Managing Wealth for HNW Investors ft. Joe Prendergast

[00:00:00] Joe

I just think keeping creative and also using data as much as you can, embracing the contradictions. keep it simple, but also think laterally and be creative. Learn to distinguish what’s a fact and what speculation when people are speaking. I think that’s incredibly [important]. There’s a lot of lazy supposition out there.

Most importantly, remember, nobody knows anything for sure. So, do be skeptical, but, again, don’t let that stop you making decisions and having a strategy. Once you have a strategy, which is totally different from a trade, sticking to the plan, that’s always my line. Stick to the plan.

[00:00:48] 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.

[00:01:43] 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.

[00:02:46] Alan

Thanks very much, Niels. Today, I’m delighted to be joined by Joe Prendergast. Joe is Global Strategic Advisor and Head of Investment Strategy at Goodbody in Dublin. Joe has been in the markets many years, and immediately prior to being at Goodbody, Joe was Head of Financial Markets Strategy at Credit Suisse in Zurich. Joe, great to have you on. How are you today?

[00:03:05] Joe

Good morning, Alan. I’m pretty good. Thank you very much. How about yourself?

[00:03:08] Alan

I’m great. Yeah, great. We’re doing an early one, and it’s in the run up to Christmas, but it’ll be early January by the time this is out, I’m sure. It’s a good time to be setting the forecast for the year ahead. We normally like to start, Joe, just getting our guests to give a quick recap on their experience, how they got involved in financial markets and their route to their current role. So if you wouldn’t mind, give us a quick overview of how you got started in the markets and ended up at Goodbody.

[00:03:41] Joe

Sure. Alan, if someone had asked me, was I destined for financial markets when I was setting out in my career, I would certainly have said no. I had a big interest in everything creative, all kinds of photography and art and stuff like that. Having been soundly rejected from art college, probably quite wisely, I guess I did a little bit of a rebellion and did the most serious thing I could think of which, at the time, was economics, but it turned out to be something I particularly liked.

The economic history part of it, particularly history of economic thought, was something that definitely resonated with me and really, specifically, creative rising around that. I’d done a lot of reading of Charles Kindleberger and JK Galbraith, trying to be pretentious at the time carrying around these books. But they were absolutely fascinating, and I absolutely embraced the idea that you could marry finance and creativity together.

Originally, I thought that would lead me to journalism, but actually, I became an analyst. So that’s my introduction to financial markets.

[00:04:49] Alan

Good stuff. I know you spent many years at Credit Suisse across investment banking, asset management, and wealth management as well, over a couple of decades, I think. How did that come about? What were the learnings from working both on the sell side and on the buy side?

[00:05:09] Joe

Yeah, you’re absolutely right. I spent almost all of my career at Credit Suisse, more than 20 years, and I did the full triathlon from starting in investment banking through wealth management and actually ending up in asset management, albeit just for a short time, before I left. I absolutely loved it, I have to say.

As a company, it was extremely entrepreneurial, especially when I joined it, when it was Credit Suisse First Boston, back in the day, and really a big trading-driven house, mainly hedge fund clients. It’s something I absolutely loved, at the time. Moving to wealth management was a totally different experience. But I had a very strong boss and mentor, Giles Keating, who you may know, who had started on the investment banking side but moved to the wealth management side to run the research and strategy part of that.

I joined him in Zurich in 2008. Of course, the financial crisis was just unfolding. There was a lot of work to do and we really embraced the wealth management side of it. I , inevitably, for Credit Suisse, people are going to ask about the demise of the firm more recently, which for me, personally, of course is very sad, and not something I would have ever expected.

But to me, I suppose, when I look back at the 21 years there, the first 17 or 18 were fantastic. There definitely was a bit of a change of mood and maybe also in terms of management and governance in the last few years. Obviously, there was a couple of scandals and things which are well known mostly after my time. But yeah, it was definitely quite a traumatic experience to see such a fantastic firm descend into a very ignoble end.

[00:07:00] Alan

Yes. You’ve transitioned back to Dublin here, with Goodbody. Maybe, before we get into the meat of the conversation, could you give us a sense of the types of portfolios you’re running at Goodbody, types of clients, constraints, etc.?

[00:07:15] Joe

Yeah. Goodbody is an old company, 150 years old next year, one of the original 19th century brokerage houses, the only remaining one actually steeped in tradition and heritage. Our clients are very much the business world of Ireland. An awful lot of our business today, particularly in terms of the larger clients, is exit from business on the wealth management side.

So very often, a client will be active across both the investment banking, M&A advisory part of the business initially, but then ultimately, if there’s an exit or something, could end up being a wealth management client. So it’s very integrated in that sense, but we cover pretty much all types of clients. we’re really focused on the wealth side, on the 1 million plus client profile.

My own big focus is what we call strategic clients, which is more the bigger end of it. It could be the individuals in the 30, 40 million bracket or more quasi-institutional types with maybe 100 or 200 million. That’s where we are focused. The objective, it’s all about peace of mind at the end of the day.

