Late last year I interviewed Andrew Frankling from Barrington Asset Consulting. Barrington primarily help charities and NFPs invest and I thought it’d be interesting to get his take on the asset class.
Andrew, can you please explain how you see fixed income fitting into a portfolio?
Andrew: We help our clients invest across asset classes and tend to favor multi-sector funds. In terms of fixed income, we see that it’s there to serve two primary purposes. One, is obviously liquidity in its different forms. The other is offsetting the dominant risk in most portfolios and that’s equity risk. We are always mindful of tail risk hedging and diversifying away from equity risk. That’s a critical concern for our clients.
If fixed income’s there to diversify away from equities, what sort of allocations are you looking at providing to your client? Is capital preservation a concern for them as well?
Andrew: The client base pretty much all have CPI plus goals in mind. So that’s one consideration, and there are solutions in the marketplace that have CPI plus goals themselves, which are something we have an interest in researching. Realistically though, a lot of those numbers are probably goals of CPI plus three to four per cent per annum. If clients want to go further out the risk/return spectrum, we can introduce different kinds of equity strategies for example. The opposite applies if we wanted to reduce risk, we can mix in some short duration fixed income with those strategies. What we typically do is to go through with the client and assess their liability profile, that is their future financial commitments. And commonly, the approach is that they end up with two or three investment pools.
Many will have a short-term pool, which includes a fixed income allocation. Working capital is separate and we try and keep that out of that pool. Often there is also an endowment pool or other long term pool. Some clients have legacy assets as well. It depends on the client’s history and where they’ve got to. One large faith group we work with has numerous different effective legal entities that are the owners of the capital and we’ve had to work with them to define these fund pools.
Also read: Floating Rate Investments Still Ares’ Preference
Then, once clients have defined the investment pools, they can have a single investment strategy for that particular pool. And when it comes to the shorter end and when we’re talking more cash fixed income, a common approach we would take would be to use some sort of proxy of cash flow requirements to represent unknown risks. For known cashflow requirements, as you can probably imagine, most clients’ expenses tend to be dominated by staffing costs. Investing in assets to match known and unknown cashflows is key to general liquidity management.
It’s very interesting because even though you are dealing with big multimillion dollar entities, I think individuals can take away a lot of what you’re saying in that they have different buckets and different requirements. Like a superannuation account is for long term, they might have medium term goals of, I’m not sure, maybe very extravagant holidays or weddings or family time. Then obviously short term where you need to pay your expenses as and when they come to you. You would see though, for your clients the fixed income is in the shorter end of the curve. You’re not investing longer term with fixed income in mind?
Andrew: No. There’s two primary exposures. One is what you just described and the other way we access fixed income is via multi-asset target return funds. So, we go out and select some of the solutions in the marketplace and then these professional managers make the decisions as regards whether they think fixed income is good value relative to other asset classes. But obviously the ways to diversify away from equity risk are fairly limited. It’s pretty much derivatives, insurance linked securities, fixed income and/or commodities, and they’ve all got their own strengths and weaknesses.
Okay, that’s really interesting. What are your clients most looking for? Is return at the top of their wish list? Is that always the case or is it a mixture of things?
Andrew: After being a consultant for many years, every client is a little different. However, with one notable exception, I don’t think I’ve ever had a client or met a prospect where return is the number one priority.
I would have expected ESG to be a big priority, and it is for some clients, but it’s surprising how often it is not as big an issue as you might think.
In terms of the charity sector, the biggest issues are often quite high fixed costs and wanting to diversify income streams away from government funding. It’s not a great surprise I suppose that their goals are often more focused on not losing money than making money.
Yes, because they have to be accountable to their members?
Andrew: Well, there is accountability, but the other thing is that there may not necessarily be great funding elsewhere or any funding, so they need to conserve their funds.
Right. They’re looking at survival almost then or longevity, perhaps?
Andrew: Well, in fact, I’m working with one group where their current investment goal, is CPI plus, and to maintain the real value of their Endowment. We’re thinking about recommending they go up the risk/return spectrum a bit but even then it’s quite clear it’s not going to actually fully fund their current costs.
Yes, I understand, these boards may not be very financially literate. They don’t necessarily have financial backgrounds. Do you think there are problems with the way they’ve structured things or are there some common problems you could talk about?
Andrew: I don’t think a lack of financial literacy is a particular issue. Some clients have had some operational issues, which can come down to resourcing, and I suspect the sector probably suffers from this in general. Two examples of good practice are making sure you have got a dedicated bank account and email address for your investment portfolio. Also, while it doesn’t sound like much, but ensuring the right team members get information, and being intentional about how the organisation spends its money, are really important.
That sounds like could easily be a very common problem. In regards to how you source product for them, can you talk a little bit about your due diligence and what you’re looking for?
