How to Run a Multi-Billion Dollar Sovereign Fund ft. Peter Madsen

[00:00:00] Peter

We were really well-prepared for 2022. So, for us, we kind of stand back and say, we’re ready for this potentially new macro regime with a bit higher inflation, or maybe just a bit higher macro volatility on things like GDP, like inflation, the different tensions in geopolitics be it trade or be it conflict. I think we’re in a really good position for that going forward.

We’ve never really loved the idea of a really simple 70/30 portfolio. Having said that, if you don’t have the resources or bandwidth, and fees are a real problem or behavioral risks are a real problem, a 60/40 or 70/30 portfolio, that could be a great way to go. But if you are willing to be a bit more thoughtful and deploy a lot more resources, I think being more diversified and mindful of the different regimes and opportunities that are out there, then that’s a great way to go forward as well.

[00:01:03] Intro

Imagine spending an hour with the world’s greatest traders. Imagine learning from their experiences, their successes, and their failures. Imagine no more. Welcome to Top Traders Unplugged, the place where you can learn from the best hedge fund managers in the world so you can take your manager due diligence or investment career to the next level.

Before we begin today’s conversation, remember to keep two things in mind. All the discussion we will have about investment performance is about the past, and past performance does not guarantee or even infer anything about future performance. Also understand that there’s a significant risk of financial loss with all investment strategies, and you need to request and understand the specific risks from the investment manager about their products before you make investment decisions.

Here’s your host, veteran hedge fund manager, Niels Kaastrup-Larsen.

[00:01:53] Niels

For me, the best part of my podcasting journey has been the opportunity to speak to a huge range of extraordinary investors from all around the world. In this series, I have invited one of them, namely, Alan Dunne to host a series of in-depth conversations on the topic of what it takes to be a world-class allocator.

In today’s world, portfolio construction is fast moving to the top of the agenda of many investors as they tried to analyze and understand the riskiness of their portfolios. With ever-increasing uncertainty around the globe, being well-diversified across many different strategies and themes in your portfolio can mean the difference between ruin and survival when the next crises emerge.

The aim of these conversations is to try and understand the experiences that have influenced these highly specialized allocators and the processes they follow to harness the best returns for their clients so that we can all become better-informed investors. With that, please welcome Alan Dunne.

[00:02:52] Alan

Thanks for that introduction, Niels. Today I’m joined by Peter Madsen. Peter is CIO of Utah School & Institutional Trust Funds Office, that’s the State of Utah’s sovereign wealth fund. Peter and his team manage about $3.5 billion in assets.

Peter has been working in the investment industry over a number of years. He has served a range of institutional clients as a consultant and investment manager. Prior to joining SITFO, he was Managing Director of Cube Capital Group in London. Peter, how are you today? Good to see you.

[00:03:30] Peter

Likewise. Thanks for hosting me, a longtime listener, first-time caller, as they say. I’m a big Top Traders Unplugged fan, so it’s good to be on the podcast.

[00:03:39] Alan

Good stuff. Well, I guess you know the drill then, that we like to get people to talk a little bit about their background before we get into the meat of the conversation. So maybe tell us how you got involved in markets and investing in the first place.

[00:03:50] Peter

It was a bit of a circuitous path. I wasn’t quite sure what to do with myself early on, so maybe call it late bloomer in some ways with regards to investing. But my undergrad was in Russian, and really, the last year or so, I decided I was more interested in policy or economics, and when I went to grad school then directly after undergrad was started out in the policy program. It was called Commercial Diplomacy at Middlebury.

On one of the first days, orientation day, someone asked wasn’t really glad I was in the MBA program, and I realized that was actually some kind of message or sign. So I quickly took the GMAT and switched over to the MBA program and started learning finance and more of a quantitative approach to finance, etc., and ultimately just ended up with a bit of luck getting a job with a group that spun out of Russell and was working on management consulting for investment managers, and then from there just stay focused on institutional investing.

[00:05:04] Alan

Good stuff. Obviously, now your role, you’re CIO of this portfolio at SITFO. So maybe for people who are not familiar with how that’s set up and what the entity is looking to fund or achieve, maybe you could give us a bit of background on that.

[00:05:21] Peter

Yeah, of course. As you said, we’re effectively a sovereign wealth fund for the state of Utah. There are, if I’m not mistaken, 22 of us. We’re all slightly different. We all follow a framework that was set out by Thomas Jefferson. Depending on how well or how successful you’ve been in trying to manage that original investment policy if you will, or governance framework that was put into each individual State’s constitution, you may be more or less constrained.

When I started in 2015, we worked to amend the constitution to allow us to be more properly diversified. But we still have what we refer to as a corpus. So there’s a land management group. They, like many other sovereign wealth funds, try and optimize or maximize the revenues they can generate from the lands that they hold in trust or benefit of public education.

We manage that portfolio of financial assets, but any contribution they make, we’re not allowed to spend or distribute. So there is an interesting constraint on how we can build the portfolio. We need to be mindful of volatility as we have what we call a corpus in an earnings portfolio where the earnings is free to distribute or to use for expenses, fees, etc., but not for corpus.

[00:06:54] Alan

Okay. So in terms of the overall portfolio then, how would you characterize that? It’s obviously an absolute return objective, but as you say, you’re trying to minimize volatility and drawdown. Did I understand correctly that there is an annual draw on the portfolio? Is that correct?