I always observed, and this goes back years, on the wealth management side in Zurich, meeting so many people who would do exits from companies, and they had this really deep sense of understanding of how the company worked; every cash flow, every little movement, they could almost feel it in their veins. When the company is sold and it turns into a pile of cash, it’s an incredibly (what’s the word) disempowering kind of event.

People definitely struggle because there are all these complicated things to do with the feeling that the money is blowing away in the wind through taxes and fees and then having to make decisions in financial markets which are very different, liquid financial markets from owning a direct business. So very early on, on the wealth side, I really try to focus on this idea of peace of mind; putting a structure and the purpose around wealth, coming up with a framework for management and very clear metrics of success.

It’s all very well to talk to people about benchmarks and so on, but these are abstract concepts to somebody who’s just sold a business. So, really trying to focus on that aspect has been my specialty.

[00:09:49] Alan

Okay, very interesting. So maybe translating that into something more tangible, from an investment perspective. It’s useful to get a sense on, obviously, you’re talking about peace of mind, which suggests, to me at least, a robust, long-term kind of thinking, I would guess. But yeah, from an investment philosophy perspective, how would you describe your approach to managing money and setting out asset allocation?

[00:10:19] Joe

The approach is absolutely rooted in strategic asset allocation which, as you’ll know, from all the discussions I’m sure you’ve had, it’s obviously very, very common in wealth management that strategic asset allocation is at the heart of most approaches to this. However, my approach always was to think of strategic asset allocation, really, as a risk control mechanism.

If you look at the core portfolio, that we might build for a larger client, it will look not that different from the portfolio that anybody might have as a strategic asset allocation and it might be more oriented to 50% equities, 50% lower risk assets at the core. The reason for that is this idea that if you take a five-year time horizon, and look at just a Euro-based benchmark because almost all our clients are Euro-based, the reality is that, over a five-year time horizon going back 20, 30 years, that 50/50 portfolio has an extremely good track record of preserving nominal capital. We’ll talk about real maybe later on.

But the chances are, if you extrapolate forward, if you use this as your core portfolio, you should have a very low probability of loss in nominal terms. To me, this is really important for the peace of mind function for the investor, because you also want to have other bits. You do want to have a liquidity related piece where there’s really almost no market risk at all, and that’s very driven by what liquidity does somebody need for the next year, two years, five years, whatever they’re comfortable with. Of course, then an illiquid piece where you’re saying, well, this is maybe a bit longer term.

This is where the real risk is being taken, the aspirational part of the portfolio which might be classically in private equity or some other higher risk premia. But at the core of it is really this idea that there is a high probability strategy that you’re not just putting everything on the table. You actually have a strong sense that this is preserving and is a sensible thing to do. You’re not up at night worried about whether the S&P is up or down 5%. That’s really at the heart of it.

Around that, we can build out as much as we like, in terms of core satellite type things and all of this, but that simple strategic asset allocation is really at the heart of it. It’s not for everybody, and there’s some clients who definitely want 100% equity or whatever it is. But we would almost always counsel against that and at least get them to listen to the idea.

You can have 100% equity as your portfolio, but if you look at the number of times that portfolio may have had a drawdown in the region of 50% over the last 20, 25 years and have not recovered fully over five years, whatever, about 10, 10 would be more likely, it just seems not a very sensible thing to do. If you had the option instead of having a high probability strategy but still have the more illiquid equity where you might be able to identify a larger risk premium, maybe that’s a more compartmentalized and safer way to do it.

[00:14:00] Alan

Okay, fair enough. Obviously, you’re focused on this 50/50 broad split. A lot of people talk about 60/40, so you can debate the numbers, the philosophy is similar. If you go back to the last year, obviously, last year was an unusual year in the sense of declines; concurrent declines in both bonds and equity. A lot of assets struggled at the same time. There was a change in the macro environment in ’21, ’22 with higher inflation and a big jump up in interest rates.

One, did you think that was an unusual year? Do you think we could see more of those types of years going forward and does that change your thinking around the strategic asset allocation at all?

[00:14:44] Joe

On the last part, first, in terms of does 2022 in particular change the perception on strategic asset allocation? My answer is no but I am leading that back to one of the opening statements which is that I really see the strategic asset allocation being about risk control. Even though you had a very big drawdown in the bond market, in benchmark bonds, the other aspect of this would be to say, well, what do we mean by bonds?

I would say, if you look at the benchmark that typically people will use, like the Euro Aggregate or a similar index, it’s obviously quite a long duration instrument. So, the way I would think about it is, as a private investor who’s not forced to be at the benchmark, who looks at the capital-weighted bond market nonetheless as an investable entity, and therefore, the benchmark is relevant, you can be anywhere between cash and fully extended in duration.

Unless you had an exceptional circumstance with curve shapes and yields, you’re probably not going to really be looking at duration or the term premium as a big attractive risk premia in your basket. So, in terms of 2022, the big sell-off in bonds was far greater, I think, than most people expected and certainly far bigger than I expected. It was of relatively short duration, of course, which I would consider to be almost part of the strategic approach, and this was a big help with us.

Yes, particularly if you had a very conservative portfolio, it was really shocking. Could we have another one? I don’t think it’s impossible, but obviously, the starting level of yields, today, is completely different. What troubles me a little bit is the curve shape obviously is inverted still. Inflation is coming down, which is great. But if it were to go back up at some point, which is not impossible of course, then the long end of the bond market could still react to that.

