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Franklin Templeton CEO on valuations and advice commissions

This is an edited transcript of an interview between Morningstar’s Aman Ramrakha and Franklin Templeton President and CEO, Jenny Johnson, at the 2023 Morningstar Investor Conference in Sydney.

Aman Ramrakha: We've had some superannuation fund executive on stage earlier, and there's a debate of valuation of listed versus unlisted assets. How do you think about that in terms of capabilities and is it a simple arbitrage? Is there any liquidity premium? When you're offering some of the private market product sets to retail, how do you think about packaging them up?

Jenny Johnson: On the valuations, there's no question. The average private equity (PE) firm delays public market valuation decreases for about six months. And it's usually marked down about half of what the public markets do. So, does that mean it's not a real valuation?

For those who don't know about secondary PE, I've become a huge fan. The concept behind it is, here's a true transaction that Lexington [Lexington Partners, a Franklin Templeton company] had with a U.S. state pension fund. So, they've got an investment mandate that says I'm going to allocate 20% maximum to private equity, 10% to private credit, whatever. Here's my public equity, public fixed income. What has happened? In 2022, the stock market dropped 22%, fixed income dropped 15%. That's really unusual. Now, you have to pay your pensioners. So, you're pulling from your liquid portion of your portfolio. You're continuing to sell down your public equities and your public fixed income. And meanwhile, the 20% allocation to private equity is suddenly 25%. You're now about to breach your limit because your cash ATM is the public markets. 

So the State of Florida will call up Lexington Partners and say, listen, in 30 days, I need a billion dollars out of my private equity portfolio because I have to report my quarterly allocations and I'm over-allocated. Lexington comes in and they'll say, okay, I'll take this manager's Fund 7, this manager's Fund 2, this manager's Fund 5, and I'll buy them. And right now, the discounts are anywhere from high teens, in the case of real estate about 22%, in the case of venture capital, it's 50% discounts or more for later stage and the earlier stuff is not even moving.

But it's not that those assets should be rightly valued there. In that case, it's a supply and demand issue. There's so much oversupply in the primary market and not enough buyers in the secondary. I think those end up being part of the reason why you see this arbitrage essentially or a mismatch, what feels like could be a mismatch in valuations.

My grandfather got into the mutual fund business because the average investor couldn't get access to the equity markets and there were excess returns in the equity markets. We're facing that same moment today where there are excess returns in the private markets that right now we've left out 85% of the population. The problem is, they're illiquid. They're difficult to understand.

And, by the way, the top managers are far superior to the bottom quartile managers in the space. I mean, you picked the wrong growth equity fund and maybe you're 200 basis points (2%) off. But top-performing private equity outperformed the bottom quartile by 20%. Top-performing real estate manager outperformed the bottom quartile by 10%. Top-performing private credit manager outperformed the bottom quartile by 5%. The biggest issue in retail is, what have we taught everybody? It's all about fees. It's only about fees. Guess who's on sale in the private markets?

Ramrakha: On financial advisers, I think the US was ahead of Australia in the move to fee-based or fee-for-service. Can you comment on what you're seeing in a global sense and perhaps, what you're seeing advisers do well in this changed environment?

Johnson: I think people are much better served with a financial adviser helping them for a few reasons. Back in 2008, we had a regulatory push that said if people are paying for advice, we want to make sure that's external. They need to be able to see it, so we're going to take it out of the product. So, that pushed a lot of people into fee-based.

I do not agree, and I think that's the model that has come up in both Australia and the UK. I do not agree that 100% of advice should be delivered fee-based. I think there's about 20% to 25% of the population that is better served paying a commission, a one-time commission and maybe at a small trail versus paying the external fee. Because what happens is, a client is too small for an adviser to take on and the adviser will do it if they can get a commission and we leave out a huge percentage of the population. 

Advisers can coax people into saving. I often tell people that Australia has set up compulsory saving through the employer, that this is one of the best markets and much of the world should look to Australia and have a similar model. But in too many places, young people aren't getting any advice. And the difference between starting to save between 20 and 30, if you save, say, $5,000 a year and earn a 7% return from age 20 to 30, you will have more money at the end than somebody who starts at 30, saves for 30 years, $5,000 a year from 20 to 60. So, that first 10 years when you turn 20 of savings is so important to retirement.

Ramrakha: The banks were servicing that sort of lower end and are no longer doing that. Is that an opportunity for others to step in for the end investor?

Johnson: The average person will buy high and sell low. There's tons of studies on that, and Morningstar's ratings volatility is one of the things that you ding managers on, right? Because that experience is a real problem for the end investor. So, while in theory, we say people are going to fight that, it's not true. They don't do it. It's emotional.

And what a financial adviser does is in those most difficult times, it keeps a person invested and says don't look at it today. Just stay in. And maybe it's even a time to add more to your equity portfolio because it's been down. So, I think that that's very important, and that is hard to deliver in scale. The beauty of the financial adviser is they're at the tip of the spear. They understand an individual's debt, they understand the family spending, they understand the family dynamics. There's no way you can deliver if you're not close to that end investor.

