INSIGHTS

Link para o artigo original:https://www.man.com/maninstitute/lss-podcast-alpha-difference

DECEMBER 2022

2022 has seen inflation move from ‘transitory’ to recessionary risk, supposedly low-risk pension investment strategies caught in a liquidity crisis, and the return of high interest rates and high asset price volatility. As investors and policymakers alike look to manage risk ahead of 2023 which appears set to be a repeat of 2022, delivering returns is more important than ever.

For the final episode of the year, Luke Ellis, CEO at Man Group, joins Peter and Long Story Short to discuss the state of today’s markets, hedge fund performance in 2022, and what comes next for an industry with a duty of care for its end savers.

Recording date: December 2022

Episode Transcript

Note: This transcription was generated using a combination of speech recognition software and human transcribers and may contain errors. As a part of this process, this transcript has also been edited for clarity.

Peter van Dooijeweert:

Welcome back to the podcast. For our final episode of 2022, I’m delighted to be talking to Luke Ellis, CEO here at Man Group. Luke, thank you for joining us today.

Luke Ellis:

It’s always a pleasure.

Peter van Dooijeweert:

We have a lot of things to talk about, but I thought I’d start with the central banks. You’ve been pretty vocal, especially early this year about policymakers not having the will to fight inflation properly. Powell’s gone after with the last slew of 75bp hikes, the ECB maybe not so much. What do you think now?

Luke Ellis:

I’m not sure I’ve changed my opinion very much. What I said at the time was that in order to actually get rid of inflation, once inflation’s into wages, and we definitely have wage inflation going on everywhere, you could debate your number, but it’s somewhere between the latest Fed numbers five point something for the US, the ADP, which I prefer as a wage inflation number, but it doesn’t really matter, is seven point something. So we’re five to seven. That’s not compatible with 2% inflation. If the Fed wants to get inflation down to their official target, they have got to change the employment picture, and what they’ve done is to raise rates a reasonable amount.

Interestingly, financial conditions haven’t been tightening for the last six months, so they aren’t achieving much on financial conditions. But really importantly the employment market remains very strong. Now, I’m not saying it’s a good thing to cause mass unemployment, but if you want to get inflation down to 2%, they have got to cause a significant amount of unemployment.

What it seems to me that Powell indicated in the last couple of weeks quite clearly, which was sort of what I was talking about earlier in the year and it still feels the same, is that as you start to see the first derivative of inflation turn negative, which we have, I think now definitively, seen that what would happen was that they would back off on further rate hikes in the hope of having some wonderful gold locks outcome where they get inflation down to target without having a recession. I think there is a essentially zero chance of that scenario. And so what you’re seeing is the Fed talking about backing off on rate rises and the market is pricing in rate cuts next year from the Fed. And if they stick where they are, if they raise another 50, a couple of fifties, they’re not going to have done enough to get rid of inflation.

So we’ll see headline inflation come down to, pick a number, three or four and then go up again, and we’re never going to see 2% unless they’re willing to take real pain. And my sense then, and I don’t think I’ve changed, is they’re not willing to take real pain.

Peter van Dooijeweert:

Yeah, I think we’ve seen it from some of the other governors already trying to back off. I don’t know that Powell per se has backed off, but they’re clearly not doing 75’s. So you just could hike infinitely. I mean do you subscribe to something like the Taylor Rule which implies a rate closer to eight or 9% or is that just kind of-

Luke Ellis:

I mean, it’s a nice theoretical model. We’re not getting there. So it’s a slightly pointless thing. I don’t know what the number is one would need to get to, but the bit about it is the Fed has got to be raising rates into the beginning of pain, not raising rates until the first sign that maybe things aren’t perfect, at which point they’re… So they’re far talking again about not cutting rate. The market doesn’t believe that story. If they mean what they say, they’ve got a lot of work to do to convince the market of it, and if they really want to target 2%, look, the fed rule used to be 2% inflation was consistent with 6% unemployment. 6% unemployment is a long way from now. As of last week we’re still getting significant job growth, that’s all inconsistent with the Fed talking about backing off rate rises.