On a 12-month time horizon, I think things are going the other way and bonds are probably going to do quite well because there seems to be a pretty clear monetary pivot. We do tend to see bond markets trend very, very strongly around those kinds of times. I know a topic close to your heart, Alan, that there’s great persistence and returns around those types of times. But at the same time, yields are not exactly at record highs.

So, the chances are that there’s a limit to how far that will go. But we’ve certainly been comfortable extending duration modestly. Still, we’re way below what people would consider the bond market benchmark. The way we justify that, by the way, because you could say, well, if you’re not getting the term premium, surely, you’re going to underperform. That of course depends on the curve shape and the roll and all that stuff.

But what we would prefer to do is probably have a somewhat more overweight corporate exposure with relatively short duration as a compensation for the fact that we typically might not be getting the term premia particularly with curve shapes the way they are now, which we would see as less attractive than it could be. So we are extending duration, but we still maintain a lot of relatively short-dated corporate exposure as well.

If I take a step back to this high probability idea that the 50/50 or I’ll call it the 60/40 (I mean, 50/50 I would prefer because the 60/40) would have somewhat more incidents of loss over that five-year time horizon. To me, that comes about because you have the drag, the positive drag of yield in bonds, dividends in equities, and, given a bit of time, if the balance is right and the starting yield is okay, your probability of a positive outcome is pretty good. So we would still hold with that today.

[00:18:49] Alan

Okay. You touched on those recurring five-year periods and this approach been reasonably robust over history with that kind of timeframe. If you go back the last 10 years, 2010, 2019 were particularly favorable for the approach, and obviously starting valuations were good with a very benign low inflation environment rates at zero.

I guess, maybe, just thinking about the question a different way, it sounds like even if we were into a changed macro environment of more volatile inflation or more uncertainty… Obviously, we’ve been in a stronger nominal growth environment the last few years and it could be the way things evolve going forward.

We’re obviously in a higher rate environment. But all of that, your perspective would be that this is an approach that is robust through multiple cycles. Is that fair to say?

[00:19:58] Joe

Yeah, I certainly would believe that. I think a lot of that just rests on the stats that, even through some of the really trying times we’ve had in the last 20, 30 years, the outcome has delivered what we would expect. But of course, we’re looking back, Alan, so of course, it’s just not a huge statement to say it has delivered. But I think that today’s environment is really interesting for many of the reasons you mentioned.

I think it’s all about being realistic ,in terms of the return and the under probability. This goes back to the peace of mind function. Nominal growth has been relatively high because of inflation. We’re settling down to, probably, more normal levels of nominal growth now in the next few years. But throughout COVID, that whole experience with COVID, we’ve seen enormous volatility in GDP, enormous volatility in earnings, probably a really significant overshoot in earnings to the upside.

Something that I really look at and I would strongly recommend people look at is, if you go back (and you have to use the S&P for this because the data is just not as good elsewhere), back over the last 70 years, you look at nominal earnings per share in the S&P 500, in almost any variant you want, and just look at that number (preferably in log terms so it’s normalized, so you get a sense of the rate of growth), draw a straight trend line through it, and it’s one of the best-behaving time series you will ever find.

It has a very, very strong, clear trend. It deviates up and down, but not by a whole lot. It’s almost like a little description of how the world works. When earnings get too high relative to trend, things are happening to bring them in the other direction and similarly on the downside. Its policy reaction, it’s whatever it is, it’s corporate action, whatever it is.

To me, as we came in the last few years, we were obviously pretty strongly above trend earnings growth. I would just assume we gravitate back towards trend earnings growth over time and that’s going to give us a pretty moderate expected return for equities, not negative, but moderate or modest compared to some of the stronger numbers we’ve seen over the last 10 years.

So we’re probably in for less of an equity bull market than we had before. But we’re still probably going to have equities going up over time because the earnings trend is still positive over time and you’re really just talking about this idea that policy has leant against the wind. You’re going to see the normal lags occur and the equity market is just not going to have a stellar outlook for the next couple of years. There are things that might change that, but just taking that as your starting point.

When you look at the relationship then between the equity market and those earnings, okay, the price earnings ratio has gone up over time. Probably the long run average is about 16 in the S&P. In the last decade or so, it’s closer to 18. You can argue all day about whether that’s reasonable, sustainable, whether that’s a trend or is it going to reverse itself. But even allowing an 18, you can still get some modest positive equity return.

You also, then, have of course of very significantly positive bond yield compared to a year or so ago. Adding those things together, as a conservative starting point, you get a pretty decent starting point. But you have to be clear that the expected return of that strategy is contained. You’re talking something in the region of 4% to 5%, nominal, as a likely return to your 50/50 core strategy.

It’s allowing about 7%, 7.5% return on equity. It’s assuming you have a decent amount of corporate exposure, as an investment-grade corporate exposure within your bond allocation. So that’s very much how we would look at it. It’s actually more about adjusting what you expect to get out of that, and that goes back to something else I mentioned at the beginning, which is this framework for the management of wealth and defining the metrics for success in the beginning.