[00:07:14] Peter

Yeah, that’s right. We have a 4% distribution. There’s a policy. There’s a formula around that. But effectively, it has a cap at present of 4%, and believe it or not, we’re going to try to amend the constitution again this year. So check back with us in mid-November to see how that goes. But hopefully, it’ll get up to 5%.

We think we can support inflation plus 5% because we have both the land assets generating revenue as well as the financial assets. That 4%, at present, and potentially 5% distribution annually, we want to make sure that that’s quite stable. So our distribution policy looks back five years and there’s some other stabilizing factors in there like population growth, student enrollment, etc.

As we look at that really slow-moving distribution where it increases just modestly over time assuming that over five-year rolling periods, our return is positive, that equates to us wanting to meet or exceed CPI plus 5% for our investment target. I think that’s pretty common. That’s not a unique to us.

The one aspect though that I think is slightly different, I think most folks would say it, but we definitely don’t have the priority on measuring ourselves against peers. We’re really focused on that CPI plus 5% outcome over the long run. We have, of course, a benchmark that looks at our asset allocation to see how well we’re implementing, and it helps manage risk and communicate with the trustees that we have looking at that framework.

We really want a narrow confidence interval around CPI plus 5%. We’re not really trying to beat it by 200 or 300 basis points and take on the extra volatility given that corpus framework that I mentioned. So we really prioritize the drawdown when working on asset allocation. That’s a big focus, less so a simple volatility number.

[00:09:16] Alan

Okay, interesting. Maybe just taking that a step further then, what does that look like or what does that lead you to in terms of asset allocation? I guess more broadly, how do you think about asset allocation?

[00:09:29] Peter

I was fortunate enough to hear Harry Markowitz and Peter Bernstein speak. I think Peter Bernstein referred to the 60/40, he might be the originator of the 60/40 portfolio, or at least he referenced it as the simple, almost equal-weighted version where you’re not really making any decisions. Markowitz actually just said that the best starting point or the best portfolio was just 50/50, for example. So equal weighting something is a good starting point. And that resonated with me.

As you go forward and you think of all the different asset classes you might want to avail yourself of, and you equal weight those, it might be a great portfolio on paper but maybe it’s not practical, maybe the volatility is too high or the return is too low, liquidity factors, etc. But as we built our asset allocation, that was a type of starting point. And then we use broad categories. We have growth, real assets, income, and defensive.

Most of those are risk-oriented. Defensive has volatility, but it’s meant to not have any equity beta. Then we have public and private in each of those, not in defensive, that’s all public and highly liquid. When we put those in the optimizer, we’re trying to have just public equity, private equity, public income, private income, etc., and work with running what we call mean downside instead of mean variance optimization.

We’re currently working on a conditional expected drawdown. We have a couple of risk-focused analysts here and that’s something that we’re working on internally. We’re also looking at working with a third party. We’re on more of a multivariate optimization that looks at things like liquidity, inflation regime, other types of regimes, and then we can use more of a real volatility, if you will, when you include private markets.

So when we put all that together, we have a little less equity beta I think than many of our peers, especially permanent capital-oriented groups, as we A, want to make sure that we don’t breach that corpus, and B, we want to make sure that that distribution is really stable. So it’s 43.5% in growth, 30.5% is in public equity, 13% private equity. All of those are broken down and split up by quite a few different strategy flavors as you might imagine, a little bit of hedge funds and venture and buyout, etc., across those.

In real assets, we also have both public and private. Again, very open to what’s included, but we want that to be primarily inflation-linked. So we look for either shorter duration contract or exposures to inflation, as well as commodity exposure. Naturally, we’ll get some equity beta in there which we’re okay with. But we try and avoid duration in that bucket.

In income, that’s more of a credit-oriented or call it a moderate equity beta portfolio where we break it out by corporate, credit, securitized or consumer structured credit, and then emerging markets, debt insurance-linked securities. So all of those. There are various hedge fund flavors you might imagine in that bucket.

In private debt, again, quite opportunistic or quite diversified. In defensive, I think it’s pretty interesting in that some folks would call it crisis risk offset or something to that effect. We have cash, short-term TIPS, 30-year strips, and macro and trend or CTA strategies broadly.

[00:13:23] Alan

Interesting. I think probably fair to say relative to a lot of endowment-type investors, certainly less economic equity beta as you say. Is that primarily driven by the concern around drawdown and the desire to be delivering a more consistent return profile?

[00:13:45] Peter

It is driven by that. It’s also consistent with a personal investment philosophy I have that there are plenty of opportunities to generate equity-like returns, maybe lower risk, maybe higher risk, but diversifying hopefully over the long run. As you step back and think about how much equity exposure you have through all the various types of markets that we invest in, we just don’t feel that it’s super important to load up on either public equity or private equity.

I think a moderate amount of both is sufficient. It’s still the primary driver of risk in the portfolio. We’re a little more sensitive to volatility, especially drawdowns and equities, the primary culprit there.

[00:14:33] Alan

It’s interesting because I was reading a piece by Edward McQuarrie recently. I don’t know if you saw his paper where he did a reassessment of the long-term returns of equities and it was in response to obviously Jeremy Siegel who wrote his book and it seemed to be very much a slam dunk that anybody with a long-term mindset should be almost exclusively in equities.

McQuarrie’s analysis looked at a different data set for the 1800s, so you might question how relevant that is. But then in the international sphere, there have been prolonged periods of individual countries where equities underperformed for a long time. So is that part of your thinking, a bit of a skepticism of being all in on equities?

