Machinations of macro, asset sleeves and allocation by outcomes not benchmarks
In episode 102, Alex Proimos speaks with Mark Beardow, co-chief investment officer, and Andrew Baume, adviser, at Darling Macro.
This episode delves into a unique approach to wealth generation, asset sleeves and thinking about your personal balance sheet. We discuss asset allocation guided by outcomes and not benchmarks and the impact of dynamic covariance and correlation on the more static strategic asset allocation review process. We cover the strategic choices in which defensive strategies have worked, why defence cannot be passive and how to optimise a portfolio in the new normal.
Podcast for listeners:
A Transcript for readers:
Hello and welcome everyone. Today I'm joined by two guests from Darling Macro.
Mark and Andrew.
Mark maybe if you can kick us off, give us a bit of background on who you are, how did you come to be at Darling Macro?
My first role was 30 years ago. It was a role working at National Australia Bank. It was a fantastic opportunity to learn the nuts and bolts of how a retail bank worked. But I had itchy feet and I went to the UK and explored a whole series of roles which were, again a lot about rolling up your sleeves, and understanding the machinations of credit and market risk with the world's premier investment banks. It was at times humbling and at times a dirty job. It was it was fascinating, through the early and late 90s.
I've always had an interest in being a little less transactional, and more longer horizon investing.
I ultimately got a chance in the late 90s to start the credit investing business of AMP Capital. We started one of the first credit funds that invested in mortgage-backed securities, corporate bonds, hybrids, and private debt. I had a fantastic 20-year career there and fast forwarding right through to today and the last 4 years building Darling Macro. Trying to apply much of what I’ve learned, but not everything, in a business and focusing on alternatives.
Andrew lets switch to you.
Yes, I guess my career has been typically transactional. I started as a foreign exchange dealer in the 1980s. Not long after Paul Keating had floated the Aussie dollar. I’ve traded through a lot of different market cycles and I’ve traded through a lot of different markets.
One of the things that kept me going in the market for so long is that I’ve always been interested in what comes next rather than what came before. I’ve jumped into products where other people weren’t necessarily at the same level of sophistication as they would come to be in a few years.
One of my more satisfying roles was in my second stint at Westpac taking on the credit portfolio immediately post the GFC. The credit portfolio I’m talking about is the actual balance sheet of Westpac. That was a great trading role, but it also really made me think about how capital is used and about how different mandates actually drive behaviours.
I went back to Deutsche Bank, had two stints at Deutsche and at Westpac, and was working in the structured markets business at Deutche. Again, noticing how it had been really hammered home that mandate drives an enormous amount of behaviour. That was always a little bit frustrating.
When I left Deutsche, Mark and I were having a chat, and I realised that the things that were being done in the alternative space were actually, in some ways, trying to break down some of the traditional barriers to efficient market risk allocation. That really was an easy decision for me to come and join Darling Macro and start thinking about what I consider a more rational way of deploying your risk capital.
It's interesting, both of you come from a bit of a trading background as well.
I'll switch to you Mark in terms of, where do you think about wealth management, wealth generation for people.
How do you think that your mindset has changed around taking macroeconomic risk factors? Taking your experience in understanding how the machinations of a market work, in terms of then building portfolios for investors?
We spent substantially 20 years on gathering data, macro data to be able to build portfolios. To be able to generate an insight into the prices of those markets. Into the direction of those markets, and as Andrew said, looking forward.
At the same time, we also recognised the behavioural aspects of markets. How other investors reacted to data or reacted to their informational set. What we found overtime was the optimal investment strategy really combined those two things: behaviour and the fundamental and informational advantages.
What we think is, probably over the 20 years, the informational advantages that investors have in the macro markets has declined. Ability to get an advantage is reduced. I think in other markets, smaller markets, small cap stocks or iron all markets there is still informational advantage.
We fast forward to today, we've really just streamlined out thinking and our process to put aside the informational advantages and really focused on the behavioural insights, and the behavioural errors that investors are collectively making. I think as individuals we all make them, but it's the collective errors that investors make, which we focus on. Then we really try to avoid making our own through systematising the process.