We would always like to have metrics for success that we can outperform. Whereas with benchmarks (I always make this distinction very clearly between the asset management business and the wealth management business), the wealth management business cannot be run on a pure benchmark-oriented premise. It just cannot be because you do have a very strong obligation to try and preserve capital, whereas the asset manager, the benchmark follower does not. It’s all about relative performance.

So, our principal metric of success would be, if we sat down, Alan, and decided on a strategy for you for the next five years and we decided that a 4% to 5% return was reasonable and we all agree, we would be confident that we should be able to design a strategy that gives us a decent probability of reaching that outcome.

That’s what it’s all about, and then everything else around that, as I say, we can build a lot of things around the periphery of that in terms of liquidity management, in terms of illiquid assets. We can extend upon that but having those metrics for success. The benchmarks still matter, within the asset classes. What funds or what equities did we pick within the equity slice and the same with fixed income?

So rather than looking at the asset allocation versus its benchmark, you separate it out to say, look, this is what we were trying to achieve. Here’s where our relative metrics matter. Then, of course, the third thing is, we were very happy to be measured against others trying to do the same thing. So the likes of the asset risk consultant database or similar things of that nature, we’re very happy to be measured relative to peers also trying to both preserve capital and grow over time.

[00:26:51] Alan

Good stuff. Well, a few things to pick up on within that. It prompts a number of questions. Maybe firstly, obviously, we’ve had a very changed environment in terms of cash rates. So 4% to 5% sounded very reasonable. Maybe going back four or five years, people I speak to would say, if only I could get 4% or 5%, that would be great. Whereas obviously now, in the last year, cash rates have jumped up.

So, I’m curious to hear how that has, one, impacted client perception and investor perceptions around how the portfolio should be positioned and what returns should be expected, or what type of return should be expected. Secondly, has it impacted your own strategic asset allocation? You touched on being at the short end in terms of fixed income, so possibly picking up on the yield there, I guess?

[00:27:45] Joe

Look, it’s a great question and I think we really have to put that question in the context, of course, that positive nominal and even real cash rates are normal in the sense that we’ve been in a very abnormal period where negative cash rates, in nominal terms, and indeed real terms even more so, have been the norm for pretty much the best part of a decade. We’ve had an extraordinary phase where cash rates were a distorting factor. You can argue we’re just back to a more normal situation.

I would also, maybe, add that if you look at how cash rates have evolved, in the Fed tightening that started I think back in 2016 (if I’m not mistaken towards the end of the year but certainly in the late teens), and it was interrupted by a bit of a slowdown and then COVID, and then we’ve had this rapid re-tightening. It’s almost like the Fed are back on the course that they started when this tightening began. They had an extraordinary deviation, because they often have a deviation in the policy course, and, actually, this is all kind of just normal.

Of course, it has an impact on allocation, because the higher the cash rate is (obviously, particularly in our world where we’re very focused on capital preservation and trying to grow wealth and ideally in real terms), the opportunity of a very significantly positive cash rate is great particularly with curve shapes the way they are and equity valuations, as I alluded to earlier, maybe not being the most attractive. That does have an impact going forward. So there’s no doubt.

Our interpretation of that, however, is not then to put loads of money in cash. That’s certainly not something that we would do. What we would do instead is really continue to focus on the short to mid duration part of fixed income with relatively high credit quality because you’re getting the double effect of both the higher level of cash rate and also a pretty decent corporate credit risk premium. That seems to be the most efficient way to take advantage of that situation. So it definitely has an impact. There’s no doubt.

It also has an impact not only on sentiment in the equity market, but Fed tightening cycles ultimately, typically do break something. What it breaks can be in the credit markets, it can be in the equity markets, but it’s typically not in the high-grade corporate credit market. So that all feeds into that same theme. What I would say is, when cash rates were extraordinarily low, I think there was a lot of inflow into the wealth management business seeking alternatives.

With 2022, obviously, a lot of those things did not go well, at least not in the beginning. A lot of them, now, are coming back into positive territory now, but particularly extending into short-dated corporate instruments which would have had a positive yield. Again, as long as the duration was relatively short, the drawdowns were modest. But that’s something that I think, today, would not be as attractive to people to seek cash alternatives generally speaking.

I think there’s a lot more cash just going to stay in cash now for a little while until something happens, and then maybe it’ll be reallocated. So that might be a bit of a challenge for the industry, in the next year or so, that it’s just a little bit harder to shift money away from cash-like products, but we certainly don’t allocate a lot to cash. We go elsewhere.

[00:31:45] Alan

Maybe shifting to the other end of the risk spectrum, obviously, you’ve talked about that core portfolio. But maybe for people who want to shoot for a little bit of a higher return and even just broadening out to the discussion, we’ve talked about that core allocation between equity-like instruments and more fixed income instruments. We’ve got a whole range of alternative investments and different strategies from private equity, property, infrastructure to the whole gamut of hedge fund strategies.

Where does that fit in? Are they all in the category for more aggressive, higher return-oriented investors? How do you use those building blocks across different portfolios?

