Planting, harvesting and right-sizing: Where we are now according to Papageorgiou

There has been plenty written about how 2022 was a tough year for investors and, in particular, fixed income investors. Whilst that is generally true, it’s not absolute. 

There were a handful of income funds on the Livewire platform that managed to achieve positive returns over the year when most were underwater – many significantly. 

What stands out, however, is that of the 14 fixed income funds that managed to achieve positive returns in 2022, three of them came from the same investment house.

That investment house is Realm Investment House, and I had the privilege recently of sitting down with the founder and Managing Partner, Andrew Papageorgiou, to talk about his Relative Value Process, how he is viewing markets currently, and some of the big trends that will likely impact fixed income over the next 5-10 years.

Papageorgiou talks about positioning over the past few years. Being a contrarian, often he is "planting in very difficult conditions because this is what being contrarian and counterintuitive is all about". He notes that 2021 was all about being a 'small target' (i.e. not taking too much risk), whilst 2022 was all about 'filling your boots'. 

As for 2023, well, it's worth watching the video for Papageorgiou's full take but, to paraphrase, its somewhere in the middle; 

"2023 is about right-sizing where we've taken bigger bets, bringing them back to something like normal, doing a little bit of harvesting along the way and managing a really, really nice yield to maturity for portfolio investors".

Throughout the conversation, it becomes clear that Papageorgiou has a very clear idea of the opportunities that he can profit from, those that he can’t profit from, and the wisdom and humility to know the difference. As Papageorgiou puts it;

“essentially the secret is taking what the market gives you, not overly endowing yourself with the idea that you have some insight that others don't, and reacting to market pricing and staking your bets appropriately, which is really the Realm story over the last 10 years”.

Join me as I take a deeper dive into the fascinating story that is Realm, and how Papageorgiou and his team have built a successful business. 

 TOPICS DISCUSSED

• 0:41 – How Realm’s investment philosophy has driven performance over the past year

• 3:20 – Which investment have had the most meaningful contribution over the last year and do you still own them?
• 8:40 – The tools Realm uses to identify opportunities across the dimensions of duration and quality
• 13:22 – Volatility and why it is critically important for investors in the current environment
• 16:00 – The big themes impacting fixed income over the next 5-10 years 
• 25:56 – Is there an investment environment that you prefer?

Please note that this interview took place on Wednesday 25 January, 2023. To access the interview please click on the player or read an edited transcript below.

Edited Transcript

Please note the transcript below has been edited for brevity. For the full experience, please watch the video.

Chris Conway:

Hello and welcome to Livewire Markets. My name is Chris Conway. Today I'm joined by Andrew Papageorgiou of Realm Investment House. Andrew has a wealth of experience, approximately 20 years dealing in all sorts of markets from domestic and international equities to derivatives, direct infrastructure, real estate, as well as the domestic hybrid and convertible bond market. It's a great pleasure to welcome Andrew today.

Realm's performance in 2022 was outstanding, Andrew. You beat a lot of your competitors, many of whom were underwater and often by a long way. Can you talk to two elements of your investment philosophy that have helped drive that performance over the last year?

Andrew Papageorgiou:

Certainly. I think it was mentioned that out of handful of names in your universe that delivered a positive return, three of them we Realm funds - which we're exceedingly proud of. The two things are design and execution. So design's an interesting one because very often when strategies do what they say they're going to do on the box, it's about how you put them together and how you've built them. You've got to be realistic and pragmatic around how you actually design a strategy, both in terms of its capacity and in terms of how you manage it. So you've got to give yourself every opportunity of actually being able to deliver. And what I mean by that, for example, if you have a strategy that is enormous in size and scale, we know that the bigger a fund is, the harder it is to get results. So from a Realm perspective, managing capacity has always been very important.

In fact, I haven't heard of many fixed-income funds that have actually soft-closed strategies. In the case of our Realm High Income - Wholesale Units (Soft Closed), it's been soft-closed to new outside advisory groups for a number of years.

In the case of our Realm Short Term Income Fund, which is a short-duration credit strategy, design is fundamental there. It's less about day-to-day management. In the case of that strategy, we came up with some novel ideas around duration limits, around maturity limits that managed and controlled portfolio volatility, and 2022 was all about seeing whether it was seaworthy.

We were quite proud that in that kind of environment, the strategy delivered a reasonable positive return.

And in the case of our Realm Strategic Income Fund - Enduring Units, which is a private debt strategy, that's a fund that again just focuses on a really good part of the money market, focusing on high-quality private debt and lending money to high-quality lending programs in the Australian mortgage market and asset-backed security market.

So, again, when you're looking at our three strategies, I really think it's down to the fact that we are very careful around how we design. We're very clear that the objectives that we set for ourselves are achievable and attainable. And then in terms of execution, we think about the little things, again, things like capacity, things like areas of endeavour that we are happy to enter into. We pick our fights in terms of the markets we operate in.