Peter van Dooijeweert:

So are people over trying to predict the pivot because, I mean, we’re living data point to data point because Powell basically told us he’s data-dependent, and the market keeps trying to game the pivot. I mean, does it sound like one’s not coming if we’re just looking at the wage inflation data?

Luke Ellis:

So I think we are going to see the Fed… I think you can see, not that far out, the point where they stopped raising rates. I personally am dubious they’re going to cut rates, but I don’t think they will have raised rates enough to get inflation down to 2%. So to me this more turbulent economic environment, thereby leading to more turbulent market environment, is probably with us for years, not months because the choices are difficult, and when choices are difficult, what you get is politicians and most central bankers in the end are politicians will put off difficult decisions for as long as they can.

Peter van Dooijeweert:

So every strategist seems obligated to do some kind of year end piece or a road ahead piece. And if you really just average them out, they generally are up markets. They’re generally wrong. They’re generally random.

Luke Ellis:

There’s a lot of pages though.

Peter van Dooijeweert:

No, there’s definitely a lot of work. People are definitely getting paid a lot to do a lot of writing, and some of the contortions are crazy.

Luke Ellis:

Even then, I’m not sure the price per page they get paid would be that good when you look at the number of pages they produce in these things.

Peter van Dooijeweert:

Fair enough. But some of the reason they have to write so many pages is because of the contortions, right? There’s one who came out and said he expects the S&P to fall to 3,000 before rallying at the end of year 5,000. And so, to some degree I’ve given up on that. But of course, I was also asked to write something for next year, which tells you the enthusiasm I have for the topic.

So for the heck of it, I just said, why don’t we just stop thinking and think the worst things that happened this year might happen again next year for a variety of reasons. And so I’m just curious what your thoughts are on some of them. That would imply equity is down 25% at the lows this year, so puts the S&P somewhere around 3,000 next year. Does it sound okay?

Luke Ellis:

Look, I think the big picture in this is there’s a lot of economic uncertainty, and ever trying to predict where an equity market will be a year from now is somewhere between incredibly difficult and impossibly hard. A year is a long time away in most markets, and in the economic volatility that I think we’re going to see it’s impossibly difficult. Do I think that the range of 3,000 to 5,000 on the S&P is a good range? Yes. It’s a pretty wide range, right? And trying to think you can say exactly the path of it, I think is very difficult.

What’s the 3,000 sort of number around? I don’t think we’ve seen the lows of this cycle in the S&P. I don’t think we’ve seen the highs in the S&P, that’s forever sort of 3,000, 5,000. Hey, then we’ll knock ourselves out. What’s 3,000 around is that if the Fed tightens enough to try to get rid of inflation, that means they’re going to cause a significant recession. A significant recession means that 200 of earnings, 180 of earnings looks like a sensible number and you put a multiple on it and that gets you looking at 3000 type of thing.

Or maybe the Fed is going to actually do what the pivot suggests and chicken out and start cutting rates and then free money. We can get another big rush up, a sugar rush to some high number before they then have to deal with the pain. And so the range makes sense between where do we get with sugar rush? Where do we get if the Fed takes the pain? And so then you’re trying to think about a path and that path is while the Fed says they’re data-dependent, I suspect at some level they are. I think trying to predict the path is a mugs game.

Peter van Dooijeweert:

So don’t read the strategist reports?

Luke Ellis:

Look, they’re interesting reading. The reason I know how many pages there are is because I keep hitting alt P or whatever it is to print them out and going, “Oh, damn, I thought there was 10 pages and I’ve got 120,” and I tend to read the 10 summary pages. They’re interesting reading. There is a weird amount of consensus on this idea of we’re going to rally for a while, then we’re going to sell off, then we’re going to rally into the end of next year. That feels-

Peter van Dooijeweert:

Very specific.

Luke Ellis:

Yes, exactly.

Peter van Dooijeweert:

Oddly specific.

Luke Ellis:

Very specific about a path. While history never repeats, it does rhyme. It’s interesting looking at what happened the last time we had significant inflation, which is the ’70s. It’s not going to be exactly the same. There’s an interesting thing as to whether you think we’re in the mid-70s now or whether you think we’re in 1981 or maybe you think we’re in ’69, they give you a different view. But one of the bits of the ’70s is we saw a big selloff at the beginning, we then saw over a 10-year period no real return to equities and negative rates on government bonds. But interestingly a number of 40, 50% rallies. So the path dependency is much harder to do in an inflationary world than it is in a sort of simple non-inflationary world.