[00:32:37] Joe

There are two things I would say to start that off. The first thing is yes, we do use a variety of instruments to gather alternative risk premia, or maybe, just more prosaically, larger risk premia because they’re not necessarily alternative. They may be very similar in nature. But maybe before that, just to mention one of my own observations on risk because the minute we talk about diversification, there is a tendency to think in an institutional way and think about, what are we diversifying?

I like to think of this idea that there is both a horizontal risk and a vertical risk. The horizontal risk is basically risk over time; what people would normally call volatility. If you’re a private investor, volatility is relevant to you because the regulator makes it relevant. Your risk profile is linked to a volatility measure very clearly. Think of all the ESMA categories and all these things, these are all related to volatility and diversification is important to them.

There’s also another measure because there are many measures of risk. But there’s another one I think is really important that doesn’t get enough attention, which is the vertical risk. I mean vertical on a chart. So if you started on the left of the chart and invested in the equity market, your passage of time would have a volatility as your market goes across the page. But then you land somewhere, let’s say after five years, and if you keep doing that, if you repeated that exercise every day, you’d have this distribution and you’d have an average vol over time, but you’d also have a distribution of final outcome over five years on your vertical axis. That’s something that is completely different.

I think, for the real money private individual, the private individual investor who is not constrained by volatility, personally, outside of the regulatory requirement to look at it, as a manager, I think this this final outcome distribution is really, really important and does not get enough attention. So, when we start thinking about diversification, I definitely feel that there is probably too much emphasis on diversification with the aim of suppressing volatility and probably not enough on how that is affecting your distribution of final outcome, your probability of success over five years.

Don’t get me wrong, it’s really important to look at vol, of course. It’s very important to look at drawdown, which is something we would spend a lot of time looking at in any strategy. we’re very, very interested in strategies that can help limit drawdown. That’s where that vol diversification thing fits in. The problem is, though, the statistical measure of vol doesn’t capture those moments where everything goes wrong, and all correlations go to 1. It’s all very time varying.

So to get to the point and to your question, certainly, private equity, just partly because of the way private equity is priced. That’s not just because it’s illiquid and quarterly, but the way carry is added in and taken out over time. There is a bit of a vol suppressing element of that which you can take a view on, whether that’s desirable or whether it’s just nonsense. But it’s certainly something that we think, particularly if you look at co-investment type strategies which we focus on; very diversified as well, less concentrated, and really importantly, focusing on Europe or Asia rather than the US.

The big reason for that is that if you look at the private equity risk premium, in the US there is a private equity risk premium, but it has been shrinking. The S&P 500 is such a great index, in terms of delivering returns historically. It’s really quite difficult for the typical private equity fund to outperform, by enough, to justify what is often in pretty hefty multi-layers of fees. So that’s something that we think is really interesting.

The regional buyers for private equity, if you say, according to data that we’ve looked at, at least the private equity risk premium in the US, maybe, is generously is 2%, 3%. Over time, in Europe versus the public indices (partly because the public indices are not great and don’t have a lot of mid cap and smaller cap stuff in it), the private equity risk premium is in high single digits according to the data we observe. So that’s something that we think is really interesting, replacing some public equity in Europe with private equity. That’s something we really feel is appealing.

With direct PE, I think you really need an edge. Goodbody now has Goodbody Capital Partners, which is a business focusing on private equity, particularly in Ireland, but also looking at VC and funds and things, with the idea being that there is a particular edge there, regionally, and something definitely to look at for the future. But there are also other things, and again, they don’t have to be as exciting as private equity or exciting in theory. Things like ABS we think is very interesting in terms of generating yield premia over more standard short duration fixed income assets.

We’ve used catastrophe bonds, which obviously are highly diversifying almost all the time and typically non-correlated with pretty much everything. Traditionally, we’ve always used property assets, semi-liquid property assets, both global and Ireland, for that as well. I know we may come on to this, but there’s obviously a big focus these days on sustainability and ESG. We can definitely talk about how that is integrated. But we tend to do that in a slightly different way.

We try and make sure that the asset allocation, whether a client has a preference or not from a sustainability point of view, that we are clearly taking big account of those risks in the allocations that we make. So some of the PE, for example, one of the funds we did this year has some very particular focus on some of the UN SDGs for example. We do think there’s definitely an alpha potential by just biasing exposures in that direction still to come. We don’t believe that is a story of the past. It’s very much a story of the future.

[00:39:36] Alan

I take what you’re saying in relation to volatility management and this focus on the five-year outcomes. In defense of maybe volatility and drawdown, obviously, drawdown tends to be linked to volatility depending on the asset class and how you measure it. But I suppose what I’m getting to is that five-year outcomes are great, but what about when you’re two years into that five year period and the S&P is down 40% and some commentator on a podcast is saying that there’s another 40%, 50% to go.

That’s the whole point about having the less volatile path. Obviously, that’s the challenging bit with clients out there. But by managing the vol, they’re less likely to do something stupid at that point. Would you concur with that perspective or do you think you can manage the clients if you hit a big bump within the five-year period?

[00:40:35] Joe

Look, I think it’s really important to make this distinction, again, between the institutional and the individual. For the institutional investor, I do think there’s a very, very strong, I would say even, requirement for diversifiers, even pure diversifiers. I’m always interested in how can we do things as efficiently as possible for the client? For example, one way to suppress vol and drawdown, in the first couple of years, is to phase into the market. Go in four steps, in three steps.