[00:15:18] Peter

Yeah, most definitely. I read that research with, I have to admit, with a bit of glee, and heard him interviewed. He’s a really interesting presenter, and apparently, he’ll be on some panel somewhere with Jeremy Siegel, which would be nice to be in the room on that.

When you look back through longer periods of time or just open your mind to what might be possible in the future, you’re not necessarily relying on any historical analysis, you can make some assumptions that pretty easily look to different types of macro regimes or just where multiples are, where they might head in conjunction, and you could have- obviously, we’ve had or we could have another 10 plus year period where equities actually, at some point, have zero or negative return.

Meanwhile, there are lots of strategies that have some kind of carry or some kind of income associated with them. That’s guaranteed, so to speak, but that’s contractual, I should say. You can get that across various types of collateral, real estate, agriculture, consumer, insurance-linked, as I mentioned. That seems reasonable, if you can get a CPI plus 5%, or close enough to that type of return with those kinds of strategies, then they should be given their due in the portfolio.

I think a lot of folks, rightly so with permanent capital, look to a really long-time horizon. Yeah, we’ll have a period of 10 or so years of zero returns, but that’s okay. We have 50 or 100-year horizon, but it’s just really hard to actually manage to that time horizon, I think.

[00:17:04] Alan

Interesting. You talk about the various economic scenarios that could unfold, as you say, different regimes, different environments. As you take that and look at the current markets, do you form strong opinions and do you let the market kind of guide the asset allocation much? In particular, going back a couple of years, a lot of people said bond yields are very low, 60/40 is risky. It proved to be a good observation.

2022 proved the point that bonds and equities can go down together. But then we had 2023, equities said, well, bonds held in and now bonds look interesting, obviously at higher yields, so 60/40 is back to an extent. Looking through that whole period, has that impacted your thinking in any way or not?

[00:17:58] Peter

Maybe starting with the point about the macro regime and how that might influence us, we’re a pretty small team. We’re about 12 people in total, and that includes some admin, operations, finance, etc. We have a small what we call strategy and risk team. Everyone wears more than one hat on the investment team. But there are a few of us that focus on what I’d call strategy and risk.

We use the macro environment to try and inform our decision-making to some extent or at least just to have the broader context. So we’ll try and understand we call it the grid framework. We have growth, real assets, income, defensive. If you think about Bridgewater, I think they were the authors or architects of that, the different regimes and risk parity.

When we’re not doing risk parity, we are looking at those different regimes, the potential for say low growth and low inflation or some combination of those two. So that’s how our portfolio is constructed. And then when we look to the macro regime, we look to maybe we put some tilts on. More so though, we’re directing cash flows.

As I mentioned, we have revenues coming in each month, small amounts of revenue each month, and then we have that distribution. We actually send it out quarterly. So that gives us a chance to either lean in or lean out of certain parts of the portfolio incrementally. We look to that macro regime of basic leading indicators and research providers that assist with that to be a bit more sophisticated.

And then we have valuation and momentum models where we look to understand and have a systematic framework of what might be attractive from a valuation and momentum perspective. Those things generally have some rhyme to them over time. So that’s how we inform the marginal cash flows, if you will.

As we built the portfolio originally, given my comments earlier about not being part of the, maybe you could call it the cult of equity, and then thinking about a more diversified portfolio that does well or has the opportunity to do well in a multitude of different regimes, we were really well prepared for 2022. We’ve underperformed the 70/30 call it for the five or so years leading up to 2022. It really outperformed in ’22 and kind of kept pace in ’23.

So for us, we kind of stand back and say we’re ready for this new, potentially new macro regime with a bit higher inflation or maybe just a bit higher macro volatility on things like GDP, like inflation, the different tensions in geopolitics be it trade or be it conflict. I think we’re in a really good position for that going forward. We’ve never really loved the idea of the really simple 70/30 portfolio.

Having said that, if you don’t have the resources or bandwidth and fees are a real problem or behavioral risks are a real problem, the 60/40 or 70/30 portfolio, that could be a great way to go. But if you are willing to be a bit more thoughtful, deploy a lot more resources, I think being more diversified and mindful of the different regimes and opportunities that are out there, then that’s a great way to go forward as well.

[00:21:24] Alan

You say you’re not part of the cult of equity, but at the same time, equities are pretty much the largest allocation and definitely probably the largest risk allocation. As an allocator like yourself in terms of thinking about future returns, it strikes me if you read the research out there, there’s a wide variety of opinions as to what future equity returns might look like.

I think GMO published their seven-year forecasts that always seem to have negative returns in real terms for US equities going forward. At the other end, Jeremy Siegel himself as you say was saying there’s a 7% more upside in this year alone for equities. So always a broad range of views. In a sense, I guess it will probably depend on the regime.

Obviously, if we went back into a regime of higher yields, you could have a big rerating of PE multiples, but that’s a big unknown. So how do you think about that in terms of what’s a reasonable return expectation for equities in the public and the private space?

[00:22:37] Peter

When we run through our asset allocation every year, we do it as more of a stress test and a thought exercise than actually looking to change what’s supposed to be a long-term target. So we still collect capital market assumptions. We call them CMAs. We work with a couple of consultants and advisors, independent research shops, and we also monitor the industry broadly.

Folks like JP Morgan and as you mentioned, GMO, AQR, all these books publish capital market assumptions. We try to aggregate them up and we have a group that we call Valuation Sensitive, which would be the few and far between like Research Affiliates and GMO. We put them into a category. We have an industry average and then we work with our consultants to actually try and get closer to how we’re implementing.

