about capital allocators, why not ask what they think about the potential new show intro? We'll take you out with it one more time. And thanks so much for spreading the word.

5:05Please enjoy my conversation with Raf Arndt. Raf, great to see you. What's it? Well, it's actually been five years since you last came on the show. Since then, there have been a couple of things that have changed. So you are now the CEO, not the CIO. And there are two pieces that I've seen you put together that sort of was the impetus for this, the 15 -year letter of the history of the fund, and then last year's piece on the death of portfolio construction. Maybe we should start with, how do you feel about being CEO? Yeah, what an interesting question and what an interesting time and a lot has changed in the world.

5:42I think COVID was a real catalyst for a lot of things and it just so happened that right in the middle of 2020, I changed jobs and became the CEO. It wasn't something I was really looking to do. I was happy being the chief investment officer and I was quite passionate about that. But what happened was that the role was vacant and there was a market crisis. From a future fund perspective, we were turning 15. I had a lot of ideas about things I thought we needed to do to pivot, to double down on. I started talking to the board about that. And eventually someone on the board said, why don't you go for the job?

6:18And I thought, oh, that's an interesting idea. I hadn't thought about that. So I thought, what could go wrong? So I did. And here I am. What were some of those views of what you wanted to do in the role? They sort of fell into two broad buckets. One was internal related issues and the other one was external. So on the external, we'd really been fortunate in that we don't have members or clients. We don't have to do marketing. We're not regulated. And so we thought really deeply long and hard about the investment world and what was changing. And we'd done some research already around the return of inflation, the end of monetary policy, at least in a traditional sense when interest rates are all zero and what might come next.

6:59So when COVID happened and government started to stimulate, we sort of got really interested in whether the world was changing. And I felt like we had to reposition not just the portfolio, but the mindset of the organisation around the world being different now. And that's a big task because when you've got investment professionals that have been doing things for 20 years, sometimes or longer, and an organisation that had existed long enough in 15 years at the time that had developed a process and approach and a way of thinking to change it is a big task. And then secondly, the external world was changing and we had to adapt to that.

7:38So whether it was the things our staff expected from us, ways of working, societal expectations, things around reputation when you're a sovereign wealth fund, I felt like we needed to do an even better job at that than what we had been doing. So lots of interesting things to tackle. Why don't we start with this idea that the external market environment was changing and you needed to adapt? How did you lay out what that meant and how you should change your approach? It was really founded in research we'd been doing for quite a few years. And we'd started to talk to the board about just long -term trends, secular cycles, and things like that.

8:18And then when COVID had happened. I am in Melbourne in Australia and unfortunately that was one of the cities that was locked down the most in the world and most of our staff are there too. So that was a big disruption but also it gave us a lot of time to think in between dealing with market issues because we were stuck in our homes. I was really thoughtful that if this world was changing driven by a generational change. So people who are say under 45 today, millennial and Gen Z, really have a very different lived experience, partly because of how old they were when the financial crisis happened and what sort of jobs they got, what that felt like for them, whether they could afford to buy assets, houses and things like that or not, mostly not.

9:03And so they expect different things from their governments. And because of the research we'd done, I noticed that the world had been through these cycles before. And I challenged the team to start thinking about it. Essentially, what happened is I ran up Sue who was then our head of portfolio strategy and said I think the world's changed I want you to tear it down to first principles figure out how it's changed figure out what we need to do to succeed in that new world and build it back up you've got a year and she said oh that's an interesting question I'd love to do that but I'm too busy with BAU and I said oh BAU's cancelled so I literally went to the board and said we're going to stop reporting on a whole lot of stuff because we need to focus on this project.

9:46And the board was supportive, even though we're in a market crisis. We recognised that we didn't know what was going to happen in the world. So the next thing we did was a wiki survey across the whole organisation, as in from the receptionist up. And we said, what do you think's changing in the world? What's important? We came up with a bit over 70 ideas and we tried to group them and ultimately came up with the 10 groupings that are set out in the first paper, the new investment order. It always feels like something is changing in the world, especially in markets. Things are tops and bottoms.