We look at that from an optimal point of view. We will say, what’s the risk profile, what’s the time horizon, and so on and so forth, and we will come up with a plan. Also, the scale is very important. We will almost certainly phase in over time. The beauty of that is it’s like a minimum regret strategy because if you present cash to be invested today and we invest a quarter of it, and the market goes up, that’s great. You have a quarter invested and you’re in. If the market goes down, you have more to invest.

You’re kind of trying to find this cost point where the investor is not really sure if they want the market to go up or down, which is exactly, psychologically what you want. You don’t want to create stress, particularly in the first year or two where returns, particularly equity returns, are, relatively speaking, almost all vol. As in, if I say to you, I think the equity markets going to deliver 7.5% per year for the next five years. If you look at the scale of equity vol and what that translates into, in terms of a potential movement in one year, that 7.5% is not so significant. Over five years, because it’s linear, it’s really relevant. But the volatility being nonlinear, progressing with the square root of time, it becomes less significant.

So, this phasing in is, in a way, from a wealth-oriented investor, as opposed to an institutional investor, it can achieve something similar. Don’t get me wrong, because 100% a role or pure diversifiers, and if we had an investor who wanted to be invested straight away from the beginning, we would have to find other ways to do that. Using pure diversifies is certainly one way to do that. So this isn’t a stance against diversifiers. It’s just literally asking the question, what’s the expected return and what’s the value of that relative to the volatility-suppressing action over the life of the investment? It’s just a trade-off.

This goes back also to the cash rate question. If cash rates were negative, diversifiers would be much more attractive. If they’re non-negative, they become, to me at least, that little bit less attractive. So it’s based on that sort of logic I would say.

[00:43:50] Alan

That’s maybe a good segue into maybe talking a little bit about hedge funds. It’s the one you haven’t mentioned. I’m curious. I know you started off, at least in the early part of your career, a lot of it was focused on global markets and FX analysis. Obviously, FX trading and exploiting macro trends is a source of return for many macro-oriented funds and trend followers in quant strategies. Has that experience made you less likely to invest in those types of strategies or more?

[00:44:24] Joe

Well, when I was involved with hedge funds many moons ago, they were a very different beast to what they are now. The risk appetite of a typical larger scale hedge fund was, I would say, multiples of what it is today. There are exceptions. But the hedge fund industry certainly went through a long phase of evolving into more of a diversifier industry, almost, I would say then, a pure alpha-driven, full on, massive VaR taking institution. We use very few if any hedge funds at the moment. We have done in the past.

Again, this just comes down to thinking about how well can we define the expected return, and again, comparing that to all the other alternatives? You could pick a manager for sure. You could definitely pick a manager and say, I believe in this manager, they can deliver for me over time. If you have access, you could definitely go that way.

I mentioned the core satellite approach for example, where particularly with a very large client, you have a core portfolio, you might have satellites of private equity and some interesting slightly riskier fixed income elements, maybe some semi-liquid property. You could also have a hedge fund or hedge funds. You certainly could. It’s not typically something we do in the core model that we built for the reason that it just comes down to how precisely do we think (not precisely, because that’s a nonsense to say anything we do is precise), but how confident are we that the expected return we’re perceiving will be delivered? That’s the approach I would say that we take. So today, particularly with cash rates where they are, we ended up with quite little hedge fund exposure. That may change in the future.

[00:46:31] Alan

More generally then on the FX question, obviously being a Euro based investor, a lot of conversations tend to be dollar based in the first instance. But as a Euro-based investor talking to clients, one, what’s the philosophy on global exposure versus Euro denominated? Secondly, do you just accept the currency risk, or do you try and manage it? How do you think about that?

[00:46:57] Joe

You’re absolutely right. I spent a huge amount of my career looking almost exclusively at FX. Certainly my first 10 or more years, I was almost 100% an FX analyst and I made many discoveries at that time. The one thing FX taught me is never believe anything anybody says to you about financial markets. Especially when I was doing it in the beginning, people would say things like the Fed is going to tighten.

I remember back in 1994, when the Fed was going to tighten, and it was the consensus view. They ended up tightening a lot more than was expected, but there was this big view that the dollar would go up. I’m not sure why, maybe it was just my own ignorance or something, but I just looked back at all the past Fed tightenings to try and figure out what had happened and then I just made this discovery the dollar 100% always went down when the Fed tightened for the first time in a cycle. But it has to be really the first one in the whole cycle, and it went down, really quite a lot. That was repeated in 1994.

So I learned a huge amount about empirical work and not believing anything people say, because a lot of the time it’s just supposition. It’s what I used to call the missing paragraph. You hear somebody say something like UK retail sales were very strong, therefore, I like the pound. I used to think, well, why do you like the pound? Can you link those things together for me? There might be, of course, an interest rate related thing. So I really became very empirically focused.

It’s the same, actually, with the approach to FX in the portfolio. So, when you look at the value of global exposure, and we are very willing, we hedge everything in fixed income. We take almost no, well, not almost no, very low amounts of non-Euro fixed income risk. We just don’t see the need to do that, certainly not at the moment. We have done it in the past.