For example, if we don’t just have a high yield allocation, we have structured credit, etc., we try and customize those capital market assumptions. When you look at them, as you say, the valuation-sensitive folks have call it a zero real return from US large cap. But if you looked at that year to year and tried to use it to inform your decision-making, you’d be either almost no equities or underweight persistently over time.

We don’t think that’s a great idea, so we try and look across those averages and just come up with the different scenarios that might happen. Most consultants don’t want to go to their clients each year or every two or three years and say, guess what, your new allocation of public equity should be 15 points lower. To say it differently, they don’t want to say your expected return of 7.5 is now 5.5 on your total portfolio. So they shade those, they move those 50 basis points one way or another at the lowest year over a year.

So if you think about that framework and you think about what numbers come out of their potential range would be something over the 10-year period for US large cap, for example, or maybe call it global equity just because even though that’s – because that’s 60% or 70% US, there’s a range of a zero to plus 5 real return over the 10-year horizon.

We’ll lean into over or underweight based on again our macro, our valuation and momentum framework more so than drop or change the asset allocation. But going forward, expected returns on US large cap look pretty difficult just given where multiples are now.

[00:25:20] Alan

Okay. Obviously, within each of growth and real assets and income, you have public and private in each category. Well, I guess it’s interesting because in this debate that we’re hearing now about 60/40, you hear some people saying it’s now going to be, say, 40/30/30 and 30 is in private. For some people, it’s 30 in alternatives. But obviously, you’ve done what I think is the right thing to do with putting the privates within the asset class rather than having them as a distinct category.

But from your perspective, is that just capturing what’s, I suppose, the standard view is it’s the illiquidity premium? Is that how you see it or what’s rushed out splitting between public and private.

[00:26:06] Peter

When we look at private markets, a long time ago, call it 20 years ago when I was getting started in the business, hedge funds were an asset class. You’d have a line item called hedge funds, or absolute return line item called private equity or real estate. While those are obviously very different strategies, public equity, private equity, or hedge funds, etc., the underlying exposures are what you’re after and then maybe the vehicle is related to the business model.

So as you say, we think of private equity as equity beta. We do avail ourselves of when the proper, I guess you could call it, or official statements come out, we use the volatility that we’re provided by the consultants when they calculate performance with the custodians. That’s a benefit to us. That’s a feature, not a bug. That’s one reason to include private markets.

But the other is a huge part of the economy, a huge part of the investable opportunity set are private securities or private assets. And as you know, I don’t remember the numbers, but the number of public companies is shrinking. The number of listed companies is shrinking. The number of private companies is actually growing. I don’t think it’s just proportional, but as the economy grows more broadly, it’s more in the private markets.

That is an opportunity for just call it diversification, like I said, that volatility. Cliff Asness calls it volatility laundering. That’s a feature for some of us, not a bug. You can model the risk, you can model the liquidity risk. While I’m not sure if there’s a liquidity premium or discount, I think there’s a debate there.

There’s pretty solid bit of evidence that the leverage these folks are able to use and the value add from operations, acquisitions, building companies, growing revenues organically as well, that should provide some strong outperformance versus just being a shareholder in a company that you think is going to be outperforming. Maybe it does, maybe it doesn’t.

Being able to be hands-on, be in control of the leverage and in control of operations I think should provide some premium to public markets. But that’s just a pretty basic standard view.

[00:28:22] Alan

Yeah. You touched on this debate with Cliff Asness, volatility laundering, etc. It is a bit of a bugbear of people in the hedge fund industry that the private markets are marked less frequently and seem less volatile. I guess the key question is, in a severe economic downturn, have you got more equity risk in the private side potentially or not?

[00:28:50] Peter

It depends on the amount of leverage that’s involved and in the quality of the companies. Maybe the sector exposure matters, for example, venture. If AI turns out not to be anything at all, then there’s going to be a world of hurt in our venture exposure. But generally speaking, I think that the equity beta in private markets, it’s difficult to calculate. We try and look at that. We try and model it.

There’s a couple of ways of thinking of it. One is those sensitivities are real but they will be marked at a lag. So as we calculate that equity beta, we have the benefit of it being diversified by time. So as the public markets are drawing down they’re informing the private markets, and in a world like COVID or something maybe like 2022, private markets maybe get marked down, maybe not, and then maybe stabilize because public markets, public equities are also rallying again, and that provides a sort of stabilizer, if you will, to the equity beta.

The real problem is over the long run, the general partners you’re investing alongside, if they’re not able to manage those companies well and exit well, then you have trapped capital that’s not performing or not delivering. That’s the real cost or risk that I think we face. It’s less so the drawdown or equity beta per se and more that managers don’t deliver and that capital is locked up for 12 or more years.

[00:30:25] Alan

Okay. Obviously, within income, you have private credit as well. That’s kind of been a bit topic of conversation of late I guess, very strong growth in that side of the industry and mixed views. Obviously, it’s a source of opportunity and return for investors. But equally, anecdotally at least ,some of the borrowing costs for some of the companies seem very high and tend to be a variable rate.

So from your seat, do you see that just as an opportunity? Are you in any way worried about something systemic in the private credit space?

[00:31:04] Peter

That’s a great question. The systemic risk is concerning. Like you said, on the one hand, we’re looking at really attractive rates that are being reported to us, where any given deal being inked as of late. Also is the underwriting that was done assuming you’re making some assumptions about rates and companies who are bearing that interest rate burden now.