In terms of investments that have had the most meaningful contribution to your performance over the last year, what were they? And do you still own them as we head into 2023?

It's a good question. It's not as relevant in our case, and I think it goes to what makes us a little bit different. It's not necessarily about the investments. It's when you own them and how you own them. So for us, in terms of the Realm High Income Fund, which is our flagship strategy and holds the majority of our funds under management, the strategy is active and it is managed in a contrarian fashion. So the reality is that what makes that strategy what it is, is that at times where it needs to look like a high-grade credit strategy where you're taking very little risk, we want to make it look that way. When do we want it to look that way? Well, we want it to look that way when markets are really complacent.

Think 2021. Interest rates are near zero. You're being compensated very little for things going wrong. Well, that's exactly the type of market you shouldn't be taking a lot of risk because essentially the market is forward projecting an almost perfect environment, all right? So when you are buying credit assets, when you're buying the interest rate in credit premium that a credit asset gives you at that stage, what you are taking is, essentially you're buying a Goldilocks scenario which doesn't allow for Russians marching over the border into Ukraine, or inflation shocks, or anything else as the case may be.

We don't have a crystal ball, so we don't know where the bad things come from. We don't know where they lay, but we know they happen.

So as soon as a market doesn't project a very high probability of these bad things happening, it's not necessarily a market you need to be heavily involved in. So 2021 is all about being a small target. 2022 is about filling your boots.

It's about planting. It's not a reaping and harvesting year. It's a planting year, and very often you're planting in very difficult conditions because again, this is what being contrarian and counterintuitive is all about.

You are planting at a time where volatility is spiking, where the narrative is negative, where the forward projection of the market is that things are bad and they're going to stay bad almost in perpetuity. Now, just as we know that things are never going to be as perfect as a perfect market projects, we know that it's very, very difficult for people to feel really, really terrible on an extended basis.

At some stage, the news sinks in and markets normalise. So when you can buy a market that is forward-projecting the worst of outcomes, that's not a bad time to get invested, but you get invested under really bad conditions because you're also buying in at the time that volatility is peaking, that these assets are moving around on any given day in such a way that your return series are taking a beating.

But the right thing to be doing is to be taking that volatility at that time. So, what were we buying in 2022? We were buying higher beta investments, investments where risk tends to drive their performance to a greater degree and they exhibit greater volatility…basically we just picked through the most unloved parts of the market where the dislocation was greatest versus historical relationships to other credit markets, and we built risk positions which saw us take some incredible punches to the face in June and in October, like everyone else.

But what it's done now is, it's set us up with a really nice portfolio where the focus will now move to harvest. So in some ways it's almost about switching, being flexible enough to switch your point of attack. So when the market is expensive, you want to maximise Sharpe or information ratios, which means you're all focused about risk-adjusted returns. When the market turns and when it starts looking cheap, you unashamedly want to focus on returns. It's all about the number. So 2022 was all about loading up for the number.

2023, as these positions start to mature, as they start to come near fair value, it starts to become about right sizing, not necessarily harvest, because we're not necessarily talking about a 2023 where we go back to 2021.

We still have our problems, we still have issues, we still have a fair level of uncertainty. You can't forward project us moving back to a perfect environment. So 2023 is about right sizing where we've taken bigger bets, bringing them back to something like normal, doing a little bit of harvesting along the way and managing a really, really nice yield to maturity for portfolio investors. So just to summarise all of that:

Essentially the secret is taking what the market gives you, not overly endowing yourself with the idea that you have some insight that others don't, and reacting to market pricing and staking your bets appropriately, which is really the Realm story over the last 10 years.

Andrew, let's talk a little bit about duration and quality if we could, and how they impact your portfolio. And just to follow on from what you were just talking about, maybe some of the tools that you use in terms of identifying the opportunities. You talked quite a lot in that answer about process, but what are some of the tools that Realm uses to identify those opportunities that you were talking about across the dimensions of duration and quality?

In terms of interest rate duration, the key thing we do is just assume we don't know. So we use a range of quantitative tools that essentially look at what your interest rate positioning should be to complement a credit portfolio.

So this again is in our Realm High Income Fund, which is the only fund that carries active interest rate duration. So for interest rates, the question we simply ask ourselves is, "How much rate exposure should we hold to provide a better risk-adjusted return to our unit holders given that we are a credit fund?" And we don't look much further than that. There are certain inputs that go into that number which include the expected volatility of interest rates, that look at the expected volatility of credit markets and the total level compensation of both. And the reason why we are more credit-focused than interest rate-focused is that, and this might be controversial, but we think it's a better quality return.

