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John Woods on diversification using asset allocation

John Woods CFA is Head of Asset Allocation at Australian Ethical, which manages over $6 billion based on principles in its ethical charter. The multi-asset funds are Balanced, High Growth and Diversified Shares.

 

GH: John, let’s start with a personal question on how you started in funds management.

JW: It was a circuitous path. I started my career as a software engineer, working in industrial automation and business intelligence. I found the best data was in the finance industry, so I started to research companies, initially in the telecommunications sector, which was aligned with my background. As I broadened into other sectors, I became an Asian strategist with a focus on emerging markets. I moved more into macroeconomic research and then multi-asset roles. At Australian Ethical, I put it all together based not just on the financial impact but an ethical lens as well.

GH: And if you could speak to your 25-year-old self who might be starting on that journey, what is one lesson you would give yourself?

JW: There are many but maybe the most important is to keep an open mind. Predicting the future is really difficult. As an example, if you recognised the potential of say 3D printing at an early stage, there were many companies involved, but you would have been better investing with the big, established technology companies. It wasn’t that you couldn't see a trend happening but the hard question is how to take advantage of that trend.

GH: So even if you identify a theme, you then need to work out how it translates into financial performance?

JW: Yes, and economies are at a transformative moment in time, where the world is pivoting towards more sustainable, climate-related outcomes. That's fantastic for the planet and potential investments but you need an open mind on how you implement. It may not be as obvious as just buying the newest idea.

GH: In your asset allocation role, what changes have you made recently and in particular, how are you handling the defensive allocations with interest rates so low?

JW: The major change is we’re increasing the level of alternative assets. Defensive assets have lost some of their diversification benefits but we don’t lose sight of the primary role of fixed income assets is to protect capital. The income component comes second. It was great when defensive assets paid you to hold them but we haven't been in that environment for some time. Fixed income will still protect portfolios during severe equity sell offs.

But we also need to protect against rises in real interest rates which permeate across multiple asset classes. We’re handling the need for diversification by bringing in new things, such as alternative assets. They comes with different equity risks than the rest of the portfolio, such as global businesses with a reasonable equity risk premium.

GH: What are specific examples of alternatives and why do they have the right defensive characteristics?

JW: Alternatives for us are areas like private equity, infrastructure and venture capital. We're specific about the way we implement them to justify bringing illiquidity into the portfolio. The institutions who bring us these investments must find assets that we can’t find in listed markets, particularly in the venture capital space. A lot of emerging technologies, such as dealing with climate change or providing food, are in that venture capital space with different drivers than the broader equity market. They've still got an equity risk premium but we have to work out if the entrepreneurs are able to take the company from a startup to the next phase.

GH: Do you gain exposure to infrastructure through managers who specialise in the asset class?

JW: Yes, and aligning with our values, such as agricultural infrastructure or medical infrastructure.

GH: Other than the trends that Australian Ethical is known for, such as climate change and ethical investing, are there any other market trends that you're particularly backing at the moment?

JW: Well, more a subject that we’re trying to solve for in a high-growth portfolio is managing inflation over long periods. A traditional response might be to invest in energy but a sector like oil may not have much of a future. So we’re focused on other ways to capture exposure to inflation, such though the carbon price. If carbon becomes a cost of energy production, we take protection through owning assets in the natural capital space.

GH: What do you mean by 'natural capital'?

JW: Assets such as water, forests and clean air. Natural capital is a way of thinking about nature as a stock that provides benefits to people and the economy. In researching a company, we check their use of water, greenhouse gas emissions and other factors that may harm to the natural environment. We look at reporting which deals with all the ‘six capitals’: not just financial and manufactured, but also intellectual, human, social and environmental capital.

GH: Is there a part of your equity portfolio which differs materially from the index?

JW: The market overlooks a lot of opportunities, especially as many asset managers as heavily benchmark aware. We try to look where others don’t. For example, our portfolio doesn’t include just the top four banks, as we have an overweighting to BOQ and Auswide. In telecommunications, we have Macquarie Telecom and Telecom New Zealand rather than just Telstra.

GH: One of your VC exposures is to CSIRO’s venture capital business, Main Sequence. What attracted you to that and how does it fit in a multi-asset portfolio?

JW: When many people think about venture capital, it sounds high risk. Now, each individual investment that venture capitalists back might be high risk, but when you build up a portfolio, those idiosyncratic risks are diversified away. What attracted us to Main Sequence was the high level of alignment. The types of problems they're trying to solve are the problems we're trying to solve.