But I think as long as we still call it extend and pretend from the macro perspective with regards to policy and solving some of the problems with the banks, I think that’s a phrase that we could use at the private credit, corporate credit level. However, I think there is actually some benefit to that.

If you’re collaborating, so to speak, or negotiating with the underlying companies as a GP, and that saves you, maybe it costs you a couple of points from what you might have perceived from your original underwriting, it’s better than putting that company out of misery or putting them into misery. Unless they’re putting them into misery from that perspective and this is part of your strategy.

We invest across the spectrum of direct lending or performing credit. There we try and look for smaller managers or I should say funds that make loans, smaller size loans to smaller companies, where they are able to have really strict covenants and they’re not price takers if you will. They’re controlling that obligation.

We also invest in the capital solutions or special situations type funds where they are there to help out a stressed company. We also invest in straight distressed or opportunistic where it’s either an off-the-run situation or its proper distressed and they’ll take over, maybe it’s a way to actually control the equity.

Given we’re diversified across those buckets and we have managers who will flex in and out of each of those categories as well, it’s not particularly concerning for us in our portfolio. We do see it as an opportunity. But it is definitely concerning if certain companies that are performing well, their interest rate burden has doubled or tripled in the last year.

[00:33:22] Alan

One area of your portfolio that’s definitely I would say differentiated is probably on the defensive side. You have, as you say, TIPS and then a category called systematic convexity. It seems to be trend following, macro, and long vol. That seems to be very much in line with the first responder, second responder kind of philosophy. Was that in mind when you constructed that portfolio?

[00:33:49] Peter

Yeah, definitely. I’ve got a fun anecdote at least, I think it’s kind of interesting, where I was new to institutional consulting, was working my way up to advising clients, supporting some of the more senior advisors. But being the mid-person, if you will, the client would often call me directly, they could reach me and just put me to work directly.

I got a call from a CIO of a state pension plan and he asked me what our views were on CTAs and strategies like global macro. I had to say, let me get back to you on that, did some research and walked around the office, put some interesting thoughts together of we have these fund of fund exposures across a lot of our clients, but as you look through them, it was almost all equity beta oriented in one way or another.

Maybe there was distressed debt, event-driven, lots of long-short equity, maybe some market neutral, mostly US-focused, mostly equity beta, hedged of course. And then when I looked at the industry data and ran some correlations, some basic work that you might do as a consultant, pull up the HFRI indices, etc., like, wow, these global macro and CTA strategies are worth considering. Why don’t we have more exposure there?

I did a bit of research, brought some folks into the office, some big names, and had educational sessions on what is global macro, how’s it different from GAA or GTAA, what’s the difference, and what is CTA, what is trend. At the end of the day, the firm decided that wasn’t something we wanted to pursue for our clients. Believe it or not, this was, I don’t remember the exact timing, but it was at some point in 2007, maybe early 2007.

Of course, certain names, and a lot of trend managers did really well in that timeframe, as well as long duration, high quality. Usually there’s a flight to quality bid on those types of securities. So just learning from that experience of those are long-lived hedge fund strategies, you need to do the homework on how to build this portfolio, how to work with these managers, the behavioral risks are really important.

So when we’re thinking about this part of the portfolio, by the way, it’s 7% of our portfolio and then we have 5% in what we call GRIPs, which is just a made-up acronym for government interest rate products, duration, short-term TIPS. We use the term first responder, we talk about the private equity types of drawdowns, etc. Our view is we think CTAs and macro can hedge us against most importantly equity beta, but then secondly, or thirdly, in interest rate risk slash commodity risk or shocks.

So we think that’s a great tool to have in the portfolio. Obviously, very liquid. When we put that portfolio together, we’re trying to find strategies that have that convexity early on, means quite strong. Maybe there’s a bit of whipsaw risk on those faster speeds. Macro strategies tend to have that property as well.

When we think about what would actually hurt us the most, it would be a long, protracted drawdown, something maybe akin to the GFC or worse. Maybe the drawdown level is only similar to the GFC at level, but maybe the duration is actually longer. That’s when the private markets exposure, especially private equity, would be most painful for us. So we do have somewhat of a bias to medium and long-term trend following strategies as well.

We had some experience with tail hedge strategies and we’ve decided to move away from those types of exposures. We had some what we’d call carry or diversifiers in that portfolio at some point to the kind of pay for the tail hedge. At the end of the day, we took both of those off and decided we actually just wanted trend and macro, especially given the view on the economic regime where maybe cash runs at 2% to 4% somewhere in there over a period of time.

Maybe it doesn’t stay at 5%, maybe it goes higher. But that’s a nice backdrop for both trend and macro strategies. We actually really want that convexity. We don’t want it muted by either the carry and we don’t want to pay the cost of the tail hedge. We really just want the convexity.

[00:38:30] Alan

There are a few interesting points to bring up from that. One, going back to your experience with the firm in 2007 who did all the analysis, convinced themselves for the benefit of CTAs from a pure portfolio diversification perspective, and still didn’t invest. Why do you think that was? More generally, it’s a question of why more people don’t invest. I have my own views on this, but curious to get your thoughts on that.

[00:38:59] Peter

Yeah, it is a bit of a mystery. I left out a little bit of extra context. After working at RVK, I worked for a hedge fund group in London, and we had both direct and multi-manager programs that we offered. In the multi-manager program, there was an allocation. That’s where I got the term defensive and borrowed from this idea. We had macro and trend. We had tail for a bit. It was standard protocol.