I think this is where the market gets itself in a bind. It's true that government bonds, in the case of Australian Commonwealth government bonds, they're AAA-rated assets, but it doesn't mean you can't lose a lot of money in any given month. And we've had a year where at times the benchmark fixed income index has been off 17 and 18%, the year. That's without any defaults occurring. That is basically because that is how volatile interest rate markets and long duration bonds can be. It's just how they're put together. 

So, yes, you know what? There's a very, very low probability that you could lose money in terms of credit quality there, but we recognise they exhibit really high levels of volatility, and on that basis we have a natural preference to take more of our risk out of credit, credit spread risk.

Andrew, you touched on volatility and we know that fixed income, as you explained very eloquently, had a very volatile period at the start of last year, January, February, 2022. The Realm funds didn't have the same volatility and the same return profile. It was much less volatile. Why is that important for investors? You touched on it, but can you just elaborate a little bit further, please?

It's that interest rate exposure. Interest rates are very volatile by their nature. So interest rate risk is a very small contributor to our pathway of delivering returns to unit holders. So when we look at our funds and we build these funds, we don't like to build in big directional levers. And let me explain what that means. Directional lever is where you put a lot of stock in your ability to get the direction of a market right. You live and die by that, if you want to be the cleverest person in the room.

And a lot of the time what you find is, it's wrapped up in ego and a sense of intellectual superiority where you feel that you can outwit, outplay the collective group think and the universe that is the market.

So interest rates are volatile. They're hard to pick. When you're most certain is when you get most hurt, and all those lovely axioms that various philosophers have given us over time, they tell us that when you are at you're most certain, when your conviction is at its highest, is where you get hurt the most. And interest rate markets are really funny in teasing that out of people, teasing a really high level of conviction.

So they're just really low-quality bets. That's the reality. So you look at our product stable. The Realm High Income Fund can take an interest rate view, but only as a compliment to the credit assets we actively trade. And for us, it's all about actively trading credit and using our relative value process to be able to look between situations within markets. So that's what we hang our hat on. The Realm Short Term Income Fund is really just all built around carry. It's all built around buying good quality credit assets, yielding a good number at a reasonable price, and we have a higher credit quality focus within that portfolio.

And the Realm Strategic Income Fund is buying basically floating rate notes in that home loan market and asset-backed market. So when you look at the actual products that we've built, we've built them very deliberately not to rely on us being smarter than the next person, and not relying on us making really correct difficult directional calls. It's just not our bag. So we believe that if you can do that and you manage it that way, you'll find that you deliver return series to unit holders which are more consistent, more stable, and more reliable.

Andrew, I know you don't like to prognosticate on the near term or even perhaps the long term, but at the end of the day there are big themes that are prevalent in markets and that will no doubt impact fixed income over the next, let's say, five to 10 years. What are some of those themes that you are seeing and some insiders to how you might be playing them into the future?

How you play these themes is by putting them into your probability outlook. At the risk of sounding absolutely uninspired and boring everyone who's watching this interview, the reality is that you almost have to think in the shape of a distribution. So if you think in a normal distribution, think of your business statistics and university or maths in year 11 in year 12, you think in outlook statements. When you're really, really certain, you see the world as a corridor where you have a really high certainty around how things work. Time should actually make certainty spread, anyway, because the further out you go the less insight you naturally have, all right? And that's just normal.

At the moment looking forward, there are some really big wheels turning that really should be making most investors feel a lot less certain they normally would be when looking at a five to 10 year outlook, which also includes a change of the rules of the game to some degree. And I'm talking here about central bank primacy and the fact that you've got your central bank puts, you've got liquidity coming into the market. We've come off a decade where the concern has been about deflation and that's almost been forward-projected as a concept. And here we find ourselves at a point in the cycle where that may have turned, the question of what a normal rate of inflation is is up for debate right now. The market, I think on a 10-year outlook inflation swap, might be a little bit over 2%.

There are plenty of people that would tell you that that is way too low. There are others that feel it's way too high. There are some people that feel that we're probably going to move back into a deflationary cycle. There are others that would say that ideas like green inflation, movements around population and demographics and the ability to import disinflation out of places like China and Asia, means that maybe we have to become accustomed to higher inflation as a normal thing moving forward. We've got the energy transition, which is this enormous thing where the numbers that are being talked about is that you need close to US$6 trillion worth of investment per annum to be able to hit our 2050 goals.

So when you start to bring this stuff in and then you put in a smattering of geopolitical issues and the question of multipolarity around geopolitics and supply chains and the sun setting of boardwalk industries like energy, there's a lot of stuff going on. There's a lot of stuff going on, and the reality is that maybe that uncertainty was always there, we just didn't see it as clearly. 

