Where this $4 trillion asset manager is investing

James Marlay: Well, Rick, I did some reading, a little bit of DD about State Street before we came in. Quite staggering the numbers, $2.9 trillion in assets under management and the firms also the creator of the first ETF passive strategy. But you employ both passive and active strategies. I'd love it if you could just start by telling me a little bit about the firm's investment philosophies and how you think about investing your client's money and then maybe tell me independently a little bit about some of the lessons you picked up and how you think about investing as well. 

Let's get into a couple of your current views. You're visiting Australia presenting to investors about how you see the world playing out in 2020. Very difficult task to do. You and I had a call last week and you suggested that you thought everyone was a little bit too bearish on the outlook and since then we've had developments with coronavirus. Does your the world is too bearish view still stack up and what are some of the key pillars to that that idea?

Rick Lacaille: It's always hard to balance the short term and the long term. We all feel like we're being epidemiologists looking at coronavirus. On coronavirus we think it's going to be a short economic impact that will be quite sharp, but then a recovery afterwards. It does mean we probably will have a little bit lower growth in 2020 than we originally expected. But it'll enough to keep us in risk assets. So we're overweight in risk assets. And by that I mean equities, credit, those assets that do well when the economy grows and when investors are able to gain those returns from businesses they've invested in. We prefer the US to other parts of the world generally, although some areas like Europe and emerging markets are particularly cheap. So we're putting a little bit more emphasis on those within portfolios.

But as an example of balancing the short and the longterm, coronavirus in a sense, is the ultimate short term event, climate risk is maybe, it's not the ultimate longterm event, but it's a very slow moving but very critical thing for us to consider. So we're thinking about climate risk and how we take account of that in our portfolios, how we ask boards the right questions in terms of how they're dealing with climate risk within our index portfolios. So like many asset managers, we're trying to balance short term pressures to forecast what's going to happen, against those longer term trends that are really, really important.

James Marlay: So what's an example of how you would start to factor in a change like climate change, governance, how does that factor in? How can you invest in that today when it's such an unquantifiable, thematic or trend?

Rick Lacaille: Yeah. Well there's two things we can do and we do do. One is we've got very large index portfolios through our asset stewardship and proxy voting policy. We ask companies, ask directors, particularly those companies that are most exposed, what their plan is. What's their plan for different climate scenarios, how they're making their business resilient. That's not to micro manage the business, but it's certainly to make sure that investors of ours know that those boards are focused on a very important longterm issue. Where we have the ability and where clients want us to focus on climate even more, we've designed portfolios that have very low carbon intensity relative to the diversification within the portfolio. So we can tilt the portfolio away from the most carbon intensive and perhaps those companies that are most exposed to more severe government action on carbon, towards those that'll benefit either through adaptation or through green revenue. So I think this is becoming a much more significant part of the investment landscape.

James Marlay: So a scenario like that, is that a fringe style case for your investing in the moment or is that pretty common place ,that you're having those conversations and making tilts accordingly?

Rick Lacaille: It really does depend where you are in the world, both geographically and in other senses. So in Northern Europe for example, and to a certain extent in Australia, people expect you to be on top of these issues. But I can tell you in the Netherlands, in the pension market, you wouldn't get very far as an asset manager unless you had a very, very clear understanding of climate risk and that you'd offered your clients the option of reducing climate risk within their portfolios. I think that mentality is cropping up increasingly in different parts of the world, but it's by no means universal.

James Marlay: Yeah, let's dial it back. The world is too bearish. Take me through the key pillars that are underpinning that slightly risk on or tilt toward risk asset position that you've got.

Rick Lacaille: Well a couple of things. I think Larry Summers secular stagnation hypothesis, which is the idea that we'll have a very low growth rate and very low interest rates for a long time caused by a number of different factors. It's a plausible hypothesis, but it doesn't explain everything and it particularly doesn't explain the growth of technology or it doesn't encompass maybe the growth of technology and the growth of emerging markets and their potential to power global growth and therefore global profitability. But if you just pick technology in healthcare for example, think about the cost of genome sequencing, which has gone from maybe $2.7 billion back in the early 2000s, to about a thousand dollars now. We have yet to reap the benefits of that reduction in cost in terms of customised medicine and diagnostics. But that's not just good for humanity, it's actually a really, really important profit driver that will keep industries like healthcare alive and profitable and providing us extraordinary returns. Even at a relatively low economic growth environment, those kinds of technological advances can really power portfolio returns.

So I think you can look at demographics and you look at some of the low interest rate projections into the future and get a little concerned. But you should remind yourself that the advances in technology are able to actually deliver very good longterm growth as well.