In Europe, I’d say it’s a pretty common hedge fund strategy to include in your portfolio. Maybe it’s not in everyone’s, but more common than in the US. I think there’s just this somehow maybe it’s because when you have your home bias and you’re in the US and US markets have done so well from an equity perspective, private equity, public equity, both, that you think the need for diversifiers is less important. I’m not sure if that’s quite it.

Because people in the US endowments, etc., they like hedge funds, they like quant strategies. But for some reason, there’s a bias against CTAs and global macro and I can’t put my finger on it. I’d be interested to hear what your thought is.

[00:40:15] Alan

I think it depends. I think in some places, very often people running multi-asset portfolios come from a bond or equity background and they just are not comfortable or familiar with the strategies. I think that’s one thing. Obviously, the return profile is very different. Zero correlation means zero correlation. So you will have periods when equities are doing well and these strategies are not, and that can be challenging I know for people to hold. But it is interesting.

I guess another point to ask you, you classify them in the defensive bucket, which I guess is not unusual. But obviously, CTAs and macro can in theory make big returns in many different types of environments. Obviously, at the moment, CTAs I’m guessing would generally probably be long equities, possibly long bonds as well. But they have that kind of all-weather potential.

Obviously, they have drawdowns which can be lengthy as well. Are you looking at them primarily as diversifiers, as vol dampeners, or are you also thinking of them as return generators?

[00:41:27] Peter

Yeah, good question. The framework we have set for ourselves is that the defensive bucket overall needs to be a zero or negative equity beta, expect a zero correlation, and cash or inflation plus 2.5% return. So it’s a pretty low return hurdle. You could think of that as an opportunity cost in some ways. Now that yield is more attractive, yields on bonds are more attractive. Those are part and parcel of that portfolio.

But the expectation we have for both macro and trend is we like that the convexity is two-sided. We want to see both outperformance when markets are drawing down, and we’d like to see participation when markets are rallying. We think that’s possible for these strategies. I think macro tends to include some momentum trading. Sometimes it can be quite contrarian.

We do have a positive overall modest expected return that I would say is competitive with for example what the capital market assumptions are for broad global equity markets. I think you can expect a 6% or 7% return from a portfolio of trend and macro managers over the next 10 or so years. That’s a reasonable if not optimistic assumption for global equities as well.

[00:42:54] Alan

Absolutely. People always talk about their allocation to these strategies, but obviously, from a portfolio risk contribution, a lot depends on what level of volatility the underlying managers are running at. So how do you think about that? Are you targeting a level of vol for that kind of element of the portfolio or just generally looking for typical CTA type vol? What’s your thought process around that?

[00:43:22] Peter

Since we’re a smaller, $3.5 billion is a lot of money, but we don’t have the resources or capital allocated enough to do separately managed accounts. So our version of capital efficiency is effectively to just go into the highest vol share class that’s on offer. Vol adjusted fees, as you know, they’re depending on the manager working with, but reasonable.

From an optics perspective, they’re higher on the higher vol share class, but it is more capital efficient. And then these strategies are quite diversifying one against the other as well, in some cases doing some similar things. A very fast manager trading intraday or shorter than a week and focusing more on say vol breakout versus a more simple or what you might call pure trend type of strategy, more medium-term and maybe fewer markets, those two are going to be quite different. So we think the higher vol can be offsetting.

Most importantly, when we zoom out to the total portfolio level and the contribution to risk when we model this out because actually, it’s negative, if you will. So we show contribution to volatility. You see obviously the public equity portfolios peak the one way over on the right and then you get this small little negative contribution from the defensive bucket in the strategies underlying.

The one thing I think is really interesting is over the year between the GFC, I think there was an increased interest in trend-type strategies after the GFC and macro. People started to think they should be including them. I think some of the funds or funds before they ended up going by the wayside where lessons learned were we should have some macro and CTA or trend type managers.

I think that interest waned pretty quickly, which I think has happened already here in the US in 2023. I think a lot of the managers started adding what we call carry or diversifying components models to those strategies to reduce that volatility to get a higher standalone Sharpe. We’re not interested in that at all. So back to your volatility, not necessarily the higher the better. We want a high volatility because that’s how we get that really strong convexity potentially in a big drawdown.

[00:45:51] Alan

Makes sense. As you say, in theory, getting 6%, 7%, from a portfolio of CTAs and macro managers should be very achievable. It does bring up the whole topic of manager selection. It’s probably very achievable as long as you avoid the small number of managers that have really significant drawdown. So, from your perspective, having done this for a number of years, what would you see as the pitfalls of manager selection or the things that you try and avoid, or the behavioral biases that you have to be aware of when you’re selecting managers?

[00:46:29] Peter

That’s a great question. It’s such a difficult job. I think the soft, I was going to say the soft skills, but the qualitative aspects are really important across many of the strategies. To the extent you’re trying to get, for example, a cutting edge, quantitative type of strategy that’s probably found in a hedge fund and you want it to be evolving, learning, adopting all the latest technologies, the culture matters there.

Are they collaborative and can you understand the research process, who’s responsible and how those ideas come from various sources and from junior folks and are able to make their way up through that trust framework at the investment manager’s shop? Can that actually happen? You develop successfully and consistently. That would be really important on the quantitative side on those qualitative skills.

But sometimes, we’ve invested with a long-standing trend manager who hasn’t really updated their model. I think they’re not able to raise a lot of assets maybe for this reason, but a really interesting track record. The culture is maybe, really you just need to focus on do they have enough people running that, model executing that strategy, who are willing to stay? That’s almost all of the due diligence for that one.