I'm curious, maybe Andrew switch to you around the idea of risk. The definition of risk. Obviously being a trader, you actually experienced risk in a much closer away. How does that play into the portfolio construction?
We've got a lot of typical ways of measuring risk with different ratios. Looking at Sharpe ratios, for example to try and look at the optimal amount of risk to have, but how do you actually implement that?
I think as a guy who's come out of an investment banking background. I was a bit wary about imposing what's, obviously, my own biases of background onto the rest of the market. The one thing that I think is really clear is that historically we haven't really thought about our own balance sheet as investors.
I think we thought, ‘hey, you know we going to accrue some money and we're going to work for a while. Hopefully our superfund will do well for us’. But at the end of the day, it's actually our balance sheet that's at risk.
When you worked in a bank, they give you access to balance sheet. They say ‘Here is some balance sheet and here is how we measure the risk you're going to take. We'd like you to optimise that’, and so you immediately come from a slightly different approach in terms of generating a return.
You always actually think about your return as it relates to the capital that you've been given, and it's a risk adjusted return. I think we really understand when we come from that sort of background that there is an ability to generate a portfolio optimised outcome, that focuses on the risk that you're taking and maximises the return you’re getting for the risk you’re prepared to take.
Now you might have a fund which is growing at 50% a year because they make fantastic bets. I struggle with that as a long-term investing concept because it feels to me that the risk adjustment return may need more than a 50% annual. We try and think about things from a really devolved basis. Where we're not so thoughtful about ‘I want to be this or that product’. We think about ‘what are the characteristics of this or that product? How much exposure should we have to it on risk adjusted basis?’ And guess what? If we can measure that it's becoming riskier, should we have less in it?
The one thing we know about traditional investing is if you give money to venture capital person, they're going to be either invested in cash or venture capital. Our idea is that we're going to invest in the things that, as Mark said, 20 years of research now 4 years of track have told us actually generate the right returns that were after given the risk we prepared to accept.
I'm curious, maybe Mark if you can lift the hood around how you think about the portfolio. Particularly as the traditional mean variance approach to portfolio construction looks at covariance correlation. You’re trying to build this portfolio. How much does that really represent the reality?
It's a statistical tool that we can use to build portfolios, but really doesn't capture what we want to do as we think about the SAA, the strategic asset allocation of the fund. How do you sort of blend that approach with the live trading of a portfolio?
I think it's still relevant. Mean variance is still relevant, but the assumptions that are used for strategic asset allocation are only right for a period of the time. If you’re seeing a five- or seven-year horizon, what you're really trying to make an assumption on is what's going to be right, on average, for that period. You're very interested on the endpoint. You're very interested in where the portfolio arrives in in five or seven years.
Our focus is recognising that those assumptions, for a lot of the paths, that you could possibly take between now and then. Those paths vary. There are multiple paths. It doesn't go in a straight line. What we're really trying to capture is how that covariance matrix and all those volatilities in the marketplace vary through time. To what extent are those variations able to be anticipated.
In some ways we're trying to predict risk. Rather than predict return. That can be powerful because it might allow us to take advantage of the current conditions in market rather than just relying on the average, reasonable average, assumptions over seven years. You may, in an SAA, be actually able to generate much more diversification, if you had different assumptions that we would use in the short run.
It's interesting. It's a real challenge and I'm curious to get your thoughts as you look at the current market conditions.
Volatility seems very much supressed because of the central bank influence across many asset classes and then ultimately historical asset classes that should have played defensive role, maybe don't do that in the current arrangement. So how do you think about the current conditions and then the potential loss of defensiveness in some of these asset classes?
It's going to be a challenge, that's for sure. You were talking before about a definition of risk and there is no perfect definition of risk. We use one, that allows us to compare opportunities across a broad universe of bonds, equities, commodities, and currencies. It allows us to do that with some consistency.