10:20How do you develop the conviction, looking at cycles, looking at these ideas that your team developed, that you should make a significant change in a substantial portfolio? I guess it boils down to expressing a form of leadership, because you can overanalyze something to death and come up with a million reasons why you'll revert to the mean or our models will tell us something will be. I guess it was a career of reading and thinking and being influenced by different things I'd read that really went to the fact that finance is people's behaviour and whether it's quantitative or not, people program the algorithms and so people change.

11:02I was pretty influenced by a book I read back in the 90s called The Fourth Turning, that really went to how generations think differently and how the world actually does change quite profoundly. I've done a little bit of reading and thinking around the Great Depression and the 1929 market crash when the financial crisis happened. I could see a lot of parallels with the world that existed then and I just had such high conviction in it. I engaged the team and got them to read up about it and talk about it to the point where they thought that was a pretty interesting project, but it was really the process of going through the project, which took a year, which ultimately engaged the entire investment team.

11:45So they broke up into work groups. And at that time we had maybe 70 or 80 people. They all worked on the project. We produced probably 30 papers internally and for the board through the whole thing to build views and conviction to the point where we could change the portfolio and people would be on that journey rather than impose it on the top down, which I don't think would have worked. So this concluding paper, you titled The Death of Traditional Portfolio Construction. Why don't you discuss your thesis of that paper? Sure. So finance is really based on observations on how financial markets and economies have worked and ascribes, quote, laws or behaviors to these actors in the economy, assuming that people in the future will act like they have in the past.

12:33But when you start to think about it, most of the data we have comes from the era post -World War II and in many cases really only the last 30 or 40 years. And so we've been in a particular part of the cycle during that period. We've had demographic and economic tailwinds. We've had the emergence of middle classes in Europe and the US post -World War II. We've had increasing debt in the world and that was a positive thing mostly because it brought forward consumption and wealth from the future, but we had a fast growing world, pretty good efficiency, productivity type effects, globalization, global trade, mostly economic rationalist government policymakers through a lot of that era.

13:19Not solely, there were obviously bumps on the way, but mostly. But actually, when you look back at hundreds of years of history, the world hasn't normally been like that. It's certainly gone through those cycles before. And so the question was, why will it continue? Why should it continue forever? Ultimately, it boils down to is capitalism performing a useful service for society at large. And if it is, it will continue. And if it isn't, then someone sometime will try to intervene in those markets and change it. So taking that backdrop, then you can start to say, well, well, why should bonds be negatively correlated with equities always?

13:56Why should equities earn a higher return than some quite lower risk asset always? Why should private markets earn an illiquidity always? And the answer is, well, on average over time, they probably should because people otherwise shouldn't buy them. But at different points in the cycle, they clearly don't. For example, we've just been through a couple of years of inflation, rising interest rates, falling bonds, falling equities at the same time. And so really, in saying the death of traditional portfolio construction, and my team made me put a question mark on the end of the title, because we're really calling for a debate, but I guess I personally think it is.

14:35What we're really saying is there might be periods in the future where bonds are still defensive relative to equities and where private markets earn a premium and so forth, but you can't assume it will always be the case. And so there is no set and forget portfolio anymore that you can just put on and then go to sleep or fill up an asset allocation with dollars every year, you have to actually be a lot more dynamic and a lot more thoughtful. So what do you do with that thesis when it comes to the actions to take on your fund? For a very first principles investor, we call it joined up whole portfolio investing.

15:13I tend not to use the term total portfolio approach because when other people do that, they do different things to what we do. So right now, we think the assets are repricing still as the world works out what should the price of money be in a higher inflation world and a world where there's more competition for capital. Credit actually looks pretty attractive because it has repriced. So why wouldn't you just put all your portfolio in credit? And there's good reasons why you wouldn't, but that's the starting supposition, rather than, oh, we'll have an overweight of some small amount within some tracking error budget to some strategic asset allocation or reference portfolio.