But if you look at the equity side, we don’t hedge anything on the equity side. Most of that, obviously, in line with benchmarks and everything else, most of that is US dollar exposure. Typically, and again, it varies over time because cost of carry will have and influence and valuations might have an influence, but typically, if the dollar is in the middle of ranges and interest rate differentials are at least creating some cost of carry to hedge, it just has not been worth doing.

We would still be very U.S. biased in our equity allocation. We really believe, particularly with a lot of the major trends and structural things that are going on at the moment, the U.S. is still very well-positioned from a corporate point of view. You can argue otherwise from other perspectives, but from a corporate point of view, the U.S. is, almost certainly, still going to be the highest productivity, most profitable. It’s going to be the center of earnings growth over time, still, for quite some time.

So, as long as we believe that, and then the currency volatility is relatively less than the equity return (over time), and there’s a cost of carry, to us, it just doesn’t make sense to consider hedging under most circumstances. There are circumstances, and my approach was always just to have a very basic sense of valuation and look at a nonlinear model of that valuation to see what’s the probability of a major snapback in valuation (which today would be pretty low because you’re not that far from what we would consider reasonable valuations,) and then look at the interest rate differential.

If the interest rate differentially is in any way significant in the dollar’s favor, actually, you’re strongly advised not to hedge, and that’s the position that we would hold at the moment.

[00:47:42] Alan

Maybe just to pick up, you mentioned the structural trends there and maybe the attractiveness of the U.S. I have a couple of questions there. One, yes, you’re right. Obviously, the US has been better at generating earnings. It has had strong earnings growth in the last 10 years. But obviously, now that is reflected in valuations. A lot of people point to that you’ve got frothier valuations in the U.S. and the opportunity is overseas.

So how do you balance those two factors: one, a seemingly more attractive earnings generating capability versus a higher starting point from a valuation perspective?

[00:51:47] Joe

It is definitely a limitation. I don’t think it’s particular only to the U.S., now, at the moment. I do think obviously a lot of the answer to that question is going to depend on what you’re plugging in for earnings growth long-term and where you think things are going. I would say two things. Before talking about the regions, if you actually consider the sectors, it’s very interesting. There are certain sectors where (and this is not new to anybody I’m sure), but certain sectors where earnings visibility is very high.

It ends up that stocks in these sectors tend to be more than compounders, more reliable. You can look at healthcare, for example, where you have very, very, very stable earnings growth over time, the odd shock, of course, but something you would say is reasonably predictable. And then you have energy, for example, where the long-term trend is pretty much zero, it’s not going anywhere, but it’s massively volatile. So, there’s creation of opportunity from time to time in something like energy.

But energy is just like very, very high volatility, high yielding assets. We don’t have to hold equity if we want to have one of those. We can do that elsewhere. So I would say, to me, the regions have not been entirely dissimilar. European equities, of course, while they’re doing very well of late from a trend point of view and an earnings growth long-term point of view, you would have somewhat lower confidence that looking 5, 10, 15, 20 years down the road, that Europe would be able to deliver the same degree of earnings growth as the U.S.

Now, absolutely in the next one to three years, there’s a lot that is priced in. But then again, it’s not to say that there’s too much priced in, because we have some big structural themes. We’re going to have some really significant rebounds, I would say, in earnings growth, sectorally, in the U.S. next year; things that didn’t do so well this year that will be rebounding. Earnings growth, it looks optimistic. I think it’s double-digit expectations for earnings growth next year. But it’s not unrealistic given what is happening among the sectors.

But I would go back, Alan, to what I mentioned earlier about if you just look at where trend earnings are. There’s no doubt that equities are less attractive than they were. We are relatively high in earnings versus trend and there is a gravitational pull. Now, there might be a lot of forces that push against that. Monetary policy, if it starts to ease now as pivot suggests, that’s going to push against that and maybe you even see a longer period of equity overshoot.

The fiscal side, it’s still very unclear if we’re going to go into any kind of fiscal reversal. Depending politically what happens in the U.S., you could even go in the opposite direction, which will cause longer-term problems. But it’s not to say that there isn’t the potential for surprises. I would say those surprises are probably more biased to come from the U.S. than elsewhere at this point in time.

[00:55:15] Alan

You touched on sustainability and incorporating ESG, so maybe just to touch on that briefly. I’m curious to hear investor interest in that as a topic, and secondly, how you’re incorporating that as a metric or as an opportunity in your process.

[00:55:38] Joe

First of all, we’re very focused on the whole theme of decarbonization, the whole theme of sustainability. We do think there’s a major structural trend unfolding. To me, it’s just simply follow the money. It’s just a question of where is the spending going to be, particularly on the fiscal side. There are massive projects that need to be undertaken. You can think of things like grid infrastructure, for example, as a theme where you would be expecting a very significant earnings growth related to some of the really big build outs that are going to come over the next decade or so.