But every venture capital investment I've ever looked at sounds fantastic and exciting, but finding a group of people that can actually sift through that excitement with real knowledge is difficult. And that's where the link into CSIRO is unique. They have some of Australia's best scientists who can answer some of those really difficult questions. In a world awash with liquidity, we need this discipline to ensure we are not overpaying for assets. Main Sequence is setting up companies to solve problems from the ground up, paying the capital expense of a startup rather than a high valuation multiple. That’s a powerful differentiator.

GH: These days, every fund manager talks about ESG and sustainable principles. How does Australian Ethical differentiate itself from what is now common practice among fund managers?

JW: It’s good to see other fund managers taking ESG into account, it’s a positive trend for society. But inevitably there will be more greenwash, so we encourage investors to engage with the impact they want from their investments. Serious ethical investing creates portfolios different to mainstream funds with different risks. We've been doing this for more than 30 years, with ethics and frameworks embedded in our investment philosophy.

GH: So how do your diversified funds differ from others?

JW: Our high-growth fund is built for investors with a much longer time frame in mind. We recommend a minimum investment period of 10+ years. We want to take advantage of early impact investments and more illiquid investments in the private equity and venture capital space. So it is 100% growth asset fund and the way we manage risk is by building diversification within those asset classes. It's still multi-asset, like a balance fund, but it has a more singular focus on growing capital over a very long time.

GH: Let’s finish with what keeps you up at night.

JW: Inflation worries me at the moment but I also think about risk management knowing that with every risk there is an opportunity. For example, being invested in the world's largest equity market, the US, has produced great returns, but will we see that cycle repeated in the same stocks? I doubt it. We are experiencing a proliferation of new technologies coming to market and we have the opportunity to sift through them to deliver good returns, missing those opportunities keeps me awake to.

 

Graham Hand is Managing Editor of Firstlinks. John Woods is Head of Asset Allocation at Australian Ethical Investment, a sponsor of Firstlinks. This information is of a general nature and is not intended to provide you with financial advice or take into account your personal objectives, financial situation or needs.

For more articles and papers from Australian Ethical, please click here.

Media Release, 29 November 2021 - Australian Ethical doubles down on climate & tech solutions with inaugural 2021 Visionary Grants, via the Australian Ethical Foundation.

 

4 Comments
Isabel
December 03, 2021

CC: The thing about alternatives is, they are held as equity... so they are sometimes disclosed as a separate asset class and sometimes not, and neither approach is wrong...

CC
December 02, 2021

The Oct monthly report for the AE High growth fund states it is 55.8% Australian equities and 22.7% in International equities plus less than 2% in cash. No mention of alternatives or other asset classes such as infrastructure.

Jerome Lander
December 02, 2021

Good to see another article emphasizing the need for greater alternatives in portfolios, However, simply taking more illiquid equity risk without considering long/short approaches and option protection isn't taking full advantage of the opportunity for alternative investing, nor is providing the protection investors need against equity risk at a time of high valuations. I prefer to consider all the available tools, not simply diversify and reduce my equity risk (as the latter is only part of the solution).

Warren Bird
December 02, 2021

Yes, you do need to include some alternatives. The key thing is to find some that genuinely fit the ethical mandate of a multi-asset ethical fund. In my previous role at UFS, we launched the first such fund in Australia back in 2017, applying the Uniting Church's long-standing ethical investment principles across all asset classes. The alternatives that we took exposure to were commercial mortgages (which we wrote ourselves, off the balance sheet business that is UFS's mainstay), ethical (mostly climate-related) infrastructure and social benefit bonds. Some of this came out of our equity exposure, as Jerome worries about, but much also from the fixed income exposure - almost no government bonds, apart from in the global credit allocation. We did a few other creative things, such as seeding one of the first ethically minded property funds, via EG Funds, where the commercial properties acquired included a strategy to improve the NABERS rating a couple of notches. That fund has since been expanded to a broader SDG-aligned strategy for the properties, and is known as the EG Delta Fund. Liquidity is, indeed, an issue and needs to be managed both by risk management of exposure limits, but the UFS EDF also has a longer notice period for redemptions, to give the portfolio team time to manage down an exposure if the redemption was large enough to require that. I was proud to have driven the creation and launch of the UFS EDF, but it's good to see the industry more broadly has also moved on from only thinking about ESG in relation to equities, which was the case not so long ago.

 

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