15:54When we look at the world going forward, we see more inflation, more volatility, probably wars, at least in localised places more frequently, deglobalisation, and more populist governments that will direct capital, all those things detract from economic growth, all those things are inflationary. And in that world, in the big picture, you would have probably less reliance on equities and you would have less conviction in bonds. And so the question becomes, where do you get your returns from and what can be defensive? And how have you gone about thinking through that? we concluded that we need better inflation protection.

16:34There's many, many reasons why we think inflation will be sustained. It doesn't mean it will stay double digits or high single digits. It will come back down, then it will go up again, then it will come back down, then it will go up again. This is the path from history. Certain types of real assets, particularly infrastructure assets that can pass through inflation, look quite attractive, but not, for example, regulated utilities, which you might in theory say should be, because there needs to be a social contract. If you're buying an essential service, you can't just charge anything you want.

17:07You can't put the price through the roof. And so we look at those assets. It's quite risky in this world. But there are other things, mobile phone towers, fibre, data centres, renewable energy infrastructure that are quite attractive. We think commodities are one of the few things that have worked through stagflationary periods and inflationary periods, and we see no reason to think the future will be different. But you've got an added tailwind now that in the decarbonised economy, a lot of commodities become very valuable, not the petroleum ones, but the rare earths, certain types of minerals and metals.

17:43And so we've put that exposure on in the portfolio. In 2020, we put gold into the portfolio for the first time because we saw that more populist governments would be more likely to print money or otherwise debase their currencies, because that's what governments always do when they're in those sort of situations, or at least you can't take it for granted that they won't. And then we still have very high conviction in skill -based strategies, particularly private equity, venture capital, the sort of infrastructure and property we do and credit we do tends to be private and skill -based. But increasingly, even in equity markets, where some years ago, we thought in this macro -driven world, skill -based strategies would struggle to earn their keep over and above their fees, where in certain pockets, we've come back to that.

18:35And so, for example, we started to great fanfare and interest in Australian equity small cap strategy earlier this year, because it was a space where there was capacity available and there is the potential to deliver a sustainable alpha. I'm trying to think about how your portfolio would change with this different lens of a paradigm after this year of work. You started with an approach that's a little bit different from traditional asset allocation as it was anyway. How much can you change such a large pool, even over two or three years, to move into the areas that you think are more likely to benefit it from a different environment?

19:13So we manage about 265 billion Aussie across seven funds. The future fund, which is the higher risk fund, is a bit over 200. And we've changed half of it in the last three years. So it is something we have conviction in. Some of it isn't obvious. If you just look at the asset allocation, because it says equities, we've still got equities, but we've got different types of equities now than we used to. Some of it is things that don't really show up in the asset allocation. We think we need to be more careful about our liquidity. We think there's going to be more volatility in currency. We think there's options in unlisted assets that can get us higher returns in lower growth world, but other issues come with that.

19:56So we've built an internal treasury management function, for example, to work the liquidity harder. We're taking some of the risk using derivatives over the cash that we have. So we're being more disciplined about how we think about that. But other things are quite different. So the nature of the type of infrastructure we're buying is different. The way we're doing real estate is different. We don't think set and forget trophy assets are that exciting because there's no reason to think that you'll just get rewarded for having capital. And so you need to have strategies that actually create something of worth that people want to pay for.

20:31And the issues in terms of office building utilization or shopping centers versus internet retail, for example, are well known and explored. But the same things are happening right across the ecosystem. So it's more inside each asset allocation, how we execute on the portfolios that is changing. This idea that credit looks interesting, couldn't you just put all your money in credit? Well, you can't do that. Oh, this infrastructure is interesting, but it's illiquid. How do you get to the sizing of all these different buckets of opportunities? Well, firstly, I'd say we can put all our money in credit.