James Marlay: What about the state of the duration of the current economic cycle? It's been something, the business cycle has been debated quite heavily. It seems like three or four years ago we've been talking about the fact that we're late cycle and 2019 markets put in circa 20% returns. Is there any reason why we can't do that again in 2020? I mean we've been told to expect lower returns and then 2019 we get that bumper year.

Rick Lacaille: Yeah, I mean I can remember back in 1991, people were saying we should be expecting lower returns and in one sense they were right. We had an enormous compression in bond yield since 1991, but actually risk assets have done pretty well and the economy's continued to turn. I think the concern now rightly is that we are very late into an economic cycle, particularly in the US and we know they don't last forever. Now sitting in Australia, it's interesting making that point because Australia's had an extraordinary run of positive economic growth for a really long time, as has Poland interestingly. So there is no magic answer that says after a certain period of time you're going to have a recession, but economies tend to run out of steam and you can keep them going by lowering interest rates, but then you tend to stack up problems for the future.

So we need to be prepared for that turn of economic cycle, but we're not really at that point yet. There's no visibility on when we're going to have a credit squeeze, for example, in the US or run out of factors of production. Unemployment is very low in the US but I think you're seeing more people attracted to the workplace. You're seeing more gender balance in many countries where you're attracting more women into the workplace. So I think there is a possibility we can carry on for a little longer, but are not in the mindset that these things carry on forever, we're going to reach the end.

James Marlay: Could I get you to talk a little bit about the defensive part of the portfolios that you put together? One of the big debates that we've seen take place in Australia is that the bonds are in a bubble and it's often been equity managers calling out about how expensive bonds look. There's been this great compression on yields. Do bonds still play their traditional defensive role in your portfolios and what's your view on the valuations that you see in government bonds at the moment?

Rick Lacaille: Well, I mean, listen, when you've got negative yields, they're like expensive ballast. I mean, you know that they'll do well if you have a very sharp down turn, but it's a remarkably expensive way of buying insurance. And I think many of our clients are concluding that they need to look for other options to insulate their portfolio and we'd be absolutely with them. So we're trying to avoid those safe haven bonds. But we should talk about defensive strategies in a more generic sense. And one of the things we're very proud of is what we've done in the equity markets where we've designed defensive equity strategies, which are less exposed to those glamour stocks and those very volatile stocks and maybe more focused on steady earners and those that we think are pretty undervalued.

Now those strategies can lose ground when you've got a very, very strong bull market. But they do perform a very interesting role in a portfolio when you've got choppy market conditions such as the ones we've just experienced in the last week or so. So I think it doesn't have to be about bonds. You can certainly design up other investment strategies to cope with downturns.

James Marlay: And you mentioned earlier gold for tail risks. Just talk to me about what size allocation would a balanced style portfolio have to gold. And what role does that play for you?

Rick Lacaille: Well, I mean this has had a great history, a couple of thousand years at least of people having gold as their store of value. And if you ask you will it be worth something in a hundred years or 200 years, I'm pretty certain it's going to be worth something. You can't say that for every paper currency. So it's got a set of properties that are quite attractive and it has very low correlation with some of the other assets in a typical portfolio. So I think we're seeing people turn to gold more in wealth management and private portfolios, than institutional portfolios. Although central banks have been well known as buyers of gold for a long period of time. The challenge with gold is when it's under overvalued, it's easy with stocks and bonds. But what we do know is that gold could have a good longterm position in a portfolio because of the way it offsets other risks.

James Marlay: So you've talked about a bias towards risk assets. Before we move on from the asset allocations, your positioning, are there any parts of the market that you're absolutely steering well clear of? The things where you've gone dramatically underweight, are there countries or equity markets that you think look really dangerous.

Rick Lacaille: There's some things we prefer to others. So those smaller countries that are exposed to continuing trade tensions, they're vulnerable. With that being said a lot of them are quite cheap. So we've begun to put a little bit more money into emerging market equities, which would encompass some of those, but we're still pretty cautious about those very open economies that have a little bit more vulnerability to the backwash of the US, China dispute. Which is we've got through phase one, but we're not yet at phase two. But we mentioned bonds before. I think we're really not that keen on negative yielding assets from a first principles perspective. It just doesn't seem to make sense. And so we're avoiding those safer haven type assets and we think there's a lot of attractions in other parts of the bond market, whether it's corporate credit or in fact emerging market debt.

James Marlay: Okay, great. The president and the CEO of State Street, Cyrus Taraporevala, correct?

Rick Lacaille: Yes.

James Marlay: Gave a presentation on what the future of the asset management industry looked like. He called out 10 really interesting trends and observations that are meant to be thought provoking. I'll put a link below this video to that article. But one of the things he said is that he said asset allocation 10 years from now will be the new alpha. Can you just break down that comment for me and explain what does that actually mean and why is it an important trend to be aware of?

