CIO Greatest Hits: Sovereign Wealth Funds – Raphael Arndt (Australia Future Fund)

This week's final Summer Series is a mega two-fer, Raphael Arndt from Australia Future Fund and Geoffrey Rubin from CPPIB. We packaged these two leading sovereign wealth funds together to compare their application of the Total Portfolio Approach – with Australia focused on partnerships with external managers and CPPIB on a hybrid of internal and external management. Both have been thought leaders on modern portfolio management and have experienced great success with their innovative approaches. Please enjoy my conversations with Raphael Arndt from 2018 and Geoffrey Rubin from 2022. Geoffrey Rubin EP. 280 – November 14, 2022 Raphael Arndt EP. 70 – September 23, 2018 Learn More Follow Ted on Twitter at @tseides https://twitter.com/tseides?lang=en or LinkedIn https://www.linkedin.com/in/tedseides/ Subscribe to the mailing list https://capitalallocators.com/ Access Transcript with Premium Membership https://capitalallocators.com/signup

Speaker names marked ? are inferred from speaking time and the show’s known hosts — they are not voice-verified.

• 0:01Ted Seides?

  Capital Allocators is brought to you by AlphaSense. Every allocator sits at their desk for hours preparing the work around investment decisions, getting up to speed on a new theme, prepping for the next investment committee meeting, and tracking what changes across an entire portfolio. AlphaSense just launched something built to help. It's called SuperAnalyst, an always-on agent that works like a power user on your behalf. It draws on over 500 million premium sources, including broker research, expert transcripts, company filings, and earnings calls, and keeps working long after you've gone home for the day. Point SuperAnalyst at a theme, company, or market, and it learns the coverage universe

• 0:46Ted Seides?

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• 1:24Ted Seides?

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  the front, middle, and back office with one set of data and powerful AI agents that automate away operational drudgery, so your talent can shift from managing old technology to materializing new ideas. RidgeLine helps asset and wealth managers understand and improve their firm's growth trajectory. To see how your firm compares to 16,000 of your peers, visit ridgeline.ai/trajectory. If you file Form ADV, your firm is already there. Then talk to RidgeLine about how you can do more with the team you already have. Capital Allocators is also brought to you by Juniper Square,

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• 3:32Ted Seides?

  Hello, I'm Ted Seides and this is Capital Allocators. This show is an open exploration of the people and process behind capital allocation. Through conversations with leaders in the money game, we learn how these holders of the keys to the kingdom allocate their time and their capital. You can join our mailing list and access premium content at capitalallocators.com.

• 3:59Speaker 01

  All opinions expressed by Ted and podcast guests are solely their own opinions and do not reflect the opinion of Capital Allocators or their firms. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of Capital Allocators or podcast guests may maintain positions in securities discussed on this podcast.

• 4:18Ted Seides?

  This week's final summer series is a mega twofer. Raphael Arndt from Australia Future Fund and Geoffrey Rubin from CPPIB. We packaged these two leading sovereign wealth funds together to compare their application of the total portfolio approach, with Australia focused on partnerships with external managers and CPPIB on a hybrid of internal and external management. Both have been thought leaders on modern portfolio management and have experienced great success with their innovative approaches.

• 4:53Ted Seides?

  Before we get going, it's time for all our back to school rituals. Time to shop for clothes, buy a few pencils and notebooks, or update electronic devices as the case may be, adjust sleep schedules, and launch into the excitement of new teachers, classrooms, and classes. But rather than hear about it from me or my kids, who are long past the precious ages of first day of school photos, I thought you might enjoy hearing about it from the Capital Allocators family. Here's Blake Arguela, Morgan's nine-year-old daughter.

• 5:27Speaker 02

  I love school because I get to see my friends that I didn't see over the summer.

• 5:32Ted Seides?

  And another from Galia Arbach, Tamar's seven-year-old daughter.

• 5:37Speaker 02

  I love school because you get to see old friends and new things.

• 5:41Ted Seides?

  The lesson from these adorable kiddos is the same as investing in managers. It's all about the people. And when it comes to connecting and learning with your peers, there are only two ways I know to bottle up similar enthusiasm in adults coming back to school. First, investor relations and business development professionals can join us at Capital Allocators University for our next course in December. Early bird rates will last another week. And for everyone else, you can tune in right here for a modern version of the classroom each week and tell all your friends to join your class. Thanks so much for coming back to school with Capital Allocators.

• 6:21Ted Seides?

  Please enjoy my conversations with Raph Arndt from 2018 and Geoffrey Rubin from 2022.

• 6:30Ted Seides?

  Well, Raph, thanks so much for joining me. Thanks, Ted.

• 6:33Speaker 03

  Start with how someone comes to be the Chief Investment Officer of a sovereign wealth fund. Sure. Well, it's an interesting journey in my case. It certainly wasn't something I planned from early in my career. I actually started by studying civil engineering and economics. And started life as a civil structural engineer, spent some time in the UK with a consulting firm and then ended up designing oil platforms of all things. And then came back to Australia and decided that the future career in engineering while it was there for me. Was probably not stimulating enough compared to what I was interested in.

• 7:13Speaker 03

  And because I'd done economics and a bit of finance and at that time in the early nineties, Australia was just. Starting down a path of privatizing infrastructure assets and working out how to procure. Government services jointly with the private sector, become quite interested in, I guess what we might call private infrastructure. Yeah. Which was a much more novel concept in the early nineties than it is today. And it appealed to me because it was not just within my technical wheelhouse, but because it had elements of law and politics and. Social services and finance that I had been exposed to and and interested me.

• 7:55Speaker 03

  So I decided that was an area I wanted to get into, but it wasn't really an industry. So I started asking around and eventually decided, believe it or not, to actually leave my job. And go and do a PhD on private infrastructure policy. Not because I wanted to be an academic, but because. I thought it was an entrance into a industry that was just starting and I could meet lots of people and. As it happened, I ended up working very closely with the state treasury through that time on infrastructure policy. And meeting a lot of people in the industry. So I was lucky enough when I finished. To get a job through some people I met as, I guess in the US, what you might call a lobbyist, but it was really a policy driven role. For an industry advocacy group.

• 8:42Speaker 03

  And I never wanted to do that for a living either, but it was it was some good skills. And I certainly learned how to articulate a complex message clearly. And again, I met a lot of people. And so a couple of years later, I was actually able to move to a role for a boutique infrastructure fund management business called Hastings Funds Management, which was based here in Melbourne. And then spent seven years there, learning the trade, learning how to be an investor. And so by the end of that time, was the portfolio manager for one of their unlisted infrastructure funds. And again, through luck, I would say of timing rather than anything else, that happened to be the time that the future fund was being established and among other things, they

• 9:26Speaker 03

  were looking for someone to head up their infrastructure team.

• 9:28Ted Seides?

  How did the formation of the futures fund come to pass?

• 9:32Speaker 03

  So in the early two thousands, Australia had benefited from some degree of the resource boom as China emerged. And through a combination of that and economic management by the government at that time, the federal government budget was in surplus and was expected to be in surplus. And the government had been paying down the federal government debt to the point where the industry started to get concerned that the all the bonds would be retired and there'd be no reference rate for the industry. And so the government was faced with the great problem of saying, what do we do with the money? Do we up our spending? Well, be it that we don't think this situation may be sustainable.

• 10:16Speaker 03

  Like many, many governments had had a series of pension fund obligations that were unfunded. And so instead it decided to establish the fund to invest that money, but also they privatized Telstra, the main telecommunications company around that time. And the the bulk of the money in the future fund actually came from the proceeds of that sale.

• 10:37Speaker 03

  And set up an organisation to invest that money with a view to allowing the government to draw down in the future to offset the unfunded pension liability.

• 10:46Ted Seides?

  What was the initial size of that pool of capital?

• 10:49Speaker 03

  Well, if you include all the inflows over a year or so, it was about 60 billion Australian dollars, of which about 50 billion was in cash. About 10 billion was in Telstra shares that were still in escrow and were not allowed to be sold for two years.

• 11:05Ted Seides?

  So that's a large amount of money you just start thinking about putting to work.

• 11:09Speaker 03

  It's a unique situation really, because what we had was a new business, really a startup being formed, but with 60 billion dollars on the balance sheet. And so that was a pretty exciting place to be and a great opportunity, which I was very strongly attracted to in terms of the infrastructure role. But also it gave us the opportunity to create a new way of investing large institutional long-term money from scratch with no legacy systems, no clients and just Blue Sky. So I was brought in to do the infrastructure role and very quickly I also inherited this responsibility for selling down 10 billion dollars of Telstra shares, which I didn't know all that much about at the time, but quickly learned.

• 11:54Speaker 03

  And I did that job for about six or seven years, establishing the portfolio and the team and the approach. And then through some internal changes, my boss, the CIO, became the CEO and I was lucky enough to get the CIO gig.