When you think about other strategies that are more active risk in terms of the fundamental side of things, that culture aspect can become really important. So trying to understand personality traits or personality characteristics, how they come together at the firm, and how that decision-making framework either avoids or mitigates behavioral biases or doesn’t hinge too much on one key decision-maker who isn’t able to be challenged, those are really, at the end of the day, what we’re trying to assess.

Otherwise, we try not to look at the track records and have them inform our decision entirely. But it is very powerful in modeling to be able to look at a profile and say, what we try and do is create these strategy peer groups for example and group managers together and then model their returns so that we can say this must be a strategy beta type that we can model versus just the path dependency of one single strategy, one manager, that’s their particular experience.

So we try not to look at just have they had good performance over the trailing three, five, seven-year period, but look at what the distribution looks like for a strategy type and how it benefits the portfolio.

[00:49:30] Alan

Okay. As you say, you try not to overly emphasize the historic track record, but it tends to be difficult to fully remove that from consideration. So if you’re looking at three, four, or five trend following managers, would performance be an important deciding factor or not generally in that type of scenario?

[00:49:57] Peter

We try to look at rolling time periods and see where they are in their own individual cycle. Maybe long-term or slower-speed managers are underperforming recently, and if you have a type of strategy peer group, that might be an observation you can see.

For example, the manager I referred to earlier, they’re actually in a drawdown right now and we’re pretty happy about that because we’re gearing up to work with this manager and invest and we’d like to see them in a 20-plus percent drawdown because it looks like once they’ve achieved a 20, it’s gone further south, but averages out around 20 or so drawdown high vol managers, pretty normal, that’s a good time to invest.

Another example would be when we look at say any kind of strategy, we’ll look at the manager who maybe has underperformed recently. For example, we’ll look at 2022, look at the managers. Right now we could have really fresh data for say a public equity strategy, we could see that all the managers who are performing really well right now, their end period number, their one, three, five-year number might look really great because it’s so input sensitive.

Maybe if we dial it back to 2022, we want to look for who actually did well in 2022 that looks poor right now, and what drove that decision. That’s another way of mitigating. When you look at performance and how it might impact your decision, try to look for the manager who’s underperforming now and potentially will outperform over the next course of the cycle.

[00:51:41] Alan

All of that sounds very sensible but not necessarily something that will always be shared by everybody. Some people will tend to place more emphasis on certain things or be more likely to allocate based on performance. How do you construct your own decision-making process to be most efficient?

In terms of your own investment committee, are you aiming for this diversity of thought, or do you like to have, well, diversity of thought is fine, but everybody has to have a common framework or a common philosophy? How do you think about that?

[00:52:20] Peter

We have the good fortune of having a governance framework that was designed by a group of professional investors and that was put into what we call statute here, the legal framework which governs us as a public agency. So our staff at SITFO afforded manager selection. We don’t need to have our trustees approve the managers we select.

So we work in a collaborative process with third parties like consultants or advisers or other networks or maybe individuals that are trustees as part of how we come to a shortlist. But once we’re working on that shortlist and really diving deep, we try to limit the decisions for them to move forward to being the folks on our team who are shepherding that through the process.

And then at certain steps, we open it up to the whole team and they will come to a meeting, will come prepared, and be able to challenge each other on what the underwriting assumptions are. But the idea is that you should be willing and able to challenge the person who’s underwriting the investment manager. That person should be able to receive those challenges without feeling like they’re being criticized. All of that needs to happen within a common framework, as you said.

So we have investment beliefs that are available on our website, which include beliefs or philosophies for each asset class, as well as we will have a thesis that we set forth before selecting a manager. There are things, overarching beliefs about passive versus active, or working with smaller capacity-constrained managers, those things can kind of be true throughout the portfolio. But then, maybe, before looking at something that’s fairly narrow, we’ll make sure and develop a thesis or say, venture in Europe: why are we going to venture in Europe, what’s the thesis behind that, what are we looking for when we do go into venture in Europe, and then work through the selection process.

So there’s principles that guide our decision-making throughout. The meeting is not going well if everyone’s just nodding along and thinking that everything looks great. We don’t want to just have random questions without a solid, fundamental point to challenge, but we definitely need to be thorough and that’s the best way. I think it’s pretty similar across allocators in that way. We just try and optimize as best we can.

[00:55:06] Alan

Ultimately, is it a decision by consensus, by majority, or CIO final say? How does it go?

[00:55:15] Peter

I have the final say on investment decisions. I shape a lot of the decisions early on. We will have team discussions, what we call idea generation, and people on the team will bring ideas from conversations they’re having elsewhere. We’ll socialize those and we’ll work together to set priorities. But I’m ultimately giving the direction and ultimately, I have veto or approval power.

But if there’s anyone on the team who has a strong objection or would like to veto the strategy, if we can’t resolve that, then we won’t invest in the strategy. So if somebody who’s underwriting comes along and says, you know what, I’ve come to this red flag here, I really think that we can’t move forward with this manager any longer, we might have a discussion, maybe I’ll get on the call with the manager to make sure we didn’t misunderstand something.

But ultimately, I’m not going to push something forward where somebody has done more work than I have and has come to a conclusion that this is not a good investment. So it is collaborative. It’s not a democracy per se, but it is collaborative.

[00:56:27] Alan

In terms of exits from managers, making that initial allocation is often easier. It’s the tricky situation of the manager in drawdown and trying to decide if performance is outside expectations. So how do you think about that? How do you guide the team in terms of thinking about that as well?