Ramrakha: We have seen leading up to maybe the last year a big shift towards passive investing. Now, it's fair to say most of that's fee driven, but how do you think of countering that wave of passive to some extent?

Johnson: I'd say two things. We know passive outperforms in momentum markets. I'm just going to take the U.S. The U.S. Fed balance sheet went from $800 billion in 2008 to 2020 at $4.1 trillion, and we wonder why Silicon Valley Bank had a problem. From 2020 to 2022 it went from $4.1 trillion to $8.7 trillion, I think. That is just money pumped into a system. And the interest rates were essentially zero. If you're going to make an investment, there was no reason to be in the bond markets. You didn't have access as the average investor into the private markets. And so, you put your money in equity markets, and the equity markets took off and it's going to be hard when you're trying to be a managed risk portfolio to beat that. Why? Look at the concentration. The concentration of the winners in the last decade. It's the FAANG stocks. 

If you were running a portfolio, you'd say that's too much concentration and too few companies, I'm going to diversify, and you immediately would have underperformed. One of the things that there's not enough conversations about is that market beta is not static risk. The day Tesla was added to the S&P 500, beta became riskier. But you never heard people talking about passive becoming riskier.

If you tracked all the big momentum markets and the top 10 performing companies going back to the NIFTY 50, the next round there was only one company that made it through four of those peaks, and that was Exxon. Every other company didn't make it into the top 10. And the top 10 in this past decade probably aren't going to be the top 10 in the next. And so, again, that's looking at that market beta risk. In momentum markets, passive is going to tend to outperform, but you're going to have to time it exactly such that when it flips that you've been able to turn into a more diversified, less risky portfolio.

 

This is an edited transcript of an interview between Morningstar’s Aman Ramrakha and Franklin Templeton President and CEO, Jenny Johnson, at the Morningstar Investor Conference in Sydney.

James Gruber is an Assistant Editor for Firstlinks and Morningstar.com.au. This article is general information.

 

2 Comments
Wildcat
June 12, 2023

We started the business 20 years ago with no commission for wealth advice, charged a fixed dollar to your bank account. At the time we were considered black sheep. For the most part it has been great for the business, great for our clients and the alignment of interests works. Years later we bought a business that had a "tail" of smaller clients, something we'd not had in the past. We assisted them when they called, communicated with them about the importance of advice and that positive steps can make a big difference. It was a case of you can lead a horse to water .... they weren't ready and wouldn't engage by and large. We used to get occasional calls and we assisted them without charging additional fees. The commission revenue by and large was miniscule per client but it worked on the sum of the parts at least allowed us cost recovery for the ones that did engage. It operated like an "insurance" policy where only a few policy holders claimed each year but related to investment or super advice. We were able to change some lives, some with enormous improvements in outcomes. It therefore worked to a degree.

We had to fire them all with the Hayne RC outcome as it meant we could now not hold them on our books and help them when they needed it, so those that do call now we are forced to turn them away. We wrote to all the carriers (product providers) and instructed them to delete us from the register for these clients. Some I called, that were very sad about this I was quite upset with narrowmindedness of regulators but the business risk introduced by Hayne and other regulatory changes meant maintaining these relationships was not tenable. Even if we did it pro bono we are not relieved of the MASSIVE compliance burden that is dumped on planners for a client file or to provide advice and would carry 100% of the advice risk, all for donating our time to help someone!!

Now the QAR is recommending that vertical integration is still not only allowed but to be encouraged. I despair as this is the one single biggest factor with all the historical problems with planning when the advice provider is EMPLOYED by the product flogger. This would include union/industry funds as confirmed from planners who used to work in this environment. Pressure is placed on them to increase product sales/usage at risk of tenure, wages, promotion, bonus or just plain bullying. Despite being employed it is still a commission model, the money to pay the planners can only come from the products, it is therefore a commission, even if an indirect one.

This experience has taught me that middle to lower ranking socio-economic citizens will never be able to get decent advice. The only model that could possibly help them is a commission model whereby it acts like a group insurance policy and should be on a BROKER style basis. When this is provided by a product provider the system will rarely be looking after the client as a first priority. Therefore commission should only be considered for planners that have no attachment to a product provider. It is the only system that has any chance of success based on my experience.

Just watch Stephen Jones announce the exact opposite in the coming weeks.

Ben C
June 09, 2023

I went to Ms Johnson's speech and it was refreshingly outspoken. Her views on private company valuation make some sense, though I suspect part of appeal of having allocations to these companies is that valuations can be 'smoothed' and managed, contrary to the reality on the ground. I've had professional dealings with Franklin Templeton and it was obvious that they did have a distinct culture that promoted manager autonomy. Not sure if this has changed given how much they've grown since.

 

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