Managing Money Through Structural Shifts ft. Richard Urwin

[00:00:07] Richard

Managing money, it’s a bit more like entering a dark room. You know you’ve got to get to the other side. You know there’s lots of obstacles in the way. One thing you don’t do is go, “Well, we’ve identified our path we’re going to take and we’re going to stick to it.” So you navigate a bit, you hit an obstacle, you work your way around it. I think that’s how a lot of successful money managers operate in practice. They might, in terms of describing what they’re doing, go heavy on the big theme stuff because it’s fascinating and it’s really interesting, but it’s not necessarily the major source of returns for that many managers.

[00:00:46] 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.

[00:01:42] 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 try 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.

[00:02:45] Alan

Thanks for the introduction, Niels. Today, I’m joined by Richard Urwin. Richard is Chairman of the Investment Committee at Saranac Partners in London. Saranac Partners is a UK wealth management firm managing $6 billion in assets under management and advice. Prior to joining Saranac, Richard was Head of the Outsourced CIO function at BlackRock in Europe, responsible for $80 billion of assets.

Prior to that, he was Head of Economics and Asset Allocation at Gartmore Fund Managers. Earlier in his career, he spent time at Warburgs and at the Bank of England. Richard, great to have you with us today. How are you?

[00:03:21] Richard

I’m good. Thanks, and a great pleasure to be with you. Thank you for having me on.

[00:03:25] Alan

Not at all. I gave a brief introduction, and obviously, you’ve had a lengthy and distinguished career I think it’s fair to say. Tell us in your own words how you got involved in economics and markets and what’s brought you to the role at Saranac.

[00:03:39] Richard

I got into it by being slightly unimaginative. I did an economics degree, I did some postgraduate work, and then I joined the Bank of England as an economist. That was something I was always interested in, I wanted to do. I spent six years at the bank. A fascinating place to work. While I was there, I was the bank’s US economist. I worked on UK monetary policy and then helped to coordinate the bank’s world economic forecasts. So all interesting experiences.

Warburgs was interesting because that was a shift away from being just a specialist economist and focusing more on the application to markets. Gartmore when I joined was one of the big four institutional managers of money in the UK. I was very heavily involved in asset allocation there. I did a few other things. I think the most interesting one there was setting up an in-house fund of hedge funds because there were a number of hedge funds within Gartmore and we put them together in a fund of funds. That worked out well. Interesting thing to do.

I joined BlackRock to work in general on multi-asset issues. But after I’d been there for a couple of years, there was an area which seemed to be growing very quickly, and this is institutional investors running complex portfolios who needed some help in doing so. When I joined, there was one client who fit in that category, and I started working on that full time after I’d been at BlackRock for a couple of years and we built up that business to over 20 clients and $80 billion. So those were the three main phases prior to joining Saranac.

[00:05:21] Alan

Good stuff. And obviously now in the wealth management business. So tell us a bit about Saranac and what the approach is there and what your own role is.

[00:05:31] Richard

I think we’re probably getting close to the 10th anniversary of the gestation of Saranac as an idea. Some current colleagues who I’ve worked with ever since I’ve been at Saranac were working in the wealth management division of a large bank and they felt that it was not possible in that framework to service higher-income clients. So they thought there was a gap in the market to service the high-wealth brackets, and Saranac was set up to be the partner of choice for individuals, families, family offices, and business owners.

So the genesis of the idea was 10 years ago. We started managing money in 2017 and have been doing so ever since. I’m also about to say that Saranac was a startup, but given that we’ve been going for quite a long time, I think it’s no longer a startup. A boutique, yes. Startup, No.

[00:06:32] Alan

Okay. You’re Chair of the Investment Committee, and I think you’re responsible for asset allocation. Obviously, you come from very much an institutional background. Has that been a notable shift being in the private wealth industry or do you think it’s the same problem for everybody?

[00:06:48] Richard

I think at some fundamental level, all investors are trying to do the same thing, which is to get as much return as possible for as little risk as possible. I think that very high-level generic objective translates across all investors. But there are some differences. I think the biggest one is on the institutional side, particularly pension funds. We’re running quite complex LDI overlays. Obviously got a bad name when we had the Liz Truss fiasco a couple of years ago, but actually, these were quite integral to the management of many pension funds and most of them didn’t have an issue at that time.

But those are just not needed in the private wealth sector. I think the big difference I’d probably draw attention to is obviously there’s a diversity of clients on the institutional side, but I think there’s a greater diversity of clients in private wealth. So the range of things that people are trying to achieve is much more varied. I would say the tolerance for risk and return there is…

We run money for clients, just running cash plus strategies, treasury managements. We run very aggressive risk-on portfolios for people who want the higher returns. So to me the big difference is we have to cater at Saranac, and it was the reason it was set up, for a very wide range of idiosyncratic bespoke portfolios.

Going back to why Saranac was set up, it was felt that in a large bank, the solutions offered to clients tend to be too limited. So whatever the question was, the answer was pretty much the same. Whereas we’re dealing with a much broader range of issues, and we run much more bespoke portfolios. So I think, to my mind, that’s the big difference.

[00:08:49] Alan

Okay. Interesting. Is there a unifying philosophy or framework that you bring in terms of the investment approach? Obviously, for different clients, different mandates, there’s different risk tolerances and investment objectives. But would you say there’s a particular philosophy around how you invest? Would that be fair to say?