• 12:08Ted Seides?

  Yeah. So let's, let's start with your initial entrance and the, the creation of the fund in the first place. What was the strategy?

• 12:17Speaker 03

  Yeah, so I, I would say I came in partway through that process. The fund had been established through an act of parliament in 2006. The board had been appointed and the board was just getting down to appointing a team that hired a CEO, a person called Paul Costello, who also had been involved in establishing New Zealand Super and very wisely made the decision that it was better to build the back office and the custody system and the legal approach first before you start hiring investment people, because believe it or not, investment people want to start investing straight away. So it wasn't until around the middle of 2007 that David Nell was appointed as the CIO.

• 13:00Speaker 03

  And he came from an asset consulting background. And so I think he's very good at strategic thinking and he really had a very strong philosophy that he built together with Paul, which was, let's look around the world at other large funds, many of whom are tremendously successful, but figure out what constrains them and how we can address that. And there were just a few simple ideas. One was to think about what many people today call total portfolio approach, but we called it one team, one portfolio. We're all in it together. We won't worry about diversifying individual asset class portfolios. We'll just do what's right for the whole portfolio. It's a very simple concept, but actually it's very hard to do in an existing organisation.

• 13:44Speaker 03

  And we had the benefit of starting from scratch.

• 13:46Ted Seides?

  To start with that, what are some of the things you would do differently with one team, one portfolio than what you saw in sort of legacy teams?

• 13:54Speaker 03

  Well, I'll just give you one example. There's many, many examples, but one very simple example is today, we have a portfolio like, like all of them really of our size, which is very growthy and very exposed to equity risk premia. And we know that in certain scenarios, for example, a big recession or a market sell off, that portfolio will not do so well. And so positions that can hedge against that are very, very valuable. So we have a couple of hedge fund strategies that really are sort of volatility traders or tail protection type mandates. And if we had diversified hedge fund portfolio, and if the person running that or the team running that were incentivised just based on the hedge fund performance, they may

• 14:39Speaker 03

  have those positions, but they would size them relatively small, because in most scenarios, we expect to lose money on them, or at least not make very much.

• 14:48Ted Seides?

  Right.

• 14:48Speaker 03

  In our case, we actually size them very big, or at least from their perspective, very big. It might be, say, 20% of the total hedge fund book, because they're actually designed to pay off at a whole of fund level in those scenarios.

• 15:00Ted Seides?

  Yeah, makes sense. So that's the first principle, one team, one portfolio.

• 15:04Speaker 03

  Yeah. The second thing was, we call it being joined up. And what we mean by that is, most funds, I would say, they're quite backward looking in their portfolio construction. What I mean by that is they take their sort of CAPM theory and their main variance optimisation and they look at historic data.

• 15:24Speaker 03

  And they then optimize the portfolio using that data. And by design, that assumes that assets continue to behave in the future the way they behaved in the past. But I don't think there's any reason to assume that. And I think that today, there's reasons why that may not be the case. Sure. And so we try to have a forward looking process. And quite a few funds do this today where we think of asset classes not so much as sectors, but through their factor contributions. So how much exposure to equity risk premia, credit risk premia, inflation, duration, illiquidity premia, those types of things. And we can then look forward using a scenario analysis and say, okay, in a stagflation,

• 16:06Speaker 03

  in a recession, in an emerging market slowdown or productivity boom, what would happen to those factors? And therefore the assets themselves, but also how would correlations change? And we can start to look at the portfolio on a forward looking basis. Typically, what funds do, because they're very large and they are complex organizations, is they then come up with a portfolio allocation. Maybe they've got a strategic asset allocation and they exercise a tilt away from that. And then they ask the sector teams to fill up those buckets to buy assets. The problem with that approach is the top down and the bottom up are very disconnected.

• 16:46Speaker 03

  And the asset teams, which in many cases might even sit in another country to the top down team, they don't understand the fund's macro view or the fund's portfolio construction, the risks, the exposures. And in reality, those teams, if they're sophisticated, they can build a portfolio to match a desire. So a property portfolio doesn't have to be vanilla real estate. You could target certain types of property or exposure, or the same in infrastructure or even equities. And so that's the top down approach. The bottom up approach is one where the teams just go out and buy the best assets they can. And they might try to risk adjust the hurdle rates. That's quite nimble because you can adapt to the market. But the the problem is

• 17:29Speaker 03

  there's no real concept of portfolio construction, certainly at the whole portfolio level. And so we try to bring those things together by by having a small team of sixty investors all in one office here in Melbourne, Australia. And we can all sit in a room and debate things frequently, and we do. And more so the teams can work together so that the economics team can say, well, I'll give you a real example. When I was running infrastructure, we were looking at a toll road opportunity in Spain, just after the financial crisis. And so the the value of those assets had fallen very significantly, as at all assets. But the Spanish economy at that point still looked reasonable. And so the view from the bottom

• 18:11Speaker 03

  up was these are great assets, they're a great opportunity. And it was only by talking to our economics team that we understood that there was a big risk of a financial crisis in Spain, given the positioning of the banking system. And we could start to take that into account in how we thought about the valuation. Equally, our teams that are involved with airports and shopping centers and seeing companies repaying their credit obligations on time or not, can inform the economics team about what's actually going on in the real world and help to influence their thinking about the opportunity set and the economic outlook. So we call that being joined up.

• 18:50Ted Seides?

  Okay.

• 18:51Speaker 03

  The third thing's being nimble and flexible. And that's really about being prepared to do something differently, not doing things the way they've always been done, understanding why you would do something, and being prepared to make the call and to take some risk. We're in the business of taking risk, we need to understand it, but we can't deliver returns unless we're willing to.

• 19:11Ted Seides?

  Yeah. How do you lay that out in a process when you have a governance board of what that strategy is to be nimble and flexible?

• 19:20Speaker 03

  Well, you need to have a very clear language that you can speak. And so with our board, they're all people with some experience in financial services. We've developed a language that the Future Fund mandate says maximize return. In doing so, don't take excessive risk, which is pretty high level. We do have a benchmark from the government of inflation plus four to five percent over the long term that they've given us. But in its essence, the way the board has interpreted that is to say, we should vary risk in the portfolio. It's not a set and forget strategy. So if risk is being rewarded, we should take more. And if risk is not being rewarded, we should take less at a point in time.

• 20:04Speaker 03

  And then secondly, we think about risk in terms of the cumulative drawdown over a three year rolling period because we think as a public fund, we've got a responsibility to the public and to the taxpayer and the tolerance for bigger drawdowns over longer timeframes could be tested and could potentially lead to poor decision making. So we debate those metrics with the board from time to time, but we've got a very clear language and we have quite open conversations with the board about why we're doing certain things. So for example, that discussion about the hedge fund tail protection strategy, we have that open conversation with the board. We're making this investment.

• 20:45Speaker 03

  We think it will probably not pay off in most scenarios, but it will pay off when we really need it.

• 20:51Ted Seides?

  And what are the metrics that you think about when you try to determine whether it's a good environment to take risk or not?

• 20:58Speaker 03

  Well, the first thing to make clear is we certainly don't believe that we can time markets. It's not a, not an exercise in market timing. It's not a short term strategy. We've got plenty of macro hedge funds that do that on our behalf and we don't think we can do it better than them. But we do think if you draw a line today and look forward, it's possible to predict, for example, what is the implied equity risk premium? Because we can have a view on long term growth, on corporate margins, we can sort of work out what we think the earnings are going to be. We can take the long bond rate or some forecast beyond that and say, disaggregate that and say, what is the implied equity risk premium?

• 21:40Speaker 03

  And that's actually a pretty good predictor of future returns over 10 years.

• 21:46Speaker 03

  And so in terms of the expected return drivers, that's probably the main one. But obviously, there's things like term premia and other things in other asset classes that come into it. And then in terms of risk, I would say it's quite a qualitative process. So we debate the issues of the day, but today we're quite focused on the the healthy economy in the US. However, that probably indicates a return to the normal business cycle. And that means that as interest rates rise slowly, eventually that will start to impact on what is still a reasonably indebted economy and slow economic activity, and usually markets will lead that impact.

• 22:31Speaker 03

  We've still got monetary policy that's accommodative, we've got fiscal stimulus happening, and so there's quite a bit of downside risk in the longer term. And then we're also looking at things like geopolitics, trade disputes and things like that, which populist politics in general is usually detractive from economic growth and inflationary. And so there are risks that are out there on the horizon. We think risk is building at the moment over that time horizon.

• 22:57Ted Seides?

  So that sounds like the general top down case of what you're looking at. Do you start with that and then bottom up and then marry it? How does that work?

• 23:08Speaker 03

  Yeah, that's exactly right. So we start with that view. All of our bottom up sector team leaders are involved with that conversation. And then the way we would translate that, for example, in property, in real estate, would be that no view is ever certain. We've got to be humble in our abilities, but let's say we thought it was. Then assets with long duration would be at risk. Because if we think interest rates are rising and that's not fully priced in, or economic growth might roll over and that's not fully priced in, or inflation might break higher than expectations.

• 23:46Speaker 03

  And albeit that real estate might have some ability to pass that through, it will be limited by the capacity of the economy to carry it. Then actually, your core long duration real estate assets should be seen as quite risky from a valuation point of view. A bit like long bonds in that type of portfolio. Whereas shorter duration strategies that are more skill based. For example, we're doing aged care development in the US at the moment because the demographics are such that there's just a definite need for more facilities in that space. Or infill housing in places where because of the impact of the financial crisis,

• 24:28Speaker 03

  people stayed at home longer and the millennials are now moving out of home and need places to live near a university, near a hospital, near employment centres. Those sort of skill based shorter duration strategies become quite attractive in this environment. They are riskier from a cash flow execution point of view. But from a valuation point of view, they've got a lot of buffer because the expected return is much, much higher, probably in the teens.

• 24:55Ted Seides?

  How often can you change a view like that? So if you're just talking about infrastructure, real estate, they're fairly liquid assets. So you rates could move meaningfully over a year or two, but it's not so easy to turn the portfolio.

• 25:10Speaker 03

  No, and nor do we try. But we're taking a three year plus view. If we thought something was going to happen for three years and then revert, we probably wouldn't move an infrastructure portfolio. But we know today that asset prices implied on those core assets are well in the single digits, probably low to mid single digits. And we just think there's a lot of risk around that. So the first thing you do is stop buying them. And because we're not setting top down asset allocations, there's no need for the team to go and buy assets to fill a bucket. In fact, we'd encourage them to come back to the investment committee and say, we think we should sell our assets and give this capital over to someone else who's got better opportunities.

• 25:51Speaker 03

  So all of our alignment and all of our culture is designed around those types of interactions.

• 25:56Ted Seides?

  How do you apply the top down view to your public market investments?

• 26:02Speaker 03

  It's quite similar. So firstly, equities are our key lever in terms of how much risk we want in the portfolio and we can dial that up and down relatively easily. From a portfolio construction point of view, for example, we have a significant overweight to emerging market equities when you just look at, for example, the MSCI All Countries Index. Why? Because we have very little emerging market exposure in private equity, property, infrastructure, hedge funds. And so from a total fund perspective, we think we need a bigger exposure because they're probably misnamed these days, but these economies are more than half of the global GDP are going to continue to grow faster than the developed

• 26:47Speaker 03

  markets or traditional markets, but are not as accessible in terms of the development of their financial markets. We also bring a factor lens and so we do invest the portfolio to target, for example, quality or value type opportunities, but we've chosen not to, for example, chase momentum strategies because we have a lot of momentum in the rest of the portfolio.

• 27:10Ted Seides?

  If you roll this all up, what does that asset allocation look like today?

• 27:16Speaker 03

  That's a good question. So the first thing I would say is, well, I will answer the question. It's not as meaningful as it might be. It needs some discussion because we don't really think of asset classes, but the equity exposure overall is about 30% of the fund. And that's roughly about half developed market equities and a quarter each of emerging market and Australian equities. In Australia, we don't pay tax. We get some from sort of tax advantages under the Australian rules and mandates in Australian dollars and to Australian inflation. So we'd always have an overweight to Australia, but it's a much smaller overweight actually than a lot of our local peer funds would have

• 27:56Speaker 03

  because we're looking for diversification. Private equity is probably about 12% of the portfolio at the moment and about half of that is venture and growth equity. So we've tried to tilt that away from buyout strategies that we feel are very similar to equities and the exposure they give us and towards something diversifying.

• 28:18Speaker 03

  Property and infrastructure between them are about 15% of the portfolio and those strategies have been tilted away from the core assets at this point in the cycle. They have been there in the past and are more focused on the more skill-based, shorter duration, higher manager activity type strategies. So they're higher risk than most asset owner, property and infrastructure portfolios would be. Debt is about 10%. That's been as high as well over 20 in the past and we've shrunk that as the opportunity set shrunk and the return for that particular risk has shrunk. We have about 15% in hedge funds and other

• 29:00Speaker 03

  alternatives as a diversifier and then we're holding about 15% in cash at the moment and that's for its option value. But we also have a series of overlays to give us currency exposure and duration. We hold almost no physical bonds. We don't have any concept of liability matching. We've only got a return target and bonds aren't paying all that well at the moment. So there doesn't seem to be a strong reason to hold them, but we do have some rates exposure as a defensive asset class.

• 29:32Ted Seides?

  So is the way you talk about this with a thoughtful top-down view and when you talk about the bottom up, you're talking about specific assets, it might lead me to believe that you do a lot of internal management, but I know that's not the case.

• 29:45Speaker 03

  No, in fact, probably the last philosophical belief is that we call it leveraging the best in the world. We actually don't manage any assets internally. So we use managers for all of our implementation and we've probably got about 120 or so managers on the books at the moment and would like it not to grow too much more than that, just so that we have the bandwidth to keep on top of it and that we don't get over diversification. But the team here, so there's about 60 people in the investment team, a lot of them are former fund managers or as consultants who have interacted with managers and I'd like to think that we can go out and interact with our managers as peers in the marketplace.

• 30:28Speaker 03

  We know their job, we know what they do and we know what drives them, a bit of poacher and gamekeeper. So we can have very sophisticated discussions with them and rather than buying the vanilla strategy, we typically would design a strategy that suits us. And then if they have one that we can buy off the shelf, that's great. And if not, we can talk to them about building a specific strategy for us.

• 30:54Ted Seides?

  Now, I've had conversations with some of the other superannuation funds. When their size got larger, but let's say larger, call 40, 50 billion, which is still a fraction of where you are today, a lot of them shifted to internal management in part because of the difficulty in accessing external managers. And you talk about 120 managers, but that's on average, what, north of a billion dollars in each one?

• 31:18Speaker 03

  Yep.

• 31:18Ted Seides?

  How have you navigated that landscape where the pool is so large that the investable opportunity set isn't really that large for you?

• 31:28Speaker 03

  Well, certainly capacity constraints are an issue that we need to think about. Obviously, in the more liquid asset markets, particularly equities and bonds, those are accessible, although not all strategies. So we do have some levers that can scale, but we work very hard and we develop relationships with managers and we have to fight for capacity. And we recognize that those relationships are mutual, they're two-way, and we try to be very open with our managers and share our views with them and give them our feedback rather than just reading their quarterly report and not never talking to them. And so we would hope that our managers get something from us as well as part of that equation and that helps us get access to capacity in the better managers. So it

• 32:12Speaker 03

  is a challenge, but we have to keep working at it.

• 32:15Ted Seides?

  Yeah, I'd love to dive into your thought process on each of the asset classes. So why don't we just start with listed equities and I'll let you take it from there.

• 32:24Speaker 03

  Yeah, sure. So I guess when I came into the role, we'd been doing equities for, well, obviously since inception, that was about eight years, seven years. And the first thing we started doing was some attribution work. And I guess we're lucky enough today to be living at a time when the technological tools available to us are improving our ability to do that type of work. They weren't available a decade ago when we started the program. And what became apparent very quickly was that while the team had done a really good job of picking the best managers in a particular style, whether it was a value manager and a moving market manager, a thematic manager, when we aggregated up all of the maybe 20

• 33:05Speaker 03

  or so mandates we had across that portfolio, by and large, they cancelled each other out at the whole portfolio level. And I would have expected we would end up with something like beta less fees. Now, actually, as I said, the team did a good job. And so we ended up with slightly better than the beta, which was a good outcome, but it was not ideal. And so even if you could pick a good manager, you still had to build a total portfolio that made sense. I sort of think of it like, if you want a car, you don't go out and buy the best steering wheel, the best seat, the best windscreen, and hope that you get a good car. You actually have a plan for a car and buy the parts that suit the car you want. So having built the technology to measure performance and disaggregate performance,

• 33:49Speaker 03

  we then sat down with the board and said, let's start from first principles. What are the objectives of an equities program? One, we think that the equity risk premia exists and it's pretty reliable. And so holding equities over a long timeframe, we think should deliver a source of return for a long term investor. Now, that's not rocket science, but it's important to state it very clearly because if that's all you wanted to do, you would buy the beta and you would buy it as cheaply as possible and in as most liquid way as possible. Secondly, though, I think the research tells us today that there are certain types of factor approaches, particularly value and quality, but there are others that do

• 34:31Speaker 03

  seem to pay off over long time periods, albeit if you're worried about tracking an index or shorter term performance, you have to worry about that. In our case, we're not worried about that. We're only worried about whole of fund performance in an absolute sense over the long run. And so developing a factor strategy was high on the agenda. Now, we've done those two things and we can execute those through third-party managers for literally a handful of basis points in this day and age, and we do. When we looked at the portfolio originally, that was where the bulk of risk and the bulk of return sat in the beta and in the factors that the managers were selecting. So you picked a value manager

• 35:13Speaker 03

  or if not, it's just a manager who had adopted a value style. And so there was no point at all paying a manager for those sort of things. We do believe in active management. We do believe that skill exists and is sustainable. That in itself is something people could debate, but we believe in it. We don't think that skill is widely available in equity markets today. Technology means that it's being arbitrage away very quickly and the manager business model and the way they charge essentially typically charges you for the beta return, the factor return and the stock picking skill.

• 35:49Ted Seides?

  Sure.

• 35:49Speaker 03

  But only one of those deserves compensation. And so using the technology, we can disaggregate those things and regress against different types of factor returns and things like that and isolate where this skill actually exists and will keep those managers. Mainly, our alpha program has now migrated to long, short market neutral hedge funds because we can pick managers with pure skill and it's very evident if they have it or not very quickly. We're only paying for the alpha. But secondly, they have very concentrated portfolios and so the likelihood that they're going to cancel each other out is very low and we can track that in the system now and make sure that we're getting an efficient

• 36:33Speaker 03

  portfolio implementation.

• 36:35Ted Seides?

  So let's dive through that a little bit. When you started using the technology to do detailed attribution on the listed equity portfolio.

• 36:46Ted Seides?

  What did you do with the managers that clearly outperformed? Did you hold them?

• 36:52Speaker 03

  Yes.

• 36:52Ted Seides?

  You did?

• 36:53Speaker 03

  We have. There's not a lot of them, I would add, but yes, we have held them.

• 36:57Ted Seides?

  Okay, so some of them survive and that's stock selection alpha that you've determined after taking out factors.

• 37:04Speaker 03

  That's right.

• 37:05Ted Seides?

  Then on top of that, you have, say, long short equities. You just mentioned concentrated portfolios. It struck me that most of the market neutral equity portfolios are multi-manager, many, many positions. In fact, they're not concentrated at all. So I'm curious, if you're really looking at stock selection skill, how are you isolating the stock selection alpha in a more concentrated book?

• 37:28Speaker 03

  I should clarify, we have many managers in that strategy. They're mostly actually sort of fund-to-fund, separate account type mandates because we don't have the bandwidth in our team to track 30 or 40 underlying managers.

• 37:42Ted Seides?

  Yeah.

• 37:43Speaker 03

  But what we're doing is they're accounts that designed in such a way as they're very unlikely to overlap with each other. So each of those underlying managers might hold 20 longs and 20 shorts, for example. Our system can aggregate all of their positions and report back to us on an aggregated basis, either in isolation or overlying the long-only portfolio. And we can see where, if we've got position concentration, we can see if there's a rotation going on and we can take that information into our broader thinking in our own portfolio construction and we can see where the alpha is being generated.

• 38:21Ted Seides?

  Have you thought about marrying off the pass-through separate account through a fund of funds or a large multi-manager hedge fund?

• 38:31Speaker 03

  Well, we have some of those. So our manager list is on our website. It's quite public and we have, for example, Citadel as one of those managers. So I think it's the same thing. It's just when we aggregate those things up, what are we getting? What are we paying for? Those large hedge fund, sort of multi-strategy hedge funds, many of them have delivered significant beta, whether it's equity Beta or credit beta, and that is not something we want to pay for. So I think it's just a matter of, again, in the same way, analyzing the track record of these managers, regressing it against a whole variety of factors. In this case, things like carry and commodities as well as bulk asset betas.

• 39:16Speaker 03

  And understanding where is the skill, where is the return coming from? And only paying for the part that's valuable.

• 39:23Ted Seides?

  Have you thought about the construction of a core portfolio? So you can access, as you said, low cost, market exposures, factors, some alternative betas, and then alpha on top. How important is it to own the core? Or to just access what you found is special in the alpha piece?

• 39:44Speaker 03

  Well, if you go back to the objectives and also your comments about scale. So today, the equity book is maybe forty five billion dollars. And we're just not going to find enough skill out there in the world to invest forty five billion dollars. But also, a pure alpha book does not give us the beta. We've actually structurally taken the beta out of it. So this desire to get exposure to the equity risk premium only comes from those other things. But we can do it very, very cheaply.

• 40:14Ted Seides?

  Yeah. All right, let's move on a little bit to private equity. How you approach that investment area?

• 40:23Speaker 03

  We approach everything in the same way. The question is, what can this asset class do for the portfolio as a whole? Under what scenarios will it pay off? Under what scenarios will it be penalized? How does that compare to some combination of equities and cash or equities and bonds? And so why are we doing it? So again, we don't set out to buy a diversified portfolio of private equity. I guess the typical portfolio construction would be sixty or seventy percent buyout, for example, and then a bit of growth and maybe a small amount of venture. Our portfolio has no large buyout at all. Because we think that large buyout is really just levered equities typically.

• 41:07Speaker 03

  And if there's skill added on top, and there might be, then most of that goes away in fees. So we don't think it adds a lot for the portfolio. So our private equity portfolio is about half venture and growth equity, and the rest is small buyout. And what we're really looking for in private equity is two things. One is a clear, sustainable outperformance over equivalent equity indices after adjusting for market timing ability by the managers. So we're not interested in people who can just time markets, putting capital in and out, because if we're doing that, we're probably putting the money in equities when it's not sitting with the private equity manager.

• 41:49Speaker 03

  And so we started by identifying managers with real skill who can improve a business, not just slice and dice it or list it or delist it and move the money around. Because as someone approaching a universal owner, we're going to own it, whether it's listed or unlisted, and there's no point just paying fees for those transactions.

• 42:10Ted Seides?

  And how do you do the due diligence to figure that out?

• 42:12Speaker 03

  Well, it's quite analytical. So in most cases, we would like a manager with some track record and we would like to understand the underlying performance data at the asset by asset level. So we would delever the returns, would take the use of debt out, because usually just using more debt gives the LPs more risk and more upside for the manager, but with a lot of downside risk. And we take the market timing out by doing something called a public market equivalent analysis, which is really just saying, if we take the cash flows that go in and out of this private equity account and put them in the equivalent equity market index with the same timing, what would the return have been? And then compare those two things.

• 42:56Ted Seides?

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• 43:33Speaker 04

  This is not an offer to sell or investment advice. Investing involves risk, including the loss of capital.

• 43:39Ted Seides?

  And now, back to the show.

• 43:43Ted Seides?

  And what do you find as you look at a group of managers compared to your sense of how the industry looks at the same group of managers?

• 43:51Speaker 03

  Well, there's a lot of brand names we don't have and it varies wide, but one of the most significant reasons is because they just use leverage we found to juice up their returns and we don't think that's attractive. And we're really focused on the smaller managers that have a tremendous amount of skill in how they can improve the business. It's not just where they listed or delisted or selling off bids or buying other companies to merge in, it's actually helping the management team access a new market, grow to a new industry that they've got some experience in, providing capital to help them grow where they can't get that capital from the market for some reason. It's those types of managers and those types of skills.

• 44:33Ted Seides?

  And what does small mean at your size? So how big are the range of the funds that you'll invest in?

• 44:39Speaker 03

  We do use fund of funds for very specific strategies. So we're very agnostic as to how we implement. For the larger managers, we could write a $300 or $400 million check to a fund. And ideally, that's what we would do because we've got only seven or eight people in our private equity team and they've got a lot of managers to get across. But for the smaller ones where, say, we can write a $50 or $70 million check, but they're in a strategy we really like, so small US buyout, for example, then we would do that through a fund of fund.

• 45:11Ted Seides?

  And how big do those funds, the direct funds, tend to be?

• 45:15Speaker 03

  Probably about $1 billion.

• 45:16Ted Seides?

  Okay, so you'll be a substantial investor in those funds, yeah?

• 45:19Speaker 03

  Yeah, we typically are.

• 45:21Ted Seides?

  Okay. How have you thought about co-investment opportunities?

• 45:24Speaker 03

  We think that's an important tool in our toolkit. We do do quite a bit of co-investing in all the private market asset classes and also a little bit in alongside the hedge funds and credit managers. But particularly in private equity, the issue with co-investing is, well firstly, you want the manager focused on their strategy first and foremost in their fund. You don't want them worrying about are they keeping their LPs happy? Have they sized it right or do they have to undersize it in the fund to allow some co-investment? So we don't demand it. We want first and foremost the manager to be good at investing the fund. But where they would have a situation where they might otherwise bring a competitor

• 46:06Speaker 03

  in alongside them, for example, we'd prefer them to bring us in and other people who are like-minded. We don't try to re underwrite the deal. We've already underwritten this manager. We've already backed them and we trust them. So our due diligence process will be focused on, is it in their skill set firstly? Secondly, is there alignment with the manager? Are they putting enough capital in? Are they underwriting and selling down in a secondary, which we typically would avoid? Or are we coming in the primary deal? And then are we tied to them so that we go in when they go in, we go out when they go out? And then lastly, more of a portfolio risk

• 46:47Speaker 03

  point of view, what is the exposure and doesn't make sense for us? And so we've developed a process internally where we can do that reasonably efficiently and typically would be able to be there when the transactions close. I guess the other part of it is you do get quite a good insight into the manager and their process. So it does help us re underwrite the manager if that's what we're intending to do.

• 47:09Ted Seides?

  And have you done enough of it to be able to measure whether it's been value added relative to just giving that same manager more money?

• 47:17Speaker 03

  Sure. We've done probably 20 or 30 co-investments in private equity over the years. So it's not an enormous number, but it's enough to have a view. We also co-invest in the venture portfolio and we've done about 40 there as well. And so I would say that broadly speaking, the performance is in line. It's a little bit of younger portfolio. And so we don't really have the same data yet that we do in the in the fund book. But certainly, we don't think there's an selection happening.

• 47:46Ted Seides?

  Yeah, I'm fascinated to turn to venture capital with a with a fund your size, how you've thought about it and how you've tackled it.

• 47:53Speaker 03

  Sure. Yeah. So the first question is, why bother? It's a capacity constrained strategy. And will it move the needle? For us, I think there were a couple of things. Firstly, our research showed that unlike almost any other asset class, the strongly performing managers tend to be persistent. And I think that's probably due to the fact that the entrepreneurs are attracted to the people who backed the last successful deals and go to them first. And that does change, the so-called winner's circle does change over time, but only very slowly. And so the first decision we made was if we're going to do it, there's no point doing it at all unless we can get into the high performing managers.

• 48:34Speaker 03

  I think the data we saw at the time was something like eighty percent of venture managers don't return capital and only six or seven percent return enough capital to justify their existence. So that's pretty daunting statistics. The second thing was there seems to be a correlation of high performing venture vintages with recessions. And a hypothesis that we can't really test is that when people lose their jobs, they go and start up that business and do that thing that they've always wanted to do, but never got around to before. And so we thought that was something that was attractive for the fund from a diversification point of view. And then lastly, a good idea doesn't need economic growth to be successful and it doesn't need leverage.

• 49:17Speaker 03

  So it seems to be a strategy that can perform even in adverse market conditions, albeit that you have to be conscious of the flow of funds in and out of the space. And so those things together led us to a focus on early stage venture rather than the late stage. We've tended to avoid the late stage. And we've primarily done that through fund of funds because, as I said, small team, small check sizes, hard to get access to the best performing managers. And we're all lucky enough in two thousand and nine that there were other people going the other way and we were able to get some access. And so we've worked very hard to slowly build the portfolio to the point where today it's about a bit over two billion dollars of exposure.

• 50:02Speaker 03

  Which is meaningful to some extent at the fund level. But more importantly, it's also very diversifying from the rest of the fund. And that's quite valuable. And we have also in the last three years or so started to co invest with the venture managers. So we do fund of funds, we do direct and recently we've done some co investments which are really follow ons. Similar to the private equity approach where we would only do that if the manager was following on themselves. And if they were saying to us, this is an attractive idea, we think you should look at it. And we've done about thirty or so of them, as I said, and that portfolio has has delivered.

• 50:42Speaker 03

  You know, really strong over twenty percent net returns over ten years now, which is very satisfying considering what's been happening in the world.

• 50:51Ted Seides?

  Yeah, you know, the futures fund started investing the capital in two thousand and seven. What was it like in those first two or three years?

• 50:58Speaker 03

  So I think we were very, very lucky with timing. I actually joined right at the beginning of two thousand and eight, I signed on at the end of two thousand and seven. And in the second half of two thousand and seven, the board was under immense pressure to get started with the investment program. They literally had tens of billions of dollars of cash being rolled overnight. And as you know, markets were running very hot. And so they made a decision to start to put an exposure on just through index positions. And to just steadily step into the market over a period of time. And David Nail, when he was head of CIO and the person who was in the head of strategy role at the time, Tony Day.

• 51:39Speaker 03

  Came on board before I joined and the very first thing they did was look at markets and say, we're not sure what's going on. But we think the equity risk premium is negative. Something's wrong and we should just stop investing and they did. Which was a very brave call and I would say really set up the DNA of the fund ever since. Which is if you have a very high conviction in something, then you should act on it. And so when I joined, it was really just prior to the crisis and I was really confronted with this problem in the infrastructure where everyone said, how will you ever get set? It's a crazy job, assets are really expensive already, nothing's available. And I started writing a strategy and as I spent more time here, I ripped up that strategy

• 52:20Speaker 03

  at least twice because it took me a little while to understand what a one portfolio approach was. That eventually emerged with a strategy that said, let's be flexible, let's not lock into a particular asset allocation and let's sort of approach this from first principles. And suddenly the financial crisis happened. And so fortuitously and through some good decisions made by the people who were here before me, we were sitting with about eighty percent in cash when laymans went broke. And so we didn't have a problem with liquidity, but we of course were a bit nervous about the world and it took a little while for us to decide that it was time to start investing.

• 53:03Speaker 03

  But more importantly, we only had probably about a dozen people in the investment team and we were still writing strategies and we didn't know each other and the board didn't know us. So actually, the first time I went to the board with an infrastructure investment, I had to say, what would you like the board paper to look like? Should it be five pages, fifteen or fifty? And they actually said, we're not sure, write one of each. So I did. But we made the decision early in two thousand and eight that the world wasn't going to end, that something was going to happen to save it. And if you had that view, that assets looked very cheap and being somewhat timid, what we decided to do was move a lot of money into credit. And so we appointed three broad credit managers.

• 53:47Speaker 03

  I said, we use external managers and in this sort of situation, there was really no other option, but we just wrote multi-billion dollar mandates to three managers and just said, get set, get in the market, do whatever you want, make money.

• 53:59Ted Seides?

  How much were you able to deploy as a percentage of the portfolio at the time?

• 54:02Speaker 03

  It was probably about fifteen to twenty percent of the portfolio into credit over about three months. So it was quite a big decision and clearly that decision paid off very well. Those initial investments returned above twenty percent.

• 54:17Ted Seides?

  Yeah, so you were pretty senior in the capital structure then?

• 54:20Speaker 03

  Yeah, this was all senior and investment grade credit at that time. There wasn't much point in buying high yield if you could get those returns in investment grade.

• 54:29Ted Seides?

  Right.

• 54:29Speaker 03

  As the crisis unfolded, that portfolio started to rotate out of investment grade into higher risks, you know, high yields and other things. And at some point, we decided that it was appropriate to start the investment process into equities again and kick that off. And also by then, we had started to build teams in the private markets. And so we started to get set in the private markets. And in fact, back then, in about 2009, end of 2008, 2009, we were buying core infrastructure and core property because they looked very attractive, given where prices had gone to. So in the decade or so since then, we've rolled those assets out of the portfolio and replaced them with higher risk assets

• 55:13Speaker 03

  where we think we're getting better rewarded.

• 55:16Ted Seides?

  And so today, you had mentioned what sounded like a, let's say, a cautious macro view. How are you thinking about the flexible positioning of the portfolio?

• 55:28Speaker 03

  Well, we've built a lot more process in the 10 years since then, which is both good, but also we need to be careful not to let that lock us into a position that isn't the best position. So we run a couple of tests. We suffer, like many Australians, from a very volatile currency. And so it also tends to be correlated with risk or more particularly risk off scenarios. So that as someone with a large global portfolio, we have to worry about liquidity in those type of scenarios quite a lot. So the first thing we do is run a sort of a crash test, liquidity test every night through the portfolio, where we expect a currency fall and a equity market fall to be correlated and make sure

• 56:11Speaker 03

  we can survive that. And that test is somewhat worse than the financial crisis overnight. So we've been somewhat cautious appropriately around that test. The second thing though is if we have not quite so severe an event, but something close to it, we we actually want to be able to buy cheap assets. And the option value of flexibility is not something that traditional portfolio theory really takes into account. And so that's why you say us sitting with sort of a bit over fifteen percent in cash and why we manage our illiquid asset pool carefully, because while you would hope you get an illiquidity premium from those assets, it also means your portfolio isn't as flexible

• 56:53Speaker 03

  as it might be in those sort of scenarios and there is an opportunity cost that arises. So we try to build the portfolio to those liquidity metrics or flexibility constraints. And then look at, okay, if that's our capital budget, our risk budget, our illiquidity budget, how should we best spend it? What are the things that are returning the best risk adjusted returns, given those whole portfolio budgets?

• 57:16Ted Seides?

  And what does that look like today?

• 57:19Speaker 03

  Well, today we look at the world asset prices are expensive. They're probably slightly less expensive than they looked a year or two ago because we've had at least in the US and in other places a strong earnings print or series of prints. So the economy is quite healthy and so risk has become more attractive. And towards the end of last year, we increased the risk in the portfolio as a result. But on the horizon, we've got a couple of really significant issues. One is just the business cycle returning in the US. We've got the Fed raising rates and shrinking its balance sheet, liquidity coming out of the system, and usually that ends in a recession. In fact, while we've got some unusual experience here in Australia, you would expect a recession

• 58:03Speaker 03

  in the US in the next two, three, four years, something like that. We've also got a very strong fiscal impulse at the moment going through, but the current view is that that will roll off around the same time. So we think the chance of a recession in the US is quite high over, say, a three-year time horizon, and it doesn't appear that markets are currently pricing that in. Secondly, we've got really as a consequence, I would say, of the financial crisis and the monetary policy response, which inflated asset values but kept wages down. We've got a growing populist politics trend across the world. And that's true in almost every developed market.

• 58:43Speaker 03

  It's more reported against in the US, obviously, at the moment, but it's true in in most markets. And populist politics, which is not unusual in history, usually ends in lower growth because tariffs and trade restrictions usually lead to that, or other types of protectionism, and higher inflation. And so we've got some skirmishes going on between the US and China currently. And there is the potential for that to become far more significant. And so I think if we look at the world today, I would say there's a lot more downside risk than upside that we can see. And the only upside scenario is we can really come up with a sort of productivity boosts based on things that aren't in the data yet and we don't know what they are.

• 59:28Speaker 03

  And so it's not really likely that that central banks can respond again in the same way they did after the last financial crisis because they've used up that ammunition. So we're not expecting a financial crisis. We think banks are more robust now and markets are better regulated, but we certainly think the risk of a recession and summary pricing of risk assets to below average is likely in that scenario and markets aren't pricing for that. So we have been reducing risk in the portfolio gradually. And as we sit today, we're just slightly below neutral because we think the cost of

• 1:00:07Speaker 03

  foregoing some return in good market scenarios over the next year or two is far, far outweighed by the opportunity cost of getting caught up in a downturn in markets and not having the ability to invest into that at the time when asset prices are cheap.

• 1:00:25Ted Seides?

  And when you say neutral, is that neutral beta across the entire portfolio?

• 1:00:30Speaker 03

  Yeah, so we, the way we think about that is we map every asset onto a factor lens. And at its very simplest, we'll just think of two factors, a cash and equity portfolio. And so we tend to think about risking the portfolio on that basis. We don't know whether any of those scenarios will play out. And the most likely outcome is some other one will play out completely that we haven't even thought of. So it's important to be humble about this. We do know that risk isn't being particularly well rewarded right now. And we do know that all the risks I discussed are out there. And so it doesn't seem sensible to be taking a lot more risk than normal in this market.

• 1:01:12Speaker 03

  I can't envisage a view other than a very short term view. Why you could support taking more than average risk at the moment, for example, for a long term investor. So going back to the beginning, you have to have a clear set of objectives and risk parameters as a language that you can talk about with, in our case, our board and our investment committee. And we have this very open conversation with the board. And so the sort of scenario we're talking about is, well, if equity markets are doing 10s, which is pretty healthy considering where they're priced today. And we have a diversified portfolio and in that scenario, we're only doing seven or eight, which beats our mandate.

• 1:01:54Speaker 03

  But in a big drawdown, you know, we might only lose 10% rather than 30. And then we can invest into that and deliver 15 or 20% returns beyond that. Is that a risk worth taking? And we think it is because we're an absolute return investor. Over the long run, we don't have to worry about peer risk. We don't have our performance published in league tables annually, let alone quarterly like some funds. And so we can just focus on that long term goal. The other thing to think about, and as I said before, the industry doesn't do enough of this, is thinking about the risk part, not just the return part. And so we sort of think about volatility, but also Sharpe ratio.

• 1:02:38Speaker 03

  And it's a hard thing to measure and there's all sorts of debates you could have about it. But in terms of our 10 year Sharpe ratio, it's about 1.3, which we think for a fund like ours is is pretty good.

• 1:02:51Ted Seides?

  Yeah, yeah. How did you make decisions as a team?

• 1:02:56Speaker 03

  Well, it depends how big the decision is. And I would say that we're evolving this at the moment. But the big picture portfolio decisions, how much risk should we have in what scenarios are we worried about? We make those decisions at the board level. But obviously those views are filtered up from the team to the internal investment committee and then recommended to the board.

• 1:03:16Ted Seides?

  How many people and how many people sit on the board?

• 1:03:18Speaker 03

  Seven.

• 1:03:19Ted Seides?

  Okay.

• 1:03:19Speaker 03

  And they're appointed by the government. They're appointed for fixed terms. They're not allowed to be current politicians and they've all got financial services skills. So we're very lucky that the governance structure that was designed for us by the creators of the fund is very robust. And really, I would say is the the whole reason why we've been able to deliver what we have.

• 1:03:42Ted Seides?

  What's the structure of your team?

• 1:03:44Speaker 03

  So the investment team, I would say about 60 people. It's split into three teams. One is public markets and there's a group doing equities, which includes the long short. There's a group doing debt and that includes both public and private debt. There's a group doing all the overlays, so all the derivative positions that shape the portfolio and it and put on interest rate, currency and some option tail tail shaping strategies. And then there's the hedge fund team, we call it alternatives. They also do alternative risk premium, things like reinsurance. And so that there's a deputy CIO, David George, who leads that team. And would like to think that those skills are fungible and that we can share the insights across those sub teams

• 1:04:30Speaker 03

  and benefit from each other's skills and opportunity sets. And then we've got a private market team led by Wendy Norris and that's infrastructure, property and private equity teams. And they obviously focus on their areas, but increasingly they're sharing their skills and resources across those areas as well.

• 1:04:50Speaker 03

  And then we have a portfolio strategy team, which is a top down portfolio design team. And they're also tasked with looking at the economic situation, how markets are priced, and looking at portfolio risk settings and investment process that I've been talking about.

• 1:05:06Ted Seides?

  Yeah.

• 1:05:07Speaker 03

  My job actually is much more about team structure and process and strategy, and most importantly, culture than about making investment decisions.

• 1:05:16Ted Seides?

  What's the nature of that culture?

• 1:05:17Speaker 03

  Well, I would hope it's very collaborative. I think we aren't into star investors or single people taking the glory. We're into a real team effort. We trust each other. We empower people to make decisions and we have to support them with the right framework so they know what decisions they should be making and when they need to escalate something and how much risk they can take. We do vigorously debate ideas with each other in a very open way and we encourage that. And so we certainly think that diversity of thinking is really important, having different people around the table with different backgrounds, different experience, and that clearly in

• 1:05:59Speaker 03

  investing, there's no right or wrong answer and no one really knows what will happen. And so the more views you've got, the more able you are to make a good decision. And then importantly, it's a no blame culture. So we know we won't get all the decisions right. In fact, we'll get a lot of them wrong. And so as long as we've made those decisions in the right way, we just move forward and learn from it. And we might ask the questions, what do we learn from this? Can we improve our process? But then we just get on with life.

• 1:06:27Ted Seides?

  How have you tried to address human biases and improve them on your team?

• 1:06:32Speaker 03

  Yeah, the first thing is to acknowledge them. And so, you know, we're all very logical analytical people here, working in investment markets. And so actually, we've got a really good chief culture officer and she's led our thinking in this space. She's a psychologist. So she's been great at educating firstly me and then the rest of the team using data. So it's very clear from the data that diverse teams make better decisions when presented with cognitive problems and they have time to debate them. As opposed to teams that have to make very quick decisions, like a sports team or an armed forces group or something like that. And so using that, getting buy-in across the team for that observation, we've then looked at our

• 1:07:14Speaker 03

  own processes and the classic one is an investment committee where you have some wise and old person, usually a male, chairing the meeting, debating things, but then dominating the conversation or letting some people with loud voices dominate the conversation over others and go around the table and vote one at a time, raising your issues. Well, it takes a strong willed and courageous person then to vote against the chair or it might be your boss or the views of the other people who might have been in the organisation longer than you. Or in some cultures, actually, they just never would do that. You know, in certain Asian cultures, they never would argue against the views of their boss.

• 1:07:58Speaker 03

  But actually, that could be the most important thing they should do. So we've transitioned to a model now for some of our committees and it's in trial where we canvas views the day before the meeting, whether people are inclined to vote for or against something and why. And then the chair of the meeting gets that information. They can feed it back to the team so that the team can firstly focus their presentation on the issues rather than wasting time just repeating what's in the paper. And secondly, use the time in the meeting where it's most needed. But then we can call out those views so that even if it's only one person who says, I don't like this because, the chair can actually say, well, you raised a concern about this. Why don't you share that concern with everyone?

• 1:08:42Speaker 03

  And we can see if we can either relay that or agree with it. And that could take us in a different direction. So it comes to how we chair the meeting as well. And it's very important in the dynamic that the chair or me, if I'm not the chair, are supporting those views and encouraging people to do that and have a dynamic where we're all working together for the good of the whole portfolio. There's no us and them. There's no, let's just get through this committee so we can do what we want. It's, you're still responsible if you're presenting the paper, but it's.

• 1:09:13Speaker 03

  Do they know something I don't? Have I got an expertise that I don't? How can I use that so we all get to a better position? And so we're trying to change the culture to that. We've got a way to go, but we're getting there.

• 1:09:24Ted Seides?

  And how's everyone incentivized in their compensation?

• 1:09:27Speaker 03

  So obviously we get base salaries, but we also have a bonus arrangement, which is linked to some extent to personal goals, which might be about the team or the individual responsibilities. And they're assessed by the managers. But the quantitative performance measure, and the more senior you are, the more important that is, is solely based on the rolling three-year hole of fund performance in an absolute sense. So it's to create alignment, sort of whole portfolio thinking that I've been talking about.

• 1:10:03Ted Seides?

  Yeah. What do you think are the core differences between a US-based, kind of US-focused investor and an Aussie-based investor?

• 1:10:14Speaker 03

  It's very luxurious to be a US investor these days because you don't have to worry about currency. You know, and that's probably the most important thing, the most important difference, I think, that there's so many opportunities in the US market in US dollars, and you don't even have to think about it. And if you decide to go offshore, then suddenly that's a big decision. Whereas if you sit here in Australia, we don't have that luxury. And as I said before, the Aussie dollar is very volatile compared to the US dollar. So that is a big impact on portfolio construction. But there are other differences too. I would say, and it's easy for me, sitting on the other side of the world, but I would say that the US investors largely are quite introspective.

• 1:11:00Speaker 03

  You know, they, I think we have a very different view of the rise of China and the impact China's having on the global economy than most people I speak to in the US who rarely talk about it. And we've probably got a much more open mindset to the benefit of exposure to emerging markets than a lot of the US investors I speak to.

• 1:11:20Ted Seides?

  So what is their view on China?

• 1:11:22Speaker 03

  Well, it's probably one of the oldest civilizations in the world. So we've got a lot to learn from them just in that respect. It's an enormous country with an enormous population and it rightly deserves to be the biggest economy in the world. And it no doubt will be before too long. And the Chinese government, whether you, whatever you think of the political structure and regime in China, has done a really amazing job in improving the life of the average Chinese person in the last two generations. So that we've had this huge and one-off tailwind to investment markets and global economies, but from the creation of a middle class in China. And they're very aspirational.

• 1:12:06Speaker 03

  The policymakers are very clever and they have a plan. And so one of the things I'm most excited about actually in the world at the moment is the opportunities that the creation of that middle class, consumption generation and an investing population, there's a huge internal domestic investment markets. And they haven't really been opened up to the world yet, but they will be. The currency has become tradable and will become more tradable over time. And so someone who's interested in the long term really needs to be aware of that and learning about it and thinking about what is their strategy.

• 1:12:42Ted Seides?

  How have you thought about allocating when your domestic economy can be tied to what's happening in China? Then you have a whole Chinese market opportunities.

• 1:12:53Speaker 03

  Yeah, so you're right. So the first thing is, you know, if you're Australian, you have an exposure to China, just in the Aussie dollar and the local economy. So we're not setting out, for example, to play commodities because we feel like we've got enough of that exposure already. And if we look at, we sort of loosely call it old China and new China. So old China is the investment-driven wealth creation through building roads and buildings, particularly property investment. There's all sorts of debates about whether that was over-capitalized and whether capital allocation was efficient. We don't get into that. All we would say is, we don't see that as a particularly attractive investment opportunity right now.

• 1:13:33Speaker 03

  But the new China, the creation of significant demand for healthcare, for education, for entertainment opportunities as people become middle class, the trading up in terms of the types of goods and services that people buy, those opportunities are absolutely tremendous. And so we've been playing them a little bit in the equity market. We're working on some further strategies there, but significantly in our private equity program, where we have quite a bit of onshore Chinese exposure, really playing those themes. And then the tech space in China is really interesting at the moment, too. And they're really market leaders in a lot of cases. And so we have a venture program focused on China as well.

• 1:14:17Ted Seides?

  So now that the fund's been up for 12 years, things have sort of settled in. You said there's processes now. As you look out for the next, let's say, three to five years, what are the key initiatives you're looking at to improve what you're doing?

• 1:14:34Speaker 03

  I think the first one is actually about our people and the way we interact with each other. So I sort of look at the traditional organization, which has a top-down hierarchy, where you have one person sitting at the top, and then a few people below them, and so on, and so on, and the authority cascades down. And I think that structure is just too inflexible and too slow to make decisions to meet the challenge of the world that sits in front of us. And frankly, our portfolio is too complex as well. And so I think that we need to move much more towards a sort of a network organization where everyone knows what their role is, where they're in touch with a set of opportunities and a set of information,

• 1:15:18Speaker 03

  and where we have to use our structure to empower those people to make the decisions that's appropriate for them. And to take the information they generate and bring it back to the rest of the portfolio and the rest of the investors. Now, we're not there. It's a hard thing to do.

• 1:15:36Ted Seides?

  Yeah.

• 1:15:36Speaker 03

  But I do think that having a venture program also exposes us to sort of the technology that's out there available to help people collaborate. And we've started to implement some of that. So we're using Confluence and SharePoint, for example, for internal teams to be able to communicate with each other and work on things together. And we're investing into our own technology quite heavily to uphold that. And I think for the next couple of years, a lot of my focus is going to be on that internal structure and team to get to that space. So it's not really about we have to take the investment program here or there. Actually, I have no idea what will happen in investment markets. I know we just have to have an internal structure and process that can adapt as that evolves.

• 1:16:21Ted Seides?

  I guess I want to ask one last question about how you've thought about fees, because you're in this interesting inflection point where you have a lot of external managers, but you also have a lot of capital and bargaining power. So how have you tackled that with your external managers?

• 1:16:38Speaker 03

  Yeah, we do think a lot about fees. It's very important, of course. But the first point is we're focused on net returns. And some of our local peers here in superannuation who have to compete for members have decided to go down a road of setting a fee budget for the whole fund and then reporting those fees as a competitive advantage in their marketing. And we think that risks cutting out whole swathes of the opportunity set, the higher fee areas of hedge funds and private equity and venture in particular. And that would be fine if they didn't do much for your portfolio, but I think they're really important for a properly diversified portfolio going forward. So we're agnostic as to the

• 1:17:22Speaker 03

  level of fees, if I can put it that way, in an absolute sense. Of course, we don't like paying them, but we mainly think about net returns. And so that's the first thing.

• 1:17:34Speaker 03

  However, the second thing is, as I was alluding to when I was talking about equities, there's no point paying fees for things you can buy more cheaply. And so each team thinks very hard about what are their arrangements and are we getting bang for our buck. So I'll give you an example in infrastructure. Some years ago, well, the typical fee model in infrastructure is come into our fund, we'll charge you, if we're not too avaricious, we'll charge you one percent base fee and 10% over rate or something like that. If we are, we'll charge you two and 20, like a private equity fund. And if you're buying core infrastructure assets where most of the return is coming from continued economic growth or flat to

• 1:18:17Speaker 03

  declining bond rates, that's not manager skill. That's an economic view that I can buy in my fund using liquid market proxies. So there's no point paying high fees for that. If the strategy is highly value added, if they're tuning around poor performing businesses, if they're growing businesses through add-ons and creating something and then exiting, much more like a private equity manager would, then maybe it is worth paying. So that's the insight we bring. And in the case of infrastructure, a few years ago, we actually, so I said we only invest through external managers, that is true, but there was an opportunity in Australia to buy some domestic airports from a listed company. And we wanted

• 1:19:02Speaker 03

  to use a manager, but when we started talking to the market, we found that they weren't aligned sufficiently. They all wanted to put it into funds and structures where we couldn't get enough capacity or where they locked themselves in as a manager forever, or where they charged fees that were not really sensible for those type of assets. So we actually went out, surprised the market by doing the transaction ourselves in-house, and then acquiring some assets which left us with essentially two large airport exposures here in Australia, Melbourne and Perth Airport, which were approximately a billion dollars each of value. Now, in this case, we'd bought the asset and we understood them and we are going to make the decision about when we should sell them and if and why. And so we don't want

• 1:19:44Speaker 03

  to buy, you know, to hire a manager that can take the value away from those decisions. So the board said to me, why don't you manage the assets? You bought them, you know how to do this, you used to be an infrastructure fund manager. And I could, and I actually built a business case or a plan to say, how would I do that? But I felt like hiring eight or so people that I thought we would need to do that well, risk our culture because how do you incentivise them? Do you incentivise them on the whole of fund when they're just managing one asset? And what if I want to sell those assets? What do I do with those people? So we preferred to hire an external manager. So we went to the market and we said, we want you to bid to manage these assets.

• 1:20:29Speaker 03

  And we want airports really, they're, you know, they earn aeronautical revenue, but they're also shopping centres and there's sometimes property development plays as well if they've got a land bank. So we want you to bring your property people or a partner who's got that expertise alongside. And it was really interesting in Australia where there's a number of fund managers who have both infrastructure and property strategies. Those teams had never worked together, even though they already own some of these assets. So we sort of said, don't turn up if you can't do that. And then secondly, we want to know the people who will be working on these assets, how much time they'll be spending on it and we'll pay you a cost plus. And so we're happy to pay you a profit, but we want to know what that is you can bid on that basis. So that was unusual in space.

• 1:21:14Speaker 03

  Secondly, we said, we believe in alignment. We believe in incentivising you to add value, but we've bought the assets. If the economy does well and the value of the asset increases, that's not your doing. It might even be that this particular business has lost market share. It's still growing in value. And so we decided collaboratively to set one and three year operating goals. How much revenue per car park? Whether the CapEx programme was delivered on time and on budget? What's the spend rate per passenger in the retail business? And we would agree fixed dollar bonuses based on the share of the value created by achieving those metrics back to the manager. We sit down every year and renegotiate those bonuses.

• 1:21:59Speaker 03

  And if we can't agree, then there are none, is the approach. And so we also said, we've bought these assets. We want to be able to terminate at any time we want. Although we recognised there was an initial cost in setting up the mandate. So we decided to pay them a sort of a demobilisation fee on a schedule for the first three years.

• 1:22:18Ted Seides?

  Yeah.

• 1:22:18Speaker 03

  And so as a result of the wonders of competition, we actually achieved what we wanted with both of those assets. We think we've got a more engaged manager who's working harder on creating value than a traditional infrastructure manager would for a core asset. And as it happens, the fee we're paying is substantially lower than what it might have been under the old arrangement. And I would encourage any of your listeners who happen to be in a role where they could do that, to think about whether their managers are actually adding value and to speak up and to make a difference.

• 1:22:50Ted Seides?

  Yeah. And yet you're not planning to do more of that? Was that a one off?

• 1:22:54Speaker 03

  Where there are those types of opportunities, we're very happy to do that. But again, we're not arrogant about it. You know, in a situation where a manager is finding an opportunity and bringing it to us, we think they deserve to be compensated for that. We just want to make sure that we're paying for actual value add. We're not paying for beta, we're not paying for luck, we're not paying for use of leverage.

• 1:23:15Ted Seides?

  Across your portfolio, roughly how much would you say you've achieved that objective? Where what you're paying today is really a good, fair assessment of value add?

• 1:23:26Speaker 03

  I think we're there in every part of the portfolio to a point, to a point. But there's always room for improvement. And I think as technology improves, you know, I would aspire to look at those infrastructure or property assets and regress them against the broad factors, just like we do with the equity managers and the hedge fund managers in the more liquid space. And so how much of this return is due to discount rate compression or changes in economic growth assumptions or inflation? How much is due to your actual skill? And the industry has a way to go to evolve to that model. But what's happening in the infrastructure and property is the big funds, rather than doing that, they're internalizing, as you pointed out. And that is creating pressure on the industry.

• 1:24:09Speaker 03

  And that will force change. And I think the same is true in equities and hedge funds, but in a slightly different way.

• 1:24:15Ted Seides?

  Yeah, great. Well, Raph, I want to leave a little time to turn some closing questions. But I think before we dive in, as you know, from the first time we spoke a number of months ago, my historical first closing question was this question about what's your favorite sports moment? And you told me you didn't like that question. Why don't you explain why?

• 1:24:34Speaker 03

  I don't think it's an appropriate question. We've done a lot of work internally on how to get diversity of thought into decision making. And we've done a lot of work educating ourselves onto unconscious bias. And I think the problem with the sports question is, I would hazard to guess that more males than females are probably interested in sports, although I'm not saying females aren't. And that your listeners are probably thinking about, at least a chunk of them are thinking about, how can I get to be a CIO or a portfolio manager or some type of lead consultant? And the point I'd like to make is, you don't have to be a sports fan to get there. You know, all people are different. Some are sports fans, some aren't.

• 1:25:14Ted Seides?

  Yeah, which is great. So I've been working on the wording. And so here's my new wording for this first question. What was your favorite extracurricular achievement?

• 1:25:23Speaker 03

  Okay, that's probably even a harder one to answer, but that's okay. So leaving aside work and family, which obviously take up much of my time, I would say in the last few years, I've really decided to try to put something back into the local community. And I've gone on a couple of not for profit boards. One is the school where my kids go. And somehow I've ended up as the treasurer there. And we're doing some work around the sustainability of the capital budget and how we can get the school fees down. And I think putting effort into educating kids and making sure that's sustainable in the long term is really important. I've also gone on the board of a community foundation called the Lord Mayor's Charitable

• 1:26:05Speaker 03

  Foundation here in Melbourne. That's a 90 year old institution that looks at the problems in and around Melbourne, which are currently things like homelessness, kids' education, integrating aged people and migrants into society, and raises an investor corpus and gives away about $10 million a year. And I'm chairing the investment committee there. So I feel like we're making a difference and that's really important.

• 1:26:29Ted Seides?

  That's great. What's your biggest investment pet peeve?

• 1:26:33Speaker 03

  I think it's probably a couple of things. One is just people who assume the future will be like the past. And I don't think that's a valid assumption. You know, there's a whole lot of things over the last 50 to 80 years, a huge leveraging cycle, a huge demographic boom post-war, that have meant that certain things behaved the way they did, that I just don't think are likely to continue. So I think we have to go back to first principles now. And someone who says, well, I've done it before and it worked, so therefore it will work again. I'd just get irritated by that approach.

• 1:27:05Ted Seides?

  Yeah.

• 1:27:05Speaker 03

  And linked to that, people who just don't understand why something works. Like, if something's a great investment idea, there's got to be a reason. And if you don't know the reason, don't do it.

• 1:27:15Ted Seides?

  Right. That's good. All right, here's a new one. If you could look one person, dead or alive, one person in the eye, shake her or his hand, and just say thank you, who would it be and why?

• 1:27:28Speaker 03

  It's an easy question for me to answer, but it has nothing to do with investing. I'm a real animation fan and I love theme parks. And so for me, it would be Walt Disney. He's a person who was an innovator, who was prepared to take a lot of risk, who went broke more than once. He really bet everything on his vision, but also he used technology to communicate with the masses. So he was the first person in an existing movie studio to use television, and he was roundly criticised for that. He built the first theme park. And he really saw people who worked for him for their talents and didn't really care what the rapper was, despite some of the rumours about him in my ratings. You know, he backed all sorts of people from all types of backgrounds. And so it would be fascinating to talk to him about that.

• 1:28:12Ted Seides?

  What teaching from your parents has most stayed with you?

• 1:28:16Speaker 03

  Pretty simple. I think they're sort of pretty straightforward people. Just work hard and be patient. Don't expect everything to come to you straight away. And be prepared to take a risk if it comes along.

• 1:28:28Ted Seides?

  What information do you read more than any other?

• 1:28:33Speaker 03

  Well, I get a lot of things to read. And some of the writings from our hedge funds and things like that are interesting. But really, I read the work of our internal team because they synthesize all of that together into what's important. And I find that the most valuable. And if I have any spare time, what I try to do now is read about historic economic conditions. And I'm particularly interested, actually, in a period called the Gilded Age, followed by the Progressive Era in the US, 1980 to 1920. When following the railway bubble and bust and financial crisis, there was a huge rise in populism that led to Theodore Roosevelt getting elected. And there's a lot to learn, I think, from understanding that period.

• 1:29:15Ted Seides?

  Last one. What life lesson have you learned that you wish you knew a lot earlier in your life?

• 1:29:21Speaker 03

  That I don't know all the answers and that other people quite often know better than me, or certainly they've got different views to me. So I really had to listen to other people.

• 1:29:30Ted Seides?

  That's great. Raf, thanks so much for taking the time. Really enjoyed it.

• 1:29:35Speaker 03

  Thanks, Ted.

• 1:29:36Ted Seides?

  Thanks for listening to the show. To learn more, hop on our website at capitalallocators.com, where you can join our mailing list, access past shows, learn about our gatherings, and sign up for premium content, including podcast transcripts, my investment portfolio, and a lot more. Have a good one and see you next time.