Andrew: This comes back to the nature of the client base and what is appropriate to put in front of people. We have a fairly tight focus on asset allocation, and there’s a preference in the case of the fund world to have managed investment schemes. That’s sort of a bias of mine. We also have a Request For Product (RFP) process.
Basically, we ask for certain background information initially. Most of the questions that we ask requests data that has been pre-generated and then we do our review and then come back with questions. We’re keen not to ask too many direct questions at this early stage because responses can be gamed if our goals for asking for information are too clear.
That’s interesting. Can you perhaps give us some solutions that you’ve used or are using and talk about those?
Andrew: For a long time we have focused on short duration in the fixed income world given what was happening in the fixed income markets over recent decades. Now obviously 2023 is different, but one short duration product that we have used is BetaShares Australian High Interest Cash ETF (“AAA”). Now whilst it isn’t quite a cash fund, in the sense of it’s not a deposit at a bank, it does sidestep charity staff, just placing deposits with the same bank, no matter what the rate is, because it is operationally easy. I’m always keen to investigate solutions where they take some of the work away from our clients, and interests align. AAA has some other nice features as well.
Do you want to just expand on those nice features?
Andrew: Sure. Part of AAA’s attraction is the non-disclosure agreement (NDAs) they have in place with their panel of banks. That helps as regards the overall yield. Our clients don’t have a particular need for ETFs per se, but it is nice having a short duration product with an alternative form of liquidity/operational risk from term deposits.
Definitely. And I think it pays monthly income too, doesn’t it?
Andrew: Yes, it does.
It’s slightly off-topic, but different client solutions having different distribution frequencies and levels makes the rebalancing discussion more complicated. I personally prefer clients to be intentional and say, “We need X number of dollars and let’s use this as a rebalancing opportunity as well”, but I can understand why clients simply take distributions to keep things simple.
You’ve touched on rebalancing, which is something we haven’t talked about nearly enough. Do you want to talk about how often you do that and to what degree?
Andrew: It depends on the nature of the portfolio, whether it has more of a strategic asset allocation (SAA) focus or a target return multi-asset approach. For the second approach, you need less rebalancing given those products do their own rebalancing. For our retainer clients, we’ll look at exposures periodically. Rebalancing is definitely part art, part science. I’m always a bit concerned if you’ve got a client that’s not staying inside the stated asset allocation ranges or deliberately making a periodic statement about why they believe they should be outside the ranges. Another important goal should be to under trade back towards a neutral allocation, because the market may take you the rest of the way. It’s also useful to use natural occurring cash flows to rebalance, as this saves some the costs.
Great, I really appreciate that. Do you help draft the investment mandates? And do you routinely include fixed income as a percentage allocation or a range in those mandates?
Andrew: Yes we help draft the mandates and when we’re asked, we include a Strategic asset allocation (“SAA”) table, which will include fixed interest.
Okay. But you put those two things together?
Andrew: Yes. For a client with SAA requirements, absolutely.
How are you thinking about fixed income and the market generally at the moment?
Andrew: There are two things. One is what’s happening with rates, and the other is inflation. The two things are obviously linked. Probably the first thing to say is that not all asset classes are going to do as well in a higher inflationary market environment. One example is private debt, where loans tend to be priced off some sort of base rate, have had an easier time of it than nominal bonds in this rising rate environment.
Okay, great. And is there anything else you’d like to talk about to our audience?
Andrew: Yes, I think the key thing is just to be aware of the different ways that you’re not diversified and simply going out and buying 10 bonds or five shares or whatever, is not diversification. And it’s really important to actually think about what investment risk is, including duration, credit, liquidity and operational concerns. Then it’s important to figure out how you are diversified or roughly not diversified in each of those different ways. It never ceases to amaze me about organizations collapsing in a scandal and retirees losing their life savings. After such a long period of time, how can we still not be getting across the message about the importance of diversification and what diversification really means?
You rightly point out there’s multiple risks that have got nothing to do with what’s in your portfolio. I mean, we’ve seen just this last year the collapse of the 60/40, 60% shares, 40% bonds portfolio. You’re right, it’s a bigger conversation.
Andrew: Yes, the Economist says that 2022 was the worst year for 60/40 portfolio in the US since 1937.One last thing about investment diversification, is that you are trying to manage for “VUCA”: volatility, uncertainty, complexity, and ambiguity. Investing is a field of human endeavor where the basic principles are strong, but it’s constantly evolving and not a particularly controlled environment. There’s a whole lot of things in your investment portfolio that you’ll never have any sort of foresight on and innumerable events that can happen. That’s the real reason why diversification is so important. Because it doesn’t matter how good an opportunity is, can you really run the risk of a big loss in your portfolio? Because you just don’t know everything that can potentially go wrong.