[00:09:10] Richard

I think we’ve got different processes in different areas. But I think that there is sufficient difference between the different areas that it’s either very hard to have an overriding philosophy or it’s just not necessary to have one. So I think the overriding philosophy is probably much more at the commercial level, which is, we’re going to spend a long time with our clients trying to understand what they’re trying to do and help them to achieve that in the most effective way.

So I think that that’s the unifying factor. But if I look at the way that we manage money directly, it’s very difficult to say that the fixed income mandates are managed in the same way as the equity mandates because it’s hard to find a common factor. So the common factor would be let’s try and manage them well, which to me means explaining how we’re going to run those dates, understanding the client’s risk tolerance, and deliver on those grounds.

But sadly, no overriding investment philosophy which covers the very wide range of asset classes we’re involved in, including private markets as well.

[00:10:21] Alan

So it sounds like you’re using all the levers available to you. Presumably, you’re using active and passively managed funds, and you’re using individual securities, and you’re doing some in-house and some externally. Is that fair to say you’re using all of the above?

[00:10:36] Richard

Yeah, I think that’s right. We’re very clear that we think that we can do some investment management in-house. I’d say I think we’ve got a pretty good track record in fixed income, in equities, in multi-asset. But again, depending on the client, we don’t have an aversion to passive mandates at all. Why would some clients have passive mandates in their portfolios and others be active? I think it comes down to a couple of things.

One is cost. If you’re a large investor these days and you’re investing in large-cap equities, you can probably get your passive exposure for a couple of basis points. It’s incredibly cheap. Active managers charge more than that. I would say that most of the time, the passive managers are going to be somewhere in the second quarter. Last year, depending on which particular area of equity markets you’re invested in, it might even have been first quarter, given concentrated nature of markets.

So there’s nothing wrong with passive because it’s cheap, you know what you’re going to get, and you don’t have to do much oversight on it. But this doesn’t mean that there’s a big theological debate, as far as we see it, between active and passive. So why would you be active? It’s because you want to do better than that benchmark return. Finding managers who do that is not straightforward. It’s not axiomatic that if you’re an active manager you outperform. But we have respectable performance in equities in that area. There are other managers who also have respectable performance.

In particular (I’m just talking about equities here to illustrate it, I won’t go through every asset class) we don’t really have the expertise to do a lot of security selection in emerging markets. Over the past few years, sometimes we’ve been passive there, sometimes we’ve used active managers. But the choice between the two tends to be very much on pragmatic grounds rather than active management is good and passive is bad or vice versa. I think the whole industry has moved on in that way.

I can remember back in the ’90s, it was much more of a theological debate. But I think there’s a recognition, particularly given the rise of ETFs, that now that you can break down the equity indices so much, the distinction between active and passive is getting pretty blurred anyway.

[00:13:06] Alan

Interesting. Well, maybe just to kick off into the investment discussion, you’ve been in the industry a long time and doing asset allocation a long time. So from the perspective of where we are at the moment, it strikes me it’s quite a changed environment maybe to what we were in during the 2010s. But a lot of debate still around have we seen a structural shift or was it more of a transitory bump in markets linked to COVID, etc., and that we’ll eventually move back to the low rates world?

How do you see that and how does that inform your asset allocation thinking?

[00:13:46] Richard

Well, I think that it’s difficult. By the way, let me take a step back here. We don’t see there being a huge differentiation between asset allocation in some of the investment decisions that we make. Country selection in equities will tend to lead to our equity team because they’re better placed to take them. So occasionally, we might run overlays, but a lot of the time, we don’t. So we don’t see a hard and fast distinction between asset allocation and security selection. There’s a gray area there.

What we’re trying to do is understand that where we’ve got themes in portfolios, let’s be careful that we’re not doing something which is inconsistent in a multi-asset portfolio. For example, if you’re very overweight fixed income at the asset class level and the managers are shorter duration as they can possibly be, then there’s something going wrong. So we try just to make sure that we we’re running positions which are consistent.

I think there’s an added bonus by adding a very good level of communication across the board. But I’m straying off subject a bit, so let me come back and try and answer the question. In general, I think when you’re doing asset allocation, it’s wrong to have a time horizon of two to three months. We do spend some time worrying about near-term conditions. So we are interested in the technical aspects of markets. Are they overbought? Are they oversold?

We have our own measure of risk tolerance. Other people who we use as research partners have them as well. So I think all of that’s important, but you’re not doing asset allocation properly if you stagger from a period when markets are overbought to when markets are oversold. So I think what we try to do is build up a picture of what we want to do based on three things.

The first is the valuation background. We do 10-year forecasts. I started doing them back in the 1990s and I was very skeptical they would add much value. However, having been through a good few 10-year cycles now, I’m quite a fan, not because they’re helpful in tactical trading, but because I think that they are helping to shape an understanding of the market opportunities.

Where we stand at the moment on this very high level and very thematic is that we’ve seen a very big compression in expected returns across the asset classes. So at the moment, I’m going to quote point forecasts. Please don’t take them too seriously. They’re also magnitude. But at the moment, you can get, in the US, five and a bit percent by investing in just putting the money in the bank. Obviously, you’ve not been able to do that for 10, 15 years.

So what do you get if you put your money into longer duration, you start taking some credit risk? Well, maybe you get another 150 basis points. What do you get or what is our expectation of what you’ll get on the equities front? Obviously, equities are a very volatile asset class. But the center of gravity to us for large cap equities seems to be coming out let’s call it 7% to 8%. Now, is it worth having? Yes.

So if you want to make some money and you want to allocate to the better returning asset class, it’s still equities. However, looking at global equity returns, that’s going to be much less than what we’ve seen in the past 10, 15 years. The US in that period has been averaging 10% to 15%. And that spread between cash and equities is quite compressed. Now, this doesn’t drive everything that we’re doing in portfolios, but it is making us more cautious than we normally are in terms of equity opportunities.

So we probably have a bit less in equities than we usually have, a bit more in credit. And also, we have more in a range of alternative asset classes because we think we can get the returns and they’re going to provide returns in a different way that bonds and conventional equity markets don’t.

[00:18:08] Alan

You raised some interesting points about the 10-year forecasts. You do still see quite a wide range in those forecasts. If you look at say GMO publishes forecasts which tend to have US large cap, something around zero to maybe AQR, I don’t know, top of my head might be 4% or 5%, and then others that are 7%, 8%, 9%. And you kind of wonder, given that a lot of these providers break them down into components, it is surprising maybe that you see such a divergence.

But then some of it does come back to things like do you believe in reversion to the mean in margins and things like that? Which, I guess, you kind of have to have a fundamental view on the shape of the world for the next 10 years. So I suppose, would those valuations be a key driver of your asset allocation or are they a framework to think about? How confident is that kind of point estimate for those asset classes?

[00:19:05] Richard

Well, I would be absolutely astonished if we’re talking 10 years down the road, and it turns out that our last point estimate turns out to be right. But to me, this is about orders of magnitude. I’ll give you a more specific answer to your question. We’ve been in a world which has felt very volatile and challenged for equities for some time. But the reality is, ever since March 2009, we’ve been in a pretty prolonged bull market where the returns have been way above the historic average.

So I think it’s good to understand where those returns came from and why there might be low returns going forward. You raised some other firms who have different forecasts, and there’s different ways of putting these forecasts together. If I’m honest with you, there are some very big numbers out there. My feeling is that (I’m mentioning no names) those may be more marketing-driven than fundamentally-driven.

So where are the uncertainties in doing these sorts of projections? I think there’s two which probably differentiate the various forecasts you’ve talked about. One is valuation levels. I’m guessing GMO, given their view on the world, just think that multiples are way too high, because historically, they’ve been slower. So I’m sure they’re building in a huge valuation correction. Another differentiator is how you do the profits.

Let’s make the heroic assumption that you can calculate a long-term trend in profits. Well, at the moment, we would seem to be at the active level way above it. So I think if you want to come out with some very negative forecasts, you say that valuation levels are too high, profit margins are too high, and they’re going to mean revert, and then you get to numbers which are lower than our very, very, very approximate seven-ish percent.

I’m not saying that our methodology is better than anybody else, but just on the two differentiating issues. Here we are, April 2024. Is the average multiple high? Not quite as high as it was a couple of weeks ago. But you break it down, and that high multiple is primarily in the US. The UK is not an expensive equity market. European equities are not expensive. Chinese equities, just on simple valuation metrics, they’re not expensive. The US is expensive.

Is the whole US equity market expensive? Well, no. It’s not. It’s that if you look at the equally weighted S&P, that’s probably trading more in line with historic norms. So all of that valuation bulge, or maybe not all, but it’s primarily concentrated in that large US cap segment. So you then ask the question, are these valuations bubble-like? Are they inevitably going to turn over?

I’m going to make some big generalizations here. But these companies, it’s not like 1999. They’re very profitable. They throw out huge amounts of cash. Their balance sheets are very strong. Unlike in the past, and this is why I think you have to be careful about mean reversion, these companies are clearly not limited to the US in terms of what they do. So very bearish people. So we’ll look at the ratio of equity markets in the US, the equity market in the US to the economy to GDP, it’s way above its historic trend. Well, come on.

These massive global companies, they’re monopolies are there for oligopolies, and they’re basically cannibalizing profits earned by other firms elsewhere. What I think we’re not saying you said this is the only part of the equity market worth paying attention to. When you do this decomposition of valuations, yes, equity multiples are high. In aggregate, they’re not bubble-like. And in the area of the market which is most extended there are legitimate reasons to think that, for a period, that those valuations can persist.

I’m also very conscious that at some stage, this rule will stop working. But I can remember in the 1990s having debates around the US as an expensive equity market. The tech sector in the US is very expensive. It’s a bubble. It’s best avoided. Obviously, that was true in 1999. After ’99, there was almost a decade in which other companies tended to make up the running. But for quite a long time, if you had a very, very, very strong view that the US equity market is bubble-like, you were struggling to make returns.

I think it really helps to look beneath the surface and try to get a better feel, a better understanding for what lies behind the aggregate numbers that unnerve some investors.

[00:24:25] Alan

Is that in itself kind of a justification for a more active approach from the perspective of, as you say, if you look at the MSCI World, excluding the US, valuations are fairly reasonable? I don’t know what the PE is, maybe something like 12 or something like that. But then the counterargument to that is obviously the index composition and the reason that the US market is more expensive is because it has more technology so they trade at a higher multiple. So if you avoid the US, you’re making me call on what you’re discussing there.

I guess you’ve got multiple kind of competing forces there, so how do you balance all of that? What do you take from all of those points when you’re thinking about your equity allocation?

[00:25:12] Richard

I think if you’re looking at the valuation of individual equity markets, you really have to look at the sector structure. If you look at the UK equity markets, which I think no one in their right mind would struggle to describe as being in some sort of optimistic bubble-like return period, there is a higher proportion of companies which have lower multiples. So areas like energy, financials, pharma, which tend to have lower multiples, these are more represented in the UK index.

So if you have a world in which energy, financials or pharma are doing quite well, then the UK is probably going to do quite well. However, you might be able to do even better by having overexposure to those sectors but don’t pick any UK companies because you can get better companies to play that sector fee. I think also, there’s another issue. I want to spend a little bit more time on the UK just to provide a bit more background on your point.

I did a little bit of research recently, which was no more than looking at Wikipedia, but came out with some interesting results. Why has the UK just been such a poor performer for such a long time? By the way, if you strip out the US influence, it’s done okay compared to a lot of other global markets because the US has been a big standout. But what I did was I looked at the 10 largest companies in the UK and I went on to their Wikipedia page. And I recorded the date when the company or one of its forbearers was first set up.

I did that for the top 10 in the UK and the top 10 in the US. It was interesting because in the UK, the average inception date for the top 10 was about 1850. You’ve got some companies, say GSK, if you look at its forebearers and antecedents goes back to 1715. Diageo, 1759. HSBC, 1856. Shell, 1890. And the youngest company of the top 10 in the UK was AstraZeneca 1930. So pre first World War.

And then you do equivalent exercise in the US and you end up with very different results. So 9 of the top 10 in the US are younger than the Beatles. Two of them were founded this century. Those just are just some numbers to throw around at a casual dinner party conversation. I think the reason that the US has continued to outperform is that it’s just much better than many other countries in generating new industries and successful new firms in those industries.

The UK still has this rather antiquated market structure, which doesn’t mean it underperforms all the time but it’s problematic in generating the same sort of returns when you’re competing against much younger companies elsewhere. I think the UK has got a fundamental problem and I think this has been much more discussed in recent months that maybe we’re not so bad at funding very young, very small companies, but we’re much less good at taking young, small companies that have got money in the early stages of funding much further.

An example of this is a company called Immunocore. It’s a UK company, biotech. In its early stages, it was funded in the UK. They carried on growing quite quickly, couldn’t get the funding in the UK, so they went to the US, floated in 2021. I think it’s come off a bit recently, but at one stage, I think it would have just about been big enough to get into the FTSE 100. But it didn’t because we don’t have the capital market structure which allows us to fund firms which then grow in the UK.

I don’t think we’re the only country which has this problem by the way. But I think it does mean that when you’re looking at ,well, the UK is a cheap equity market, why don’t you put your money in there, that you really have to look beneath the surface and try to understand some of the dynamics that are going on in these markets.

[00:30:09] Alan

Maybe going back to the point estimates again from an asset allocation perspective, you were talking about obviously higher cash rates at the moment. Presumably, they probably won’t last forever. But also relatively attractive yields in credit versus equities and maybe arguing for higher credit in portfolios.

I’m just thinking from an asset allocation perspective. In the last decade, we had this very distinct negative correlation between bonds and equities, and now we’ve moved into an environment where bonds and equities are more positively correlated. Obviously, credit will tend to be probably more positively correlated with equities and government bonds anyway.

So balancing higher and more attractive yields within a portfolio versus maybe a less attractive potentially correlation profile, is that something that you would build in in terms of portfolio construction?

[00:31:10] Richard

I think one of the reasons why we have built up alternatives in multi-asset portfolios is to cater to that point. So I do think it’s an issue. But I think one has to be very careful in talking about the correlation between bonds and equities because it’s not stable. If you go back to the pre-1998 period, it was different from what it was in the period 1998 to when we had the inflation shock, COVID-related inflation shock.

I think what’s going on is in periods where you have inflation shocks, either positive or negative, that tends to lead to the correlation between bonds and equity returns being possible. So if inflation goes up a lot, well, duh. It’s not very good for bonds, typically not good for equities for all sorts of reasons. So you don’t get much diversification in those periods.

If we’re in a world which is dominated by real shocks, so shocks to the economy rather than inflation, very crudely, a positive growth shock tends to be good for equities and bad for bonds. So the periods where you get those real economy shocks dominating inflation shocks, you do get diversification. Inflation shocks are nasty for all sorts of reasons. One reason being that it’s much harder to get diversification.

That’s why, I was running some numbers last year, I think 2022, I went back to about 1870, and if you just assumed a 60/40 equity-bond portfolio and looked at the returns in real terms, that was the fifth or the sixth worst year for 150 years or so. I think we do take accounts of this, and I think we have to take a view. Our views are not black and white views. They’re always shades of gray because the world is a difficult place. By all means, have black or white views when they’re justified. A lot of the time, one has to be I think a bit more careful.

So it would not surprise me if the period we’ve had where inflation shocks and their unwinding tended to dominate, dissipate somewhat, and we go back into the previous environment where we’ve got a bit more diversification. But against that, there are some reasons to think that on a 10-year time horizon, maybe inflation is going to be a bit higher than it has been in the past. But that’s more a prospective return story necessarily rather than a correlation story if that process happens relatively slowly.

[00:33:56] Alan

You touch on taking the view on some of the structural changes. I guess that’s maybe the next question in terms of what is your view on maybe some of these factors and how important is that in terms of formulating portfolios? I’m thinking in terms of the factors that people normally point to would be deglobalization, rising defense spending, geopolitical risk, nearshoring.

I suppose the question is, will we have more periodic supply shocks, whereas demand constraints were primarily the driver in the last decade. If so, then that would point to that positive correlation between bonds and equities and also periodic jumps up in commodities. Is that something you subscribe to and is that something then that you build into portfolios?

[00:34:51] Richard

Yeah, I think it’s very important because what I don’t want to do is give the impression that we sit down occasionally, come up with some numbers, and then build portfolios on the back of them. I think it’s important to do that, because if you don’t do it, it’s possible to miss some really important big-picture themes. So whatever happens in the next 10 years, I think it is going to turn out to be the case.

Equity returns, if you’re invested in global equities, are going to be materially less than they’ve been over the past 10 or 15 years, even if equities are still the best-performing asset class. This compression in returns between cash credit equities moving into the same space-ish, I feel comfortable that those are going to be features of the environment.

We spend quite a lot of time thinking about these longer-term themes because it’s not just what we’re doing in asset allocation, but it affects what credit securities do you want to own, what equities do you want to own? We have what we call our zeitgeist. It sounds a bit pretentious, but spirit of the times. We try to work with a number of quite high-level themes which we think are going to shape the environment that financial markets are going to be operating in over a multi-year period.

So this is not something that’s relevant for three months and then disappears. These are longer-term themes which are going to be with us for some time. I think the main theme to work on at the moment, let me run through them and then run through the implications.

There’s a big demographic shock going on globally. One of its implications is that labor markets have got much tighter. So, it’s an interesting debate to be had, tight labor markets, maybe there’s more of a sustained profit squeeze coming. Climate change is an enormous subject, but we do believe is happening. You can’t invest sensibly without at least being aware that this is an issue.

I think the fiscal background has definitely changed post-COVID. Debt-to-GDP ratios have gone up a long way. It does not help when interest rates have gone up. The interesting thing at the moment is that I would say none of the major governments are looking to tackle this at this point of time. So that’s going to be another feature of the environment.

There’s obviously the AI theme. Much scope to talk pretentiously on this one, so I’ll say nothing. But the interesting thing to me is, is this going to affect productivity growth? If it affects productivity growth (I’m sure you know that productivity growth has been pathetically slow globally since 2008, particularly in the UK), if we’re getting a big pickup in productivity growth coming through, then that has very important implications for markets.

I won’t talk through any of these in any detail, but you put them together, and at the margin, I would say that these tend to be more malign than positive influences for markets. So if you were to do the same exercise in say 1990, and this isn’t just talking with the advantage of hindsight, but in 1990, you could have said, well, the Berlin wall has come down, communism has ended, Chinese want to play the game, and there’s going to be 900 million low-paid workers joining the global workforce.

This is going to have a number of implications. It’s good for inflation. It’s good for growth. Political tensions are going to arise on the back of it. But I think you could say basically that was a positive influence which was going to last over an extended period. I think it’s true and it was important to understand that, even if maybe one of the implications for a period was to give us a massive equity bubble. But a lot of those forces are quite helpful.

I think at the margin here from a financial market perspective, what we’re talking about maybe inflation being a bit higher than it’s been in the past and certainly harder to control. There’s the scope for fiscal easing which the end of Cold War provided. We’re going the other direction now, so not only do we have a more immediate fiscal challenge, you can see demands building up. I think it’s shaping up to be a more challenging world than we’ve been in.

I will say the same for the deglobalization theme. I think sometimes this is exaggerated. It’s not as if we’ve all gone North Korean and we’re not doing any trade with anyone. The world economy for many countries is still very open. But we’re through this period where trade was growing much faster than economies were. Supply chains, I think post-COVID, they’ve got more of a focus on security rather than lower costs.

So again, it’s just an influence which it’s not particularly draconian in its own right, but I think it’s shaping up potentially to be a headwind for economics and markets.

[00:40:01] Alan

Some other people might take those same set of factors and be a bit more dramatic, maybe for marketing purposes or not. But from the perspective of saying we’re heading back to more of a 1970s style world, and also from the perspective of taking long-term cycles into account: we had a 40-year bull market in bonds, we had a peace dividend as you say post the Berlin Wall coming down, etc., and we’re now entering into a new cycle, arguably the end of the neoliberal order, etc., challenges around inequality, and all of that favoring higher fiscal expenditure. Coupled with higher inflation, we could have challenges in the bond market. It sounds like you’re listing all those factors but still being fairly moderate in the assessment as in, yes, at the margin a bit more challenging. But you’re not saying we’re facing a fiscal crisis or anything to that effect.

[00:41:03] Richard

That’s not a bad way of putting it, and I think it’s entirely defensible for a number of reasons. The first is at any point in the entire time I’ve be working, it’s possible to paint a picture of the future which is unbelievably pessimistic. I think what people have tended to miss sometimes is that you can’t just extrapolate the bad things that are going on now and assume they’re just going to be very impactful for a long time. So I think that’s the psychological aspects.

I think you’re right. If I were working on the sell side for a research institute, I would want to go out and make some really bold pronouncements about the future of the world in which I have a high degree of confidence. Because I think it’s very clear with the bad news, people are much more prepared to listen to bad, potentially difficult pessimistic outlooks than the more upbeat one. By the way, it doesn’t mean we’re not going to get a bad outturn, but I think one has to be a little careful there.

But I think the third thing is, what do we do with these views? Because we manage money, and managing money, I think if you’re doing a good job for your clients, then you accept that you need to understand the environment which is shaped by these factors. But do not invest solely on the back of them because there is so much uncertainty associated with each of them. And it’s very easy to go from one of these themes, which even if it turns out to be correct, might lose you a lot of money.

A historic example, let’s go back to the 19th century. The railway networks being built up in the UK. Was the railway network in the UK fundamentally transformative? Well, yes, it was. So, should you have invested in the railway companies? No, you shouldn’t. They all went bust. So doing that sort of exercise, it’s possible I think to end up in some fairly dangerous cul-de-sacs. I think that we need to have some element of humility, as money managers, recognizing the limitations of our knowledge about these things and how they’re going to play out.

That’s why I tend to describe these as potentially our zeitgeist environmental factors. You can’t understand the world or how it’s going to evolved in the absence of understanding these factors. But we’re not a sell-side research institute trying to attract headwinds. We’re trying to do the best for our clients. The analogy maybe is managing money, it’s a bit more like entering a dark room. You know you’ve got to get to the other side and you know there’s lots of obstacles in the way.

One thing you don’t do is go, well, we’ve identified the path we’re going to take and we’re going to stick to it. So you navigate a bit, you hit an obstacle, you work your way around it. I think that’s how a lot of successful money managers operate in practice. They might, in terms of describing what they’re doing, go heavy on the big theme stuff because it’s fascinating and it’s really interesting, but it’s not necessarily the major source of returns for that many managers.

[00:44:28] Alan

Fair enough. Obviously, one thing that you did allude to that has been a reaction to an extent to the environment has been an upweighting of alternative assets and alternative strategies. So, tell us more about how do you think about what one? Is it more assets, is it more real infrastructure property, things like that, or is it more as strategies like hedge funds or presumably a combination of both? How do you think about constructing an alts portfolio?

[00:44:58] Richard

To keep it simple, I would say we have three components. We have a hedge fund component, we have a commodities component, and we have another component where there’s some things which are a bit hard to categorize like catastrophe bonds, things like that. But why hedge funds? Because hedge funds are, I think, controversial for all sorts of reasons. But we have principles concerning what we’re looking for from a hedge fund portfolio.

So we have set ourselves a return of cash plus three, which by the way is quite aggressive because I think lots of funds of hedge funds go for cash plus two. If we get cash plus two, that’s okay. But frankly, we’d like to get cash plus three. It’s our target. So there’s an aspirational element in it. But over the past year, we’ve more than met that, so it’s not that unrealistic. So there’s a return component.

The second element is we want our hedge funds to do things that we can’t. We’ve got a pretty broad-based skilled, competent investment team, but we can’t do everything. So our hedge fund exposures, we will allocate capital to people who will just do things that we can’t do.

From a diversification perspective, we’re looking for managers who are as independent of market returns as possible. I don’t think there’s such a thing as zero correlation because hedge funds operate in financial markets. But on average, over time, we’re looking for low correlations with conventional assets. That tends to rule out very aggressive long-short equity managers who seem to spend most of their time long. Because frankly, we can buy index funds for that. So why would we pay 2 and 20 or 1 and 50 because hedge fund fees are coming down? Why would you do that? So those are the criteria that we’re looking at.

Interestingly, a couple of years ago, we did delve more into the cash-plus issue. Because obviously, when cash is zero and you’re looking for cash plus three, three is a perfectly adequate return. If cash rates are five, then you’re now looking for eight. So we went through, well, are we going to get cash plus three? Are we going to get 8% returns? And I think we divided hedge funds into three groups.

One is they implement primarily via derivatives. If you do that, you might keep a lot of money in the bank, you get cash on margin. So if cash rates going go up, you’re going to see some sort of automatic feed-through. The second group of managers who maybe don’t implement always, don’t make heavy use of derivatives, I think their alpha is pretty big. So maybe their cash plus returns come down a bit, but they’re still going to be okay.

But there was a third group who might have been delivering returns of say 5%. Perfectly adequate in the environment we’ve been in, but 5% in an environment where you get 5% by putting the money in the bank is more problematic. And we saw that those are the managers that we should avoid. It turned out we didn’t really have any in the portfolio, but it did affect the way we look to potential managers going forward. So that’s how we approach the hedge fund allocation.

[00:48:40] Alan

Across hedge funds and across alts, how do you think about sizing? That’s the first thing. And also, I was reading something recently in the FT Advisor section about how UK NPS providers tended to allocate more to liquid alts for their low-risk portfolios as opposed to high-risk portfolios with the view being that these are seen as more vol dampeners and diversifiers. But obviously, if you pick high vol managers, presumably they could be returned generators too. What’s your perspective on that?

[00:49:13] Richard

Basically, although we run a small number of hedge fund only portfolios, our hedge fund exposures tend to be in multi-asset portfolios, and for completeness for some clients, more the advisory end of the spectrum and they just want to have some concentrated themes. Maybe they’ll own one or two particular hedge funds. So I’m talking here about hedge funds in multi-asset. Set weight is around 10%.

I’ll tell you what we don’t do. We don’t optimize. We don’t say returns from this hedge fund is going to be X, the volatility is Y, the correlations are Z because it just doesn’t work. We have some simple heuristics. We start off by just simple volatility weighting. So very high hedge funds have much lower weights. We do look at the correlations. But I think one is unwise to build portfolios or put a lot of emphasis on the correlations in portfolio construction because they’re very unstable.

However, we do note where the correlation between particular managers may appear to be high because we may be building up concentrations of risk. So there’s a bit of an override there. I guess in some cases, there’s just sheer practicalities that we might in the past, we’ve overallocated to particular managers because they only accepted certain sizes. We’re not talking big numbers there, but that’s just practicalities and facts of life.

So yeah, that’s how we tend to build the hedge fund portfolios. A good understanding of what each manager is doing, the statistical properties of each manager. We’re not trying to be very smart by saying we’ve developed a super algorithm which is incredibly complicated which gives us the best weights. It’s because we felt we’d go a long way, we can understand it, it’s very transparent, and we’re not going to end up doing something stupid for a portfolio construction perspective.

[00:51:17] Alan

Obviously, you had that experience earlier in your career of building fund of hedge fund portfolios. So you’ve had this throughout your career. When you’re thinking about manager selection, it’s I would say a different kind of skill to asset selection. You’re into the realm of understanding people’s personalities and their businesses and all of that. Do you find it a different challenge, manager selection presenting a different set of behavioral biases? How do you see that side?

[00:51:50] Richard

Yeah, so it is different. You’re right. And we have a very good manager selection team who cover quite a lot of managers who do that. But the culture we’ve got in the investment team, it’s a really, really flat hierarchy. So if you’re in the investment team, there’s a lot of interchange of views, a lot of interchange of views. I think that one problem in this industry, it can become far too compartmentalized. So I don’t spend any time really on manager selection.

But I’ve got a very good understanding, seeing the team with all the heavy lifting and all the work, of what these managers are about. I think in general, that’s an interesting issue. It goes back a bit to what we were talking about earlier in active and passive. Because there’s not much point in selecting active managers unless A, you’ve got certain criteria which you want to be met, and B, those criteria actually correlate in some way with future performance.

I think it’s very difficult to be innovative in this area in terms of the criteria that you use. I think that the efficacy of the way people do it does vary. But essentially, what you’re looking at is you’re looking at the people in the team. How do they work together? How do they work together? All quite soft stuff. You’re looking at the process and you’re asking the question, are we clear about what this team is doing? Is the track record consistent?

So someone says, yeah, we’re out in our value and they’ve outperformed for the past 20 years, then you’ll probably say, well, I think you are. So this is looking backwards, but we need to understand what they’re doing. We need to understand that they’re going to carry on doing it. We need to understand that it has worked. You do look at the performance, but I think performance is much more interesting in the light of what the manager said the process is rather than just looking at performance.

So the history of people selecting everyone at the top quartile one year, for a number of very good reasons, it doesn’t seem to work. So to me, it’s about getting a good understanding of the quality of the managers involved and getting comfortable with the way that they generate returns. Is that repeatable? I think it’s a different skill from selecting stocks. It’s a different skill from selecting markets. It’s a mix between quantitative and qualitative factors.

But I know certain people like to go down the quantitative route and quantify absolutely everything. I consider this advantageous in going that way because it’s more transparent. But you have to be careful in being very quantified, that when you’re quantifying, the numbers you’re using actually bear some relation to the underlying characteristics that you’re looking for. Because really, the only thing you can quantify perfectly is performance.

[00:55:08] Alan

Just a bit on active versus passive before, and you’ve kind of alluded to value versus growth, even the case for trading strategies, does the environment influence that? And you might have said maybe the environment in the last 10 years, to 2019, was a bit more challenging: less dispersion in rates, less volatility in currencies. Would you subscribe to that view that maybe we’re into a better environment for trading strategies and does that carry on into say active as well or not? Or would you draw a distinction there?

[00:55:43] Richard

That’s an interesting question. I think I’d draw a distinction. The environment we’re in I think is going to be more helpful for macro-oriented strategies in hedge fund space, because I think one issue, over the past few years, has been with rates anchored where they were, there wasn’t enough volatility form firms to make a lot of money. This is an observation, but my observation would be the macro managers that we use and other macro managers in the market have done better over the past few years.

So I think it is definitely out there. I always think that when you’re looking at active against passive, the average active manager is going to underperform. If you’re measuring the market properly, performance across the market is going to be zero, they charge more fees. So active managers you should always expect to underperform.

Having now been in the industry for about 30 years, I have a wry smile on my face every time I see something coming from a manager which says the last few years have been tricky but it’s been an odd environment. And the environment for active managers is now about to turn very favorably in our direction. It might be because there’s a bear market coming so you need active managers, or there’s a bull market.

So I think you have to be very, very, very careful about making these sorts of generalizations. I guess the big divide is the old one of growth against value. I think it’s such a generic divide. I’m not even sure it’s particularly useful. But we have had a pretty extended period in which growth, as a style, has outperformed value, and that’s interesting. But I think it goes back to what I was saying earlier that a lot of companies which look very cheap, they’re quite old in sectors which it’s difficult to make a lot of money in.

The growth sectors have been faster growing ones. What I’m not saying is this is inevitably going to continue. But you have to be really careful of saying, well, growth has had a good run so value is now, unless you believe a lot of the growth plays are massively overpriced, and let’s say cashflow wise, they’re not strong balance sheets and so on. It just doesn’t appear to be the case.

[00:58:14] Alan

Okay. I’m conscious of time, one thing I definitely did want to hear a bit more about before we wrapped up was you are in the midst of a PhD on Black-Scholes option pricing I believe. What prompted you to embark on that?

[00:58:29] Richard

Well, to put it in context, it’s actually in the philosophy of science rather than in finance. People could quite legitimately ask what on earth has the Black-Scholes model got to do with philosophy, but the philosophy of science, it’s a bit different from other parts of philosophy. If you want to have an academic career in philosophy of science, then it’s not unusual to get a PhD in a science and then get your PhD in philosophy. These days, it’s much more about the interlink.

But the reason I got into this particular subject, there’s one particular area in the philosophy of science which is to do with that we tend to see that science progresses because we’ve got good theories. There’s a view that, actually, a lot of the progress we make is in models associated with these theories. I won’t say anything more than that because I don’t think anyone will be particularly interested.

What I’m not trying to do is say the Black-Scholes model is wrong or rewrite it. But there’s an interesting theme in that the claims made for it are quite extraordinary. These, by the way, are claims made by people in finance that Black-Scholes theory was one of the most important theories which has been developed in human history. You might say, well, it’s a bit of academic arrogance for you but there were some interesting things going on here.

Just in terms of some nuances on the things I’m interested in given this context. So, there’s a view that before Black-Scholes came along there weren’t options markets because no one knew how to price them. They were regarded as speculative. Then Black and Scholes comes along and there’s a bit of technological innovation as well, everything gets going.

Actually, if you look back, options markets have existed for hundreds of years in very different forms from modern markets obviously. There were options markets in the 18th century, 19th century, early 20th century. The interesting thing to me is that when people have looked at how options were priced, the results that drop out, if you use the Black-Scholes approach, is that they’re fairly similar to the results you get from applying Black-Scholes to contemporary options markets, which to me is interesting because the conventional view has been you needed a theory to get options markets to exist.

Options markets have existed for centuries, and as far as we can tell, and there’s obviously loads of caveats here, they seem to operate on the same principles. So what role does Black-Scholes play? That’s the first interesting thing. The second is, there’s a really good book written by a guy called Donald Mackenzie, who is actually a sociology professor. And it’s a really good book.

He’s talked to a lot of people involved in terms of how Black-Scholes got off the ground. If you want to understand a bit about the history and developments in the market, it’s the best thing you can read. But he then made a whole series of claims which I just think are a bit odd and untenable. In his view, he uses the word performativity. So in his view, the theory created the market.

One implication, and I’m oversimplifying here, is that if there had been another theory which came up, which is different from Black-Scholes, then people would have used that because all they needed to do was agree on which theory was going to be used, and they’d end up using it. Frankly, I don’t think that’s the way markets work at all. So there’s something problematic in that interpretation.

There’s more that could be said, but those are the kind of I thought nuances which might be interesting for people who are probably going to be much less interested in some of the other things I’m doing there.

[01:02:32] Alan

Well, I’m sure that would be a topic in itself if we wanted to delve into all of that and learn more about that, but conscious that we’ve gone over the hour. But before we wrap up, we always like to get some perspective from guests on advice they would give people starting off in the industry, things to do, things to read.

Obviously, you’ve worked in the industry for a number of decades, on the economic side, on the forecasting, and running asset allocation. So what things have been influential for you in your journey in learning? Obviously, you’ve had a lifetime of learning as well in terms of doing Masters and PhDs, etc. But outside of that, what would you suggest to people as important things to read or do?

[01:03:18] Richard

That’s a very interesting question, and I’m struggling a bit because of my experience in the industry, because I started quite a long time ago. When I started working in the city, it was a completely different place across many dimensions. So I’m not sure that my experience then, in terms of what works, what should you do, is necessarily that helpful.

Let me base this not so much on my own experience but observations of the people that I’ve worked with who have been very successful. I think that they’ve had very strong work ethics, really strong. They’re very focused. They had a strong desire to succeed. It doesn’t mean they’re all alpha males or alpha females, but they wanted to be successful in what they were doing.

I would also say they were not completely dogmatic. It goes back to what I was saying earlier. The world is a terribly uncertain place, and it is like navigating through a dark road where there’s lots of obstacles in the way. You’re not sure what’s going to happen next and being very dogmatic I think is problematic. So, any views that you have and you feel very strongly and you want to back it, you’ve also got to force yourself to determine and isolate and consider the exact opposite of that view.

So I think many of the best investors have actually been quite humble, maybe that’s not the right word, maybe pragmatic in the way they invest. They’ve had the right balance between being happy to back their views but are not so deeply embedded a view that they just stick with it through thick and thin long after it’s way past the sell window.

[01:05:18] Alan

Good stuff. I think that’s sage advice and makes a lot of sense. Thanks very much, Richard. It’s been a tremendous conversation. Thanks a lot for doing it today.

Make sure to follow Richard’s work because it is as important as ever in an uncertain world that we consider how to allocate capital well, and so we hope you’ve gained some valuable knowledge from today’s conversation.

From all of us here at Top Traders Unplugged, thanks for tuning in. We’ll be back soon with more exciting episodes, so stay tuned.

[01:05:49] Ending

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