[00:56:48] Peter

Yeah, that one’s tough because it’s easy to get I don’t know if you could say demoralized around manager underperformance. Behavioral risk gets really strong when you’re presenting to your trustees and you’re showing some underperformance. It’d be nice to be able to say this manager has made a mistake, not me, and so we’re going to rectify it.

Really, we have to make sure that we understand why we would be firing this manager in the first place. We call it a pre-mortem and we have a checklist of sorts where we go through all the things that could go wrong, have gone wrong in the past, or lessons learned that we’ve borrowed from other folks. We try and make sure that we understand what could go wrong and then we put what we call our thesis memo in advance, a rationale for firing the manager.

So when the manager is underperforming, we revisit that statement. Why would we fire the manager? If it’s a certain person left or strategy drift or whatever those elements might be, then we have to hold ourselves accountable and make that decision, make that determination. We might actually, or I maybe, I might actually be overly patient because I’ve seen the research, really concerned about behavioral biases, and seen a lot of examples of mean reversion at the active manager level that really go against firing managers based on short-term performance.

So it does happen. It has happened a few times, but maybe let’s say a handful of times in the last eight years.

[00:58:28] Alan

Do you find with your pre-mortem, is that pretty good at capturing the full set of reasons why you ultimately might get to remove a manager, or do you find other factors come along that you hadn’t anticipated?

[00:58:39] Peter

Other factors come along. Yeah. We had one manager that was a macro manager that we no longer work with where it seemed that there were some changes on the team but we were willing to overlook that. One key person was no longer on the team but still at the firm promotion if you will. We thought, that’s not the reason why. Underperformance preceded that. It was persisting and then it got protracted and maybe worse.

It seemed that as we spent more and more time with the team, that they were losing confidence in themselves and were having a hard time sticking to what their thesis was. Not that people should be able to change their mind, but it seemed like it came from a place of uncertainty, and less so from a place of the process driving those decisions.

So we ultimately parted ways with that manager. I think we saved a few bucks, but it was a long period of persisting with the manager with high volatility in the midst of a pretty protracted drawdown.

[00:59:57] Alan

Okay, good stuff. I’m conscious of time. We’re coming up towards the hour, so we always wrap up by just getting our guests to offer any advice that they may have for people who are maybe starting off in their careers or people who want to develop a career as a CIO or global macro investor. What are the things that you’ve done or read that have been particularly helpful in terms of your journey to becoming a CIO?

[01:00:23] Peter

Being intellectually curious is probably the most important thing. For any investor, being call it a team leader, being responsible for things like vision and macro strategy, if you will, or just the framework for decision-making, as well as being able to look out over time look across the portfolio and the opportunity set.

You really need to be open-minded, really curious. That means doing a lot of reading, a lot of homework. I like the fact that I was a liberal arts major. I studied Russian. I learned a lot about Russian culture, Russian literature. I learned a lot about the Soviet Union and how that regime operated, and then traveled quite a bit. That gave me a really good framework I think for looking past the home bias that we tend to have here. I think it’s especially pronounced in the US.

If I’m thinking about my younger self, I talked to a lot of people to find out what I should be interested in and how I should proceed, what pro tips people had, what advice. I would do as much of that as I could. I have three daughters, all in university. One’s looking for an internship and I said you need at least 100 phone calls to really have a sense for- talk to anyone tangential at all to what you’re interested in. Ask them as many questions as you can, build on each conversation, where you really have any inkling of what it’s like to be in that career role or that industry.

I think you asked about what books to read. There’s a new one that I think a few of us are all talking about. It’s by Ana Marshall. I think it’s called the “Investment Climbed Excellence”. I was an adjunct professor for a couple of years here at the University of Utah. I taught an institutional investing class. It would have been nice to have that book. I would have used it as my textbook.

Of course we read David Swensen’s book “Long-Term Capital Management”, a few others. But the coursework overall and how that generally followed the nature of that book which really covers the role of an institutional investor I should say, maybe an allocator, starting with governance and what that includes, building teams in the process, etc.

Another interesting book that I think allocators should read or people who are interested in managing portfolios more broadly, multi-asset class portfolios, is called “Strategic Risk Management”. It’s Cam Harvey, Sandy Rattray, and is it Otto Van Hemert? I’m sorry if I’ve gotten that wrong.

[01:03:16] Alan

I know the book you’re talking about. I have that one as well. Sandy Rattray, definitely, Cam Harvey. I can’t remember the last person.

[01:03:26] Peter

I think they’re all three at Man or affiliated with Man or were at Man one form or another at the time. In that book, I think the chapters are pretty straightforward and it’s really focused on some I don’t want to say basic or oversimplified, but those techniques of volatility targeting, including trend, being mindful on how to manage drawdowns.

Those are all tools that I think allocators tend to not avail themselves of necessarily because a lot of folks want to set the long-term allocation and then really focus on manager selection. I think that’s super important. But the risk management piece can be somewhat active as well with some broader tools from quantitative managers like trend managers, macro managers that asset allocators could use as well.

[01:04:15] Alan

Okay, great. Well, that’s a very comprehensive set of recommendations. So, Peter, thanks very much for doing this. It’s been a great conversation. Make sure to follow Peter’s work because as you can tell from today’s conversation, it’s an uncertain environment we’re in and more important than ever to be informed in terms of allocating capital. So from all of us here at Top Traders Unplugged, thanks for tuning in, and stay tuned for more content.

[01:04:43] Ending

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