Rick Lacaille: Yeah, I think because sometimes it's a neglected lever and I think because we've lowered the cost of making these allocation decisions, either through ETFs or index funds or other kinds of instruments, that you've opened up a palette, it's almost like you're a painter and suddenly you've got loads more paint in the paint box and you can paint a picture that's very sophisticated and looking for value in extraordinary places that maybe has been neglected in the past. So people sometimes have a preferred habitat and they say, "Well I'm a fixed income investor and if I'm going to take risks I go into corporate credit."

James Marlay: The other thing that he talked about was the fact that he thought passive would make up 75% of managed funds and active would go to 25%. I'm interested to know, and I suspect you would have had discussions internally, what active strategies will thrive 10 years from now, where will the value be created there?

Rick Lacaille: I think it's let a thousand flowers bloom. I think the 75% will require and imply a change in the 25%. So if you wind the clock back 20, 30 years, a lot of the active management wasn't very active. I think knowing that passive is an option, investors are turning the dial up a little bit on active management and saying, "We've got to have it more active and also more distinctive." So the thousand flowers bloom comment was to say that you'll have people who specialise for example, in activism, so I find companies that are not doing well, they need a management change and that's going to unleash a lot of value. You'll have others who are high frequency traders, you'll have others who are very, very longterm investors, almost like a private equity style. So I think knowing that investors can have beta for a very low cost, means that the alpha is going to be much more wide ranging and also more active.

James Marlay: Interesting. I want to get into a couple of personal questions. I know you represent State Street, but you obviously had a really long career and you work insidet, I can't imagine the resources that you get access to at State Street. I'd just really like to understand at a personal level, from all the experience you've had in markets, what are some of the philosophies that you hold core to your own beliefs? If you're teaching your grandkids or your kids or whatever it might be, how to invest, what things that you pass through them?

Rick Lacaille: Yeah, I think you've got to develop strong convictions in investing because there's a lot of noise out there. So you've got to have things to hold onto that will get you through the noise. But I think one of the lessons of investments is don't hold on to those things so tightly that they fly in the face of all the facts. And I think when you've lived through a lot of investment markets, starting with the crash in '87, bond market in '94 and then you realise a lot of the things you are holding onto, you need to keep questioning. So that's not to say you don't believe in these strong conviction ideas, but you've got to assimilate new information. Say, "What did I learn from that?" So what did I learn out of the 2008 crisis, I thought I was pretty smart before then, but there were certainly a lot of things that happened then, that we weren't expecting. And that helps you prepare for the next, if not the next crisis, then the next challenge. I think that's a personal journey that investors have to go on and certainly one that I've gone on.

James Marlay: So okay to change your mind based on your information.

Rick Lacaille: Yeah, but not like a weather vane. I mean, you've got to have some degree of conviction, but you've got to assimilate the fact and say "Let's test that against what I know."

James Marlay: Okay. What else? Is there anything else?

Rick Lacaille: Well, I think financial markets should make us focus on the end customer. At the end of the day, financial markets are just way of linking people who've got savings to people who need those savings to do something in the real world. And we shouldn't forget that we're the bit in the middle and our obligation is to be super efficient in serving, if you're in the asset management business, the saver. You need to make sure you're focused on his or her needs and making sure you're doing that and not focus on your own industry necessarily.

James Marlay: Alrighty. Final one, and it's a question that we ask all of our guests when they come in. I was hoping you could share a lesson that you learnt, a difficult lesson that you picked up somewhere along the way where it's made you a better investor, you had to reflect. Could you tell me story about what happened and just explain the lesson that you've taken away that you think makes you a better investor today?

Rick Lacaille: Yeah, let me think. There's been quite a few. Obviously starting from the crash but that's so long ago, it's almost hard to remember now. I think one of the things that was really interesting and informative, 1994 where we had bond market, very, very sharp correction and we developed strategies that were exploiting potential from bonds. And as that bear market unfolded, we realised we should turn the strategy on its head. So to be a little bit more flexible and say, "How can we profit from bonds that are in a bear market and really think about the problem in a totally different way." In other words saying, "We're not bond investors, we're not tied to the idea of always having bonds. We can go on the other side of that trade." So I think it's important as markets change that you reevaluate what you're doing. So that was a really important lesson for me because before that fact and it's a little bit like negative yields, no one really believed you to see that sharp reaction. I think negative yields are again, enabling us to think differently about bond markets.

James Marlay: Okay, great. Well listen Rick, thank you very much for taking the time to come and sit down with us. Enjoy your trip to Australia. And yeah, we appreciate you taking the time to share some insights, particularly on some of the passive strategies and how your thinking about investing in 2020.

Rick Lacaille: Thank you.