Peter van Dooijeweert:

And I think that’s why we all contort ourselves trying to guess the pivot because you can’t miss the 40% rally. If you miss it, you look bad for one reason or another and you might get proven right in 15 years.

Luke Ellis:

But in the same way the Fed says it wants to let the data tell them what’s going on, we like to let the data tell us what is going on, and this is where trend is a really sensible way of thinking about life. When you see the direction of markets change, you should change your opinion about what’s going to happen next. Not the other way around.

Peter van Dooijeweert:

Well, I guess that favors active management, but maybe asking you that question is sort of an obvious result.

Luke Ellis:

Yeah, I’ve had a slightly odd time the last month. I’ve done a lot of traveling around the world talking to senior people and clients, and I have my fundamental view about the fact that with heightened inflation, that creates economic volatility, that creates market volatility, that creates significant opportunity for active management, and within that trend. And I always say, but you could say I’m talking my book because that would suit us, but the fact that it suits us doesn’t mean it isn’t what I think.

I was quite happy in the sort of late teens period when it was clear that the great moderation meant that there was less of a return to active management, to put my hand up and say, yeah, while the world sits with zero rates and zero inflation and everything, every central bank doing the same thing. It’s not a great environment for active management. It’s an environment to have the most concentrated levered portfolio you can have. Which maybe that is the Cathie Wood story that’s the most levered, most concentrated portfolio possible. And it really worked in that environment and I would put my hand up and say yeah, until the environment changes, it was a tough time for active management.

Economics says to me that then next, and as I say, I think it’s years not months, will be a different market environment. And if you believe in that one where inflation doesn’t go back down to zero, 1% then active management should have a very good run.

Peter van Dooijeweert:

And not only that, inflation at 0% strikes me as global depression as opposed to normalization of anything.

Luke Ellis:

Yeah, exactly. If we get rates back down to zero, it’s because there’s been a really bad market. I mean, really bad economy and that will be really bad for equities when it happens. So be careful what you wish for.

I do think there’s one thing about… For active management, one has to be, there’s a caveat to all of this. The more that there is dispersion in markets, the more opportunity there is to generate alpha. But it requires skill to generate alpha. And so, one of the things is when there’s lots of dispersion, you can get it right and make very good returns. You get it wrong and bleed money quite quickly. And so it’s not that I think that lots of dispersion is good for all active management. I think it’s good for people who have skill.

I’m very happy to take the bet on man’s skill and so I think it’s very good for us. But I could see it being very bad for a whole bunch of people because they don’t have skill and they will be more active and they’ll lose money.

Peter van Dooijeweert:

Which brings to mind long-short managers, many of whom struggled this year, to put it generously, because they were apparently closet beta as opposed to alpha. I mean, is that a dead universe long-short? Equity long-short?

Luke Ellis:

No. I think one has to separate that universe into two groups, that there is a significant group, maybe it’s still the biggest part of the hedge fund industry by AUM, who runs knowingly and the clients who buy them know that they’re running with a very significant net long all the time, 60 to 80% net long, sometimes more, and concentrated bets. And that’s the classic style bought by endowments in the US, but mostly they buy them as a replacement for equity. And so they want them to keep up with equity markets in the good times and know that they’re going to have significant draw-downs in the bad taps. Now, there’ve been some that have had things that look quite close to blow up territory, but fundamentally they are delivering what their clients wanted from them.

Then you have another section, you could think of it as the more market neutral people, where they’re being bought by clients as an absolute return manager, a portfolio diversifier, but maybe portable alpha. And those managers have done okay this year. On average, no great shakes but not on average a problem either. And so they are not a problem for clients in their portfolio, and in a looking forward world, I think those continue to be for, if you like, pension fund investors globally, absolute return investors globally. They still look like a pretty good investment. They’re just not an equity replacement. They were never trying to keep up with equities in the good times and they shown none of the draw-down characteristics of equities this year.