How certain are you around where interest rates are going to be? The answer should be, "Less so than I was a year ago. Less so than I was five years ago," almost across the board. So what does that mean? That means that you are looking at a fatter-tailed environment. In other words, your level of decision-making certainty and your level in confidence in your own ability to pick through it, has to be lower. 

So this is an environment moving forward where you're second-guessing your assumptions, where your portfolio needs to be able to hold up against you getting it wrong. 

You need to be able to discount that whole idea of modal certainty. And what I mean by modal certainty is, we all have that thing that we think is most likely to occur a year from now and three years from now. When you break the probabilities on these things down, even something that you're modally certain about, if I ask you to put numbers next to it, you might only put 30 or 40% next to it.

The other probabilities might have 10 and five and three and two, and while this is the most certain of a range of outcomes, it's still less than 50%. So this is the world we live in. This is, from our perspective here at Realm, that's how you have to think about it from an investment perspective. So more than usually I would say that over the next five to 10 years, or certainly over the next five, I think the level of decision-making certainty must reduce because of a range of factors, and let's just call out a few for the benefit of people watching the interview. Geopolitics is certainly one. I saw this morning that the doomsday clock is like a minute to Goodnight Nurse. 

There are a number of bigger things out there that are just far enough where they're not close enough for anyone to really bring in into the present thinking around how they're positioning themselves. But with these themes what you find is, it happens slowly and then it happens really quickly, and then it almost gets projected to the here and now. So, yeah, from our perspective, we are looking at portfolios and starting to think beyond the immediate benefits that certain industries have gotten off the back of, off the back of what happened in Russia, what's happening in Russia and Ukraine, on the back of the COVID crisis, let's call it.

And we're starting to look at what happens beyond those things sun setting. What might the world look like? What does it mean for a range of issues? What does it mean in terms of your credit and fixed income index? For argument's sake, if you're needing to fund six trillion a year, a lot of that's going to have to end up in the debt market. So what does your index look like 10 years from now? Banks will make up a big chunk of it, you'd assume, but then outside of it, who will make up the rest? Will it be utilities? Will it be energy generators? Will it be owned by government? Will it be in partnership with the private sector? Will it be the private sector? What is it going to look like?

And what I would say is that in a lot of cases, for a lot of sectors and for a lot of names, that's become an area of renewed focus for us where we are spending a lot more time and paying a lot more attention. Because again, once it turns, it turns, and you can find very quickly that a name goes from being tradable to being completely unloved. And it's clear that there is not only environmental factors, but social and governance factors as well are having an increasing effect on how certain bonds trade.

Andrew, we've just talked a lot about how markets might be volatile over the next five to 10 years. In the 10 years prior, markets weren't particularly volatile. As someone who has as much investing experience as you do, more than 20 years, is there an environment that you prefer?

Every investment professional will tell you, we all enjoy it when it's going up and no one's complaining. So that is every investor's preferred environment. That being said, I think one of the things you learn, you do learn that you have a certain predisposition, a certain type of condition, which means that you tend to do better in certain environments than others. We're all the same. I think people that have done this long enough recognise that in themselves, they start to realise when not to trust themselves as much. And I think the whole part of the discipline and part of the craft is actually being better, trading better markets.

So as a contrarian investor, what you want to do is you always want to counter punch, right? You like when the market gives you clear signals, you like when it's clearly getting beaten up too badly and you like when it's clearly way too tight. It's the period within that that can sometimes be more difficult. But equally, I tend to feel that that kind of environment doesn't give you a strong signal, so you shouldn't be acting meaningfully on anything it's giving you. Never been really strong from the momentum perspective. So realise that that's a chink in terms of how I tend to see things. Sometimes you sort of look at it and you wonder whether, after you've had a period like this, your first instinct is to take too much off the table too quickly and not let it ride a little bit.

So that's where that momentum, being able to actually read momentum and smell and feel the market is very, very important. But the great thing about being part of a team, and I am increasingly a smaller part of the team we have here, we've got some amazing professionals in this place. And in the aggregate, I feel like we've got every environment covered. And more to the point, we've got a culture where we're accountable to each other, where we encourage everyone being able to question everyone, and we don't like the answer because it feels right. Something tells me that. We want absolutes.

We want people to really follow through their thinking, which I think has allowed us to expand from the opinions of Andrew Papageorgiou and Ken Liow and Robert Camilleri to a broader team. We've got some great people in there that are expanding our skill base and making us better in more environments, and also allowing us to really spread in terms of the types of assets we can look at as well. 

So what I'd like to think is that we are getting better at managing all environments every day because we're really focused on getting better in managing all environments every day. That being said, the process likes extremes. And think about it. That's when you should be taking your bigger bets.

Andrew, congratulations on your performance in 2022. As I said at the top, it was outstanding, and thanks for spending the time today. 

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