21:07That's a decision not to. And the reason we don't is because we might not be right, or maybe the market capacity and the size of the fund over the time period would restrict it. But we wouldn't start from the attitude that we can't. And so most of the conversations around the investment committee are we like this idea, why can't we do more? Usually the investment committee is pushing the sector team to do more of a good idea rather than less. And that's what the whole portfolio investing really comes to. It's sizing issues at the whole portfolio level appropriately. But of course, we do have an existing portfolio and we can only have one portfolio.

21:44And so there are multiple future scenarios in the world. No portfolio will be great in all the scenarios. We could have a low growth stagflation. We could have a productivity shock where everything's fine. We could have anything in between. We could have geopolitical conflict that means that certain geographies get impacted more than others. And so we do think about true diversity in the portfolio. I don't use the word diversification because we don't assume asset classes behave differently in a particular way. We try to look through that in a more granular way to say, well, these subsets, let's say, of real estate in these geographies will behave this way, but some other type of real estate will behave differently.

22:27And then we try to run it through forward -looking scenarios. And so really our job becomes to take returns in a really good scenario and see if we can shift them to less positive scenarios, for example, either through a different asset allocation or through using option strategies or other things like that. In a world where you're expecting there to be more volatility across costs, whatever these factors are, inflation, equities, bonds. How do you dial up or down the investments you make in the dynamic asset allocation portion of what you do? There's a few different lenses on it. Probably the more important one is that we talk to each other a lot.

23:05So we talk about joined up whole portfolio investing. The joined up piece is our teams are talking to each other all the time about what they like, what they don't like, what they're seeing in the portfolio, what they think is attractive. We try to learn off each other and our fund managers, of course. If we see something that's attractive, we'd work together on it. So right now, real estate credit, for example, looks pretty interesting. There's a shortage of capital. And so our real estate teams and our credit teams are working together on that. So there's that piece. And then we have a more formulaic, more traditional dynamic asset allocation piece as well.

23:43And this is something that has changed since the work we did because we think the world is more volatile and we think it's worth investing more in capturing the benefits of the volatility because we have a longer term mindset. We don't mind if we lose money over the short term or if we are running tracking errors to some sort of benchmark. And so we can take a longer term view about whether there's fundamental value in something and take a position. And so we have built a dynamic asset allocation team that's doing that now across equities, different types of currency and interest rates, and they can move intraday if necessary, but usually less frequently than that.

24:27It's really just based on fundamental longer term value plus a few other metrics about the shorter term macro cycle. And that's proving to add quite a lot of value. We've always done that, but we've ramped it up. And so we try to analyze our own performance. We pretty much start with if we just had equities and cash, nothing else, and we ran our typical risk level, what would the return have been? And then we think we can diversify the portfolio, we can hopefully get some alpha and we can be dynamic. When we break down the returns over the life of the fund, 18 years now, we've added about 2 .5 % per annum, which we think is pretty good.

25:08And it's actually split, interestingly, only about a half a percent to diversification in the traditional sense and about 1 % each in dynamic asset allocation and alpha. But if you look over the last three years, actually diversification has been significantly negative because obviously bonds and equities have been correlated in a bad way, but alpha has been really, really strong. You mentioned that to make a significant change in the portfolio like that, you had to get the organization prepared to be able to make change because people are used to just doing what they've done and incrementally moving forward.

25:46How did you get the organization to change? So first I'd say I'm lucky because we didn't have to change from the opposite. We didn't have to fundamentally change. We just had to lean into the culture we'd already built and do more of it with an open mind. But we also had to do it with more people because we decided in this more complex world, we needed more people to do more strategies, to have more managers, to make more investments, to support those investments. And of course, to support the more people. Another part of the process was bringing the board along. It really has to start with the board because if the board said, here's your reference portfolio, here's your tracking error budget, it just wouldn't work.