Peter van Dooijeweert:

All right. So I have a list, I’m going to go back to the list in order. So I’m going to stick with a couple macro topics before we talk about hedge funds. Again, understanding that you’re a CEO of a hedge fund. Just a few more of my extensions of this year to next year and one of them you’re going to say no way. So you might ask why I’m asking. The two-year note at eight and a quarter percent?

Luke Ellis:

I find that one is firmly in the noway camp. I think one of the interesting things at the moment is if you are buying equities because of the pivot, then you might as well buy two-year notes. Because if the Fed really pivots two-year notes, I mean, you could buy a lot of them and you’ll get a lot of price appreciation out of them.

Peter van Dooijeweert:

But if I extend that, and your argument is if they pivot they may have pivoted too early. So two years out, two-year notes at 8%,

Luke Ellis:

Do I think that we can see the high-yield on two-year notes in this cycle of inflation at eight and a half percent? Yeah, I think that’s perfectly possible. I mean, genuinely, perfectly possible. There is a sort of weird thing of, I mean some of this is age and I’m sort of showing my age. My first mortgage had a 17, one, seven percent coupon, and in my career, 5% yields were the median, essentially. And so I don’t think of 5% as high rates. I think of that as just ordinary normal.

And so it’s perfectly possible we get back to a place where in order to actually create contraction to get rid of inflation that the Fed needs to go to 8%. I don’t think it’s going to happen in 2023 and maybe not in 2024, but that doesn’t mean it’s not going to happen.

Peter van Dooijeweert:

To me, it’s not a fat tail anymore. That’s probably how I describe it.

Luke Ellis:

Yeah, exactly. I mean it’s that bit that people forgot that zero, one percent rates are really abnormal, but those are very abnormal and sort of 5% is fairly normal. And so therefore eight is just the other side of the distribution to two.

Peter van Dooijeweert:

Which speaking of suppression and abnormal rate environments, the UK pension crisis was somewhat predicated on a lot of buying of gilts by pensions as part of the liability hedge programs. Part of my little extension is sterling sub one, do you say 0.9 because have we ever seen that kind of a number? I think 0.9 we say. So one, is the UK pension crisis over? And two, what’s the landscape for, because Man’s a UK company after all barely. What’s the landscape look for finance, everything UK, Brexit?

Luke Ellis:

So, look, Man is a global company with our headquarters in the UK and our listing, if that matters, happens to be in the UK. I think that people thinking about Sterling up 0.9 and so on is one of those classic extrapolation things where they just got overexcited.

UK PLC, to think of a big picture, looked very cheap at 110, 105. I’m not surprised it’s comeback from there. 160, which has been the middle of a long-term channel, looks expensive given the damage that Brexit has done to the UK economy. Whether Brexit has done what it was supposed to do, we can debate. Whether people got what they were promised, again, you could debate. It depends whether you think people voted for Brexit in the knowledge it would have an economic cost or whether they thought it was a freebie. If they thought it was a freebie, they’ve got suckered.

If you believe that they actually didn’t believe the bus and that they knew they were voting for something that had a cost to it, but that was worth it for the control, I mean, there’s a good argument people did. Well, they’ve got the cost and they’ve got some of the control, and it was a majority voted for it. I’m a believer in accepting the results of elections, however annoying they are.

Peter van Dooijeweert:

And the pension crisis, gilts?

Luke Ellis:

So the pension crisis… So the liquidity crisis in UK pensions is behind us, I would say. You can create a scenario where it comes again but it’s very hard to create. I think that… Sorry actually I should be careful. It’s hard to create by yields going high, rapidly again, because they have to go a long way. And the biggest thing was the index-linked gilts that the pension funds owned in the LDI programs where they were owning 20, 25, 30-year index-link gilts with a 2.5% negative real rate per annum.

You buy something for 25 years with a 2.5% negative real rate, you are promising to wipe out at least 50% of the value of your money. I mean that is a really dumb thing to be buying. And they’ve repriced to, whether it’s good or bad value is a debate, but at least they’ve priced us something where it’s a positive real yield. And so that is at least a reason you own it over time.