It becomes important really, for two reasons: One from a portfolio construction perspective, comparing all of those different opportunities. Two, it does allow us to manage the experience that an investor has through the volatility of the fund.
I think if we ask investors how they feel about risk, volatility is one of the things that they feel. They also have an emotional response to investments which feel risky. The volatility is relevant. There's no doubt that with cash and bonds yielding sub-inflation and central banks determined to shift employment to full employment, rates are not going to be as effective. What we are also thinking about is the inflation shock scenario, that is being debated. Bonds are being less effective over the last number of years dealing with the growth shock particularly European and Japanese sovereign bonds. Treasuries have still been effective. So, what are going to be the new tools for dealing with this? One of the ones that we’ve been testing is volatility. You alluded to realised volatilities being low. There is quite a gap between realised volatility and implied volatility. We think, and we’ve done some testing on this, that volatility is going to be an important way of protecting portfolios. And then Australian dollar has been a reliable diversifier as well, that most investors use to invest in foreign currency.
When you are talking about volatility its looking from a pick-up in volatility almost a long-vol strategy?
Almost a long-vol strategy. We know to be long-vol is costly, it’s extremely costly. Another example is to be in cash and just waiting for an opportunity when assets are cheaper is extremely costly. To be long-vol may cost a handful of percentage points per year. Might be equivalent to the upside you’d hoped for from equity. The key is, it’s got to be able to be turned on and off, or at least shades of grey. You need to be able to monetise protection.
I think it is an incredibly difficult emotional aspect of increasing protection and then monetising it and going back into the risky asset. I’ve always thought it is an incredible skill to be able to sell but also buy in stress. In March the investors that were reducing their defensive assets and buying March 2020 and going back into growth assets, that was one skill, but were they also able to have reduced when they first saw the signs of corona virus in January. Two different skill sets, hard to get in one person. Which is probably why, either system or a team of voices is important.
Andrew, I ask you the question about what do you really think about defensive assets in this type of environment and really the role that Mark just touched on. The need to be really active in how you think about defence in a portfolio and trying to find diversification. How do you go about that process?
I think the issue of defence is a good question to start with. Why do we need any defensive assets?
Mark alluded to the fact that assets don’t act on average everyday like they do in the long and medium term. Now if you can close your eyes and wake up in in 5 or 10 years times, you don’t need any defensive assets as you are going to assume that markets are going to behave in their long term average. The reason why we have defensive assets is all those things that Mark just talked to. Which is that we feel that there are opportunities that we can monetise.
When markets go down in March 2020 if you were able to liquidate something that hadn't gone down as much as equities you could be buying equities 20% or 25% cheaper than you would have been buying them in January and that's an absolute advantage to your portfolio.
Now identifying how you do that and what assets are going to be defensive is the tricky one because, as Mark also said, if you're going to sit long with cash or buy a bunch of equity-puts you’re locking in some negative returns. Defence has to be something which has got the characteristics that allow you to do what you want do, which is find you re-balancing points in the cycle. There's probably only one every 7 to 10 years where you want to be able to do that. But you also don't want to be baking in reductions in your portfolio targets, in the off chance that that seven or ten year event you recognise and you exploit.
I think you need to find things that have got characteristics that last overtime and I think, particularly at the moment, fixed income is a tricky one. We're all being used to good returns from fixed income. Fed funds rate was as high as 20% in 1981, dropped to effectively zero in 2020. That massive bull run for bonds is unlikely to come back.
We don't think that fixed income as an asset allocation of itself, is necessarily going to give you that offset that you use to get from a defensive asset. By the same token when the central bank tells you they're not moving interest rates for another, let's call that 18 months, you don't want to give away the opportunity of picking that carry-up as well.
I think we look at that market, in particular, as being a market where you have to be quite nimble because, because, from time to time, you're going to be able to get some great carry-out of fixed income and that defensive characteristic will work for you. You need actual techniques to be able to move your defensive around, in my view.
I think some of the other ways of being defensive, to own assets that are unlikely to have market variation. That means that when you have hiccups, you're not getting too perturbed about it. But what that comes with, is a necessarily lower amount of liquidity. You tend to find that, for example, non-investment grade lending situations are relatively harder to get out of if you wanted to make a switch into the equity market.
I think, in 2020, we did see some funds finding that they had to put exit fees onto people because they were looking to manage the sell-down of assets, in order to give liquidity that people thought that they need it.
I think you need a mix in the defensive space of things that aren't going to be heavily influenced by market pricing, but you also need to access to things that have liquidity and have some of those old characteristics of being negatively correlated. That's not an easy thing to do.
It's interesting you know, Mark touched on the issue about long-vol and the cost that comes alongside it, Andrew, I wanted to just continue with you around some of the other alternatives that are in the space or within that umbrella, which is: trend-following, relative-value, there's also other sorts of other alternative strategies, long-short for example, that are often used as this defensive piece. I'm just curious around your thoughts on those as potential defensive aspects of a portfolio.
I think that one of the things that disappointed some people in 2020 was that things that were explained to them as having low market betas actually ended up having quite higher market betas.
I think some of the things that you've talked to when you deconstruct what their returns look like at the time, they didn't give you the sort of market neutrality that perhaps was on the outside of the tin. What was inside of the tin wasn't the same.
I think that there's no doubt that many, many strategies using effectively either a long-momentum and a short-value, or short-value long-momentum, but either way, there is a large amount of market beta around the momentum side of that.
Anytime you've got a long-short, where there's momentum on one side and value on the other, you're going to have market beta. I think the key is really understanding what it is you are getting out of that structure. Really understand the conditions that are going to make your portfolio influence the same way and it's just simply not going to be that case.
I don't think there's an easy answer to what is a defensive asset. I'm not sure that some of the things that people have thought of as defensive assets, actually me all the characteristics that you might write down in a textbook of what a defensive asset should be.
It's quite nuanced, and that's difficult, because we as people and as investors we like to compartmentalise things which is probably one of the reasons why sleeve-based investing has been the most commonly used, because it's very hard to do what someone like the Future Fund does, which is being relatively product neutral and take each individual investment on its own characteristics. Rather than making it conform to a particular definition of what sort of asset type it is.
That's a great place Mark, for you to give context around how do you guys think about asset sleeves versus a traditional asset allocation that most of us would know from a standard superfund, for example.
I think even the process of SAAs and the allocation of the capital following those SAAs gives you a bit of an insight into the problem in our in our mind, is that once those SAAs have been determined, capital is allocated to specialists in those areas, and then they’re given specialist benchmarks. The evidence is that taken collectively, those strategies don't add value versus benchmarks. You've got a whole lot of effort and a whole lot of fees being allocated, to a large part of the portfolio, which is not adding value.
The other difficulty is, and I've seen this firsthand, is how do you get ideas across the portfolio from equity, or from bonds, or from other asset classes, actually informing each other. All these asset classes are operating in the same global economy, the same global markets, but how can you get ideas working across the portfolio.
What I have observed firsthand, is that language, the way risk is measured across those sleeves and the different languages, the different terminologies, that different horizons, often means insights from different parts of the portfolio are not able to be translated into other parts.
What tends to happen is investors go back into their sleeve and just try to beat the benchmark. A lot of the of the industry is set up that way. If you look at the results, and saw the results were significantly ahead of benchmark and not a zero-sum game then that might be OK. But we think there is a tremendous loss of information because all that moneys locked in those sleeves.
I'm curious then, in terms of what role do a lot of these illiquid options that are coming up. Private market is such a key part of a lot of the superannuation funds, as a way to dampen volatility because the prices aren't discoverable as often and a way to lock-in capital and hopefully get an extra premium associated with it.
How do you think about illiquid assets as part of your portfolio or the role that they could play or don't play?
I see an illiquid asset to be consistent with an SAA. It's just the short run pricing, as you alluded to, is going to be less volatile and it's going to look like it's particularly diversifying. Actually, the allocation to private markets is a long-term allocation. There isn't an ability to come in and come out of that. It's quite consistent with the SAA way of thinking. Our approach is to, as I said before, recognise these different paths. To be able to dynamically manage risk between the sleeves. Take account of different correlations, take account of different volatilities. The instruments that you need to use, need to be the most liquid global instruments. At very low cost. The ability to do gives you a much greater ability to turn the portfolio over without high transaction costs. We used global futures markets. Illiquidity doesn't play a role in our portfolio, but I think it's absolutely valid in the context of a total portfolio. It does play a role, and particularly where it's lined up with the horizon of the investor. If it's not lined up with the horizon of the investor, then you have the situation, that Andrew alluded to, which is a bad wealth management outcome, where investors lose confidence in investment and they don't see it through to its finalisation. They want to withdraw, and they want to redeem. They're doing it for a range of reasons. You mentioned it at one point, our view of wealth management. I think it's trying to align money weighted and time weighted outcomes. In some ways that's the Holy Grail. For investors, money weighted outcomes are the same as time weighted then they've seen through the investment opportunity to its conclusion.
We've all been quite used to returns that have been relatively positive across all of our asset allocations, with obvious notable exceptions in GFC and the down in March of 2020. I'm not sure that we've been through phases where people have understood that there might be extended periods of time where certain parts of your portfolio are below you target or in the negative. But they've enabled other parts of your portfolio to make gains that you would have perhaps felt were a ‘two risky, eggs in one basket’ concept if you didn't have those offsetting assets. Now because historically, we haven't seen extended periods where assets have stayed at disappointing levels for long periods of time. I don't think we've developed a total portfolio view where you can actually take the concept that an illiquid asset is a 7 to 10 year horizon. That's why you do need to have things in your portfolio, and why Darling Macro been designed the way it is. Darling Macro gives you access to very, very liquid markets which allows you to complete on your strategic investment in the illiquid market. At times where you do feel that there are things that you need to do; is it reallocation or just in terms of having money for other things outside of your investment universe. If you overweight the illiquids to the point where you lost your flexibility. There is a potential that people are going to get and, as we said earlier, the worst outcome of all, which is unexpected return or an unexpected characteristic. You need to be very mindful that a defensive asset class, which is illiquid is going to fall down on one of the very key things that people say that they're interested in, which is that capacity to have liquidity. You need to do it in a sensible way, aligned with some other assets that are highly liquid.
Mark is it fair to say that really what you're doing in terms of the constructions’ portfolio almost a type of risk parity strategy, as you think about different assets to build in.
Risk parity, there's some similar principles that's for sure. In the way we measure risk, in the way we think about it in a portfolio. But there are a couple of fundamental differences, in that risk parity probably doesn't take account of correlations exactly the same way we do.
We are a little bit more dynamic in the way we think about correlations. Also, risk parity, of the classic version, assumes that all four of those economic scenarios are essentially equally probable. Whereas we think from an ongoing basis some of those scenarios can be discounted as being to be less likely. Therefore, the portfolio you would need for that scenario can be down weighted. It is a little bit like coming back to the long-Vol strategy, we were talking about, there will be times when your signals might indicate you don't need that long-Vol to the same degree. You can turn it off. You can save some premium, which is necessary. These are some of the ways in which we are different from risk parity.
Some similar principles: We are probably, a bit of a blend of risk parity and trend. Risk parity gives the exposure to the markets, the participation in the markets, the kind of portfolio construction efficiency, the particular way of viewing risk. The trend then allows us to switch on and switch off. It gives us exposure to a divergent type of exposure. The way I think about divergence is that it's really being long the possibility that markets do things that are less likely. The tails are a little bit fatter than we all think and I tend to think there are two ways of looking at the world.
You talked before about relative value. I think relative value, as a strategy, is more akin to value. It's convergent. The world is going to continue to be a more normal place overtime, and it's quite susceptible, quite fragile to volatility because it's assuming that two things, two assets, of possibly different risk are going to converge overtime. We found relative value does give exposure to quite big drawdowns. Typically, but not always. Whereas trend is a compliment to that. Coming back to the point I was making before, about illiquid assets and our strategy or strategic and dynamic. The key to a great portfolio is actually not excluding things, particular things, but working out how they can complement each other. Relative value being a compliment to trend, and strategic being a complement to dynamic
Andrew, Mark mentioned a little bit earlier about the power of the Australian dollars as a hedge as well, versus the US. Another key area that a lot of investors are looking at is gold and other commodities. Curious to get your thoughts on how you think about commodities and gold, particularly, playing that defensive role.
I think that the idea of what is a defensive asset is caught up in the way that you look at it. A lot of people look at gold in a way that is very different from somebody who is more focused on a cash generating kind of situation.
It's hard to think of somebody who's invested in the toll road as being equally keen to diversify into gold. They’re fundamentally the opposite ends of the spectrum. The toll roads never going to go up in value because it suddenly became, I don't know, shinier. Gold has a real role for people because they do get a strong sense of solidity from it. Which is in some ways, dissociated from what its fundamental behaviour is. Whereas a currency like the Aussie-US, has exhibited specific hedgeable kinds of qualities, when historically the markets have become more volatile because there has been a perception that has played out in the currency markets, time and time again.
Of course, the interesting thing is that, that relativity is now changed. Australia is now a current account surplus economy. It's really interesting to think about the way that those historical relationships that have been very, very helpful in portfolios may actually manifest incredibly differently in the future because the landscapes changed. Going back to gold, really when it comes down to it, bitcoins become the gold of Gen X. So, does gold begin to be less allocated towards from the world weight of money coming in, from younger investors, who actually say well ‘I don't really get gold but I get bitcoin’?
I think the key point of all of these is if you measure all your asset allocation choices on backward looking measures and that’s what a sharpe ratio is. It's an average, over many years, of empirical data. You can fall into the trap of missing out on the fact that there's been some fundamental changes. I like the idea of observing market volatility and momentum current time, to look at the things that are working under those sets of parameters.
Now gold may still be a fantastic asset for the foreseeable future. Bitcoins obviously had its massive extension it’s come back a long, long way but there are still a lot of true believers in Bitcoin. The Aussie-US is going to be a really interesting thing to watch play out as Aussie goes to a strongly current account, positive country from years and years of being the other way round. For me it feels like you can't compartmentalise anything as having X or Y characteristic. Because, for me, we are actually in a new normal. We are actually finding that different things are going to affect us into the future. We talked at some length already about the fact that, given interest rates where they are, the interplay between rates, valuations in the equity market, and the defensive capability of a fixed income portfolio, are all somewhat up in the air. That's again what attracts me to the idea of using volatility and current momentum as good indicators. Because it doesn't necessarily rely on relationships that are fundamentally not the same markets that we saw those relationships being written about and put into textbooks.
Well, Mark, final question. It comes from some of Andrew’s comments, which is really the power of narratives. He talked about gold and Bitcoin and the confidence and things. Given your experience, what role does narratives play in really driving markets today?
They do play a large role. Any one single individual finds it difficult to assimilate a huge amount of data and that’s why we use machines to assimilate that data. If you think about collections of people, we collectively can't think in society about multiple themes and multiple regimes and we tend to, and have to, work it down to a smaller group of narratives. We like to think about having explanations for things, so we tend to use the same narratives to explain what's happening in a particular market because we've only had a few that we were able to remember.
My feeling is narratives do play a role. They're a shortcut for the way we think about trying to explain things. They’re a way of aggregating our understanding about global economy and global markets which are incredibly complicated, incredibly complex. My feeling is, looking at them into the future, they're going to continue to exist and probably strengthen. The empowered investor, the empowered self-advised investor is a trend of the future and narratives are going to form a part of the way they view the world for some time to come.
Well, that's been a fantastic conversation. Thank you very much for your time both Andrew and Mark.