Now, some of that’s priced in, of course, already, but those themes I think are going to remain really very, very strong. Where we struggle a little bit, I suppose, is dealing with the regulation side of things. The regulations that have been introduced, over the last year or so, in terms of having to serve client preferences and interpret those references in portfolio terms has definitely been challenging due to some lack of definitions and, maybe, we need to be more precise in terms of what the regulation is actually specifying.

I think more work is being done on that. But we’ve certainly tried to approach it in three ways. One is to, of course, have the ESG integration. I mentioned grid infrastructure, for example. Almost every model we run would have some exposure to grid infrastructure because it’s not just a sustainability related theme. It’s something we want to own for the reasons that I mentioned.

The second thing is to have, what we call, a sustainability enhanced portfolio. This is just literally identifying a relatively straightforward, all collective portfolio structure for the client who says, or the investor who says, I want my portfolio to reflect sustainability, as much as is reasonable, without affecting my expected returns. That’s obviously very difficult to be precise about but ex ante, you would not have any different expected return for that portfolio compared to any other one, at this point in time at least.

So that’s something that we spend a lot of time on. But we are definitely not selecting what we would call sustainable investments. When you think about what is required in selecting a truly sustainable investment in the way that an Article Nine reporting fund would do, we’re definitely wary of going too far down that road too quickly.

Our approach is to say, look, there is a core sustainability-enhanced portfolio, and then if you, as an investor, you have a more granular sustainability preference, or an ESG preference, or you might have a particular interest in biodiversity or whatever it is, and that’s come out in your really granular expression of your preferences, we can approach that from a core satellite perspective.

So, you have a very straightforward sustainability enhanced portfolio, but then you could select a small number of buy and hold investments around the side, including even impact investments. You could do that to address those preferences more directly. That’s all still in its infancy in practice. Of course, clients are expressing preferences, they’re being surveyed, and this has been underway for some time.

As those preferences come in, you realize just how many different variants there are. That’s why I think a core satellite approach does make sense. But whether we can address all preferences, we just have to wait and see, I think.

[00:59:49] Alan

Okay, good stuff. Conscious of time and we’re running up towards the hour. We normally wrap up by asking our guests just to maybe reflect on their careers and thinking about any advice that they might have for people, not so much investment advice, although it can be investment advice, but as much career advice.

You mentioned reading Galbraith and Kindleberger at the outset. Anything else that you’ve read that you would highlight or anything else you would say to people who are interested in wealth management, asset allocation, and investing to do or read?

[01:00:28] Joe

Well, Kindleberger and Galbraith, definitely. Just even for the entertainment value alone; absolutely fantastic to read. The one book I would say, and I think it’s a… I’m not sure what people’s opinion of this book is really, but Thomas Piketty’s Capital. I just think that this book is incredibly important for anybody who is investing and expecting to make money. Because this whole idea that the return on capital is greater than the rate of economic growth is kernel to what we’re trying to do.

It sort of tells you it’s possible to do what you’re trying to do, that there is a bit of an excess return out there, and if you apply capital to the market, you should be expecting to see some kind of decent return. I know that’s not the point of the book, but it’s a really important corollary. The other thing I like about that book is there are a lot of great stories about financial events and crises of the past, real detail that is just a fascinating read. So that’s one. It always looks a bit, it looks big. It’s not as long as it looks, let’s put it that way.

The other book, and I know everybody probably mentions this, but years ago when I was a young lad at Credit Suisse First Boston, I went to visit a hedge fund manager you probably know, Jim Leitner, in the U.S. When I was leaving, he went to his cupboard and he pulled out a copy of “Fooled By Randomness” by Nick Taleb, the original book. He had a whole load of them in there. I think he was giving them to everybody. In financial markets, I think that’s the best thing I ever read. I just think that’s so great.

When you think about manager selection and all these things, and just thinking about how to approach information in financial markets, how to approach track record, how to think about decision making, that’s one I would definitely say you have to read either that or of course “The Black Swan” book, but I personally like the original “Fooled By Randomness”.

The only other piece of advice I have, just thinking back to my own starting point, trying to keep things creative, I love to write and I’ve done all kinds of stupid things with writing. Alan, I actually even came up with a series once where I was interviewing currencies like they were people to give them characters, which I’ll leave someone else to say whether it was successful or not. We also used to write in 100 characters, a daily comment, not words but 100 characters, like incredibly challenging, it was haiku style, but to have a beginning a middle and end.

I just think keeping creative and of course using data as much as you can, embracing the contradictions. Keep it simple, but also think laterally and be creative. Learn to distinguish what’s a fact and what’s speculation when people are speaking. I think that’s incredible. There’s a lot of lazy supposition out there. Most importantly, remember, nobody knows anything, for sure, so do be skeptical.

But again, don’t let that stop you making decisions and having a strategy. Once you have a strategy, which is totally different from a trade, sticking to the plan. That’s always my line. Stick to the plan.

[01:04:00] Alan

Great stuff. Well, Joe, thanks very much. This has been a great conversation. Thanks so much for joining us today. Make sure to follow Joe’s work because it’s so important in an uncertain and ever-changing financial landscape that you consider how to allocate capital well. Hopefully today’s conversation has been beneficial and insightful. From all of us here at Top Traders Unplugged, thanks for tuning in. We’ll be back again soon with more content.

[01:04:26] Ending

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