The place where we can get back into a UK pension crisis is twofold. One, if we see those index-linked gilt yields going negative again, I’m not sure any lessons have been learned in the LDI crew about not buying them when they have negative real yields. And so I could see that the crisis getting stoked up again that way. And then secondly that I can see a problem in the UK defined benefit market, which is what this is about.

Where the conclusion of the consultants who sort of got them into this trouble in the first place is that what the pension should now do is to keep owning as many gilts as they had before because it reduces the accounting variability, which is a purely accounting effect, not a real effect, but sort of stick with being concerned about that more than real returns, and to de-risk the rest of the portfolio even more. And if they don’t run enough risk then they’re not going to generate reasonable returns, which means that that’s going to create a different sort of pension crisis that the guarantors of the pensions are going to have to put their hand in the pocket for more than they should do if there was reasonable investment returns.

You won’t likely get exactly the same one again because rates go higher, but the right lessons haven’t been learned, sadly, yet in the UK pension industry.

Peter van Dooijeweert:

And I think what people discover, there’s really a lot of ways to lose money even if you’re just hedging something, which is time and time and again the thing. And so people always try to find a Lehman moment in these sort of crises, but Bear went under first. So this UK gilt crisis is that a Lehman moment, a Bear moment? I’m more concerned about liquidity, the treasury market, that sort of thing.

Luke Ellis:

Look, I think the better way of thinking about that is so far in the unwinding of the excesses that two things have broken, a whole load of stuff in crypto is broken and no, let’s not spend an hour talking about crypto. But you can see that a whole load of things in crypto are broken and the sort of lending financing part of crypto is, I mean, that was horrible.

Peter van Dooijeweert:

It was a joke to begin with.

Luke Ellis:

Yeah, exactly. And that’s broken and there’s still more to unwind. And the UK guilt market broke. Do I think that we’ve seen the end of… Have we seen all the things that need to break in order to unwind the excesses of the zero interest rate, negative interest rate, free money, excess leverage world? No, I think there are more things that have got to break. Whether they will break in 2023 or longer, depends how the different central bank behavior goes. But as I said, I mean, I’m afraid, I think we need a jobs recession in order to get wage. If they want to get headline inflation down to 2%, then you need to have more people looking for work than there are jobs.

It’s a wage recession, it’s a jobs’ recession. I’m not saying that’s a good thing but it is a necessary thing if you want to get to 2% inflation. And to get there, that will mean a real default cycle which we haven’t seen in a long time. And I think there’s a whole load of strategies that are predicated on there never being a default cycle in there. That’s an example of one, but you can think of a number of things where something’s going to break at some point.

And I think to really reset this cycle, you need to clear all of those excesses out. That’s sort of what 2007 and 2008 did. All the things that could break broke and then you started a new phase.

Peter van Dooijeweert:

So you just said you don’t want to talk about crypto. FDX Is probably not going to buy Goldman Sachs. I mean, is this an asset class, is it just done and over with? And if it’s not, is it tradable in some way?

Luke Ellis:

So look, cryptocurrencies are definitely tradable. We trade them. Do I think it’s possible to come up with fundamental valuations for any of them? No, not at all. Right? They are a purely speculative instrument. That’s okay as long as you trade it in a purely speculative way. You can trade it in a trend way, you can trade it in a relative value way, you can trade it in a mean reverting way. They can all make sense as long as you don’t try and trade it in a fundamental way.

You can sit there and you can look at the fundamentals of a company and understand the valuation of the company over time, and you can do that based on fundamentals. You can’t do that with a cryptocurrency. They are just speculative things. That’s sort of pure crypto. As I mentioned earlier, the sort of lending world around there, the Stablecoin world around there. I mean that’s got lots of problems that are going to go wrong.

Peter van Dooijeweert:

And a 20% rate should have told you this isn’t safe.

Luke Ellis:

That’s the thing, right? I mean, when the return for lending money to the US government was 0% and you could get 8% for lending money to Sam Bankman-Fried and then when the US was offering you two and suddenly he’s offering you 20. When people are offering you those sorts of returns, that’s because they can’t give you your money back.

That is true. It’s always been true. It’s nice to get a bit of extra return. When you get too much return, it means because they can’t give you the money back. I think the bit that one’s supposed to say now is, of course, if you put cryptocurrencies to the side, the blockchain technology is of course fantastic and going to change the world. And I love Ken dearly and I know he did the podcast talking about how that’s true, but I have to say I’ve yet to find a convincing use case for blockchain technology where it actually makes a difference that is going to gain critical mass and remain for time.

And so, the big example that’s been used in presentations in finance for the last seven, eight years, I can’t remember when they started, was the Australian stock exchange who had a big program to put all of settlement and clearing on the Australian exchange into the blockchain world and they’ve just written it all off and I think 250 million something, it’s a big number for ASX and they’ve written it off to zero because they just haven’t been able to get to critical mass. And I worry that this may be one of those things which a bit like Esperanto, sorry that’s a language that they had in mind in Europe, it was a great idea that never found a use case and has never happened.

Peter van Dooijeweert:

Well, I worked for George Soros who is a huge believer in Esperanto, but he never spoke to me in that.

Luke Ellis:

Nor has anybody ever talked to anyone else in that language really.

Peter van Dooijeweert:

So all of the crypto stuff brings me to venture capital and privates. I love seeing the various SoftBank slides with flying unicorns that go up and they go down, and I used to use them in tail hedge presentations to say if they’re a flying unicorns you’re supposed to hedge as a thing. But the UK pension crisis also brings up the idea of illiquidity being a problem. They couldn’t sell their privates. So between due diligence, what are eventually going to be big markdowns in a lot of the VC stuff and illiquidity is the game up for private markets.

Luke Ellis:

No, but one should. So liquidity is extremely important and understanding the liquidity that you actually have in a portfolio and the calls that may come on your liquidity is really, really important. And clearly the LDI world or the UK defined benefit world misunderstood the calls could be on liquidity. That’s a bit sad because it wasn’t a very difficult-

Peter van Dooijeweert:

It wasn’t complex.

Luke Ellis:

It wasn’t very complex and it wasn’t a very difficult one to imagine. There are more complex ones to imagine. I was chatting with a sovereign wealth fund the other day and we were talking about the liquidity calls they could get from FX hedging on their portfolio and from some levered bond positions, and some of the things they do with us which have leverage in and they run.

And we were talking about the scenarios they run and they were very sensibly conservative in the scenarios they run. And then I said, have you run the one where the government asks you for, it’s a sovereign wealth fund, right? So it’s, I don’t know whether you call that owned by a government or whatever, and have you run the scenario where the government asks you for 20% of your capital in cash because the reason that your portfolio’s getting stressed is that something bad is happening in your country and therefore the government needs the money all of a sudden? And made for a pretty interesting conversation about you can get calls on liquidity, you should think of all the things you can think of and stress them to the maximum amount and then you should always have a big buffer because other stuff happens that you’ve forgotten.

Again, actually another Australian example, but in the super funds, people thought that they understood exactly how their liquidity worked and then in COVID the government changed the rules and said people, even if you were 25, could take 20% of your savings pot out of your super fund. Well, that changed the liquidity profile quite dramatically. You should always think about extra risks on liquidity. So important that any saver is thinking really honestly about how much liquidity they need and have investments in things which can deliver that liquidity.

Now, then secondly you get to whatever amount you can take illiquidity risk. Looking at private markets is a perfectly sensible idea and there are times where it’s exactly the right thing to be doing, but you ought to be getting a premium for your illiquidity and you ought to be getting something you can’t get just as easily in public markets for your illiquidity.

We used to talk about the illiquidity premium. The reality is in many things and when you look at some of the SoftBank things, it’s a good example. People were paying premium prices to buy something privately compared to what they could get in public markets. That isn’t an illiquidity premium, that’s an illiquidity discount, which is not a good idea.

The venture capitals, real venture capital starting out new businesses gets you access to things you can’t get in public markets and is a very sensible thing to have within your portfolio. Still entry point matters, right? And good VCs know how to negotiate for very good entry points. They don’t just pay whatever double the last valuation is because they can.

We’ve seen excesses get into private markets where people were willing to pay the wrong price. And if your entry point is wrong, it’s incredibly hard to make a good return. You have to make really heroic assumptions, and as we know, we can all pick different examples of things where in the past the valuation of, certainly the more recent past, you got valuations for different private businesses where the only way you could support those valuations was assuming they were going to take over the world, that every single person was going to take an Uber every single day or the only way any office worked was to be in one of, what’s his name? Andrew Norman’s free offices and so on. And those extrapolations were nonsensical.

Peter van Dooijeweert:

And it’s funny that they happened twice, right? In the 2000s and then they happened again. There doesn’t seem to be any memory. And you’re trying to get people to remember inflation from the ’70s, but they can’t even remember the tech bubble from the 2000s.

Luke Ellis:

I mean, one of the things, the investing world is made up of people, and most of those people have been doing the job 20, I mean, sorry, not most. Most of the people in positions of authority have been doing the job 20 years and if you’ve been doing the job 20 years, you don’t remember the tech bubble and you certainly don’t remember inflation. You’ve got to have been doing it 40 years to remember inflation or be Brazilian. I’ve always found some of the best portfolio managers who are running macro risk I’ve ever had are Brazilian or Argentinian because they’ve lived through the bounce of real mega inflation lots of times in their lifetime and so they really understand the time value of money

Peter van Dooijeweert:

With respect to private markets, so Man has a very large quant systematic effort. Do you think quants will be able to access private markets anytime soon?

Luke Ellis:

I think that there are quantitative techniques around data analysis, gathering information analysis where quantitative techniques can really help investments in private markets. Do I think that the quants are going to take over private markets? No. It’s sort of, I still think that discretionary fund management makes sense. It’s just if you tried to do discretionary fund management using a pen and paper today, you have no chance. Everybody uses technology, everybody uses… And we’ve spent a lot of time and money using our quantitative skills to process as much information as possible for the discretionary fund managers so they can concentrate on the thing they do best and uniquely, which is to interview people. We are not yet at the place where a computer can do this interview either asking the questions or answering the questions, maybe one day but not for some time type of thing.

In the same way, the ability to, when you’re looking at venture capital, you are investing in ideas and people, and honestly the numbers are all a bit BS. Right? They show you this upside case which means that they take over the world and the business is worth a gazillion dollars. That’s not how anybody invests and succeeds in VC. What they’re doing is investing in the idea and the people to do the execution and they’re putting guardrails to stop them doing stupid things, if that’s not what quants are great at. But if it comes to where should I buy a property and extracting the data about the different prices in different locations, the different quality of schooling, the longevity of leases, so on and so forth, that is stuff that computers can do incredibly well.

Peter van Dooijeweert:

So why don’t we move on to platforms in the hedge fund business. They’ve gotten a lot of press in the Financial Times and Wall Street Journal just to name a couple. Higher fees, liquidity constraints, they’re getting bigger and bigger. One, is this kind of a rational outcome? Is it the end of the niche manager? What are the implications of all that to you?

Luke Ellis:

Well, I think it’s an interesting thing as to what one defines as a platform manager. You can very justifiably define Man as a platform manager. We have a hundred plus different investment strategies based on one platform of technology.

I think that what you’re seeing is a couple of things going on. So yeah, I do sort of think it’s the beginnings of maybe the middle innings of the death rows of the niche manager. We used to talk about 10,000 hedge funds and while I’ve met a hell of a lot of hedge funds, I never quite thought 10,000 was a realistic number. But I certainly used to meet, back in my fund of funds days, you used to meet 500 new managers a year. So you could think there were 5,000 managers, and you could think credibly about investing with 2000 of them and then work out which ones were good.

Today, really a huge proportion of the industry is controlled by the top 200 managers and I don’t think… If you got to a thousand, you are looking at things that are really people’s personal account, they’re not credible managers now, and that there is more and more concentration in the top 20 managers. Now again, I could be accusing of talking my book because we’re clearly firmly at near the top of that top 20. But I think what you see in…

So in every industry in the world, technology is becoming more and more important and whenever technology becomes important, whether it’s a pure tech business or a business where technology is transforming the way it delivers, what you see is natural concentration of success because technology creates these natural moats people talk about and the more money you spend on the technology, the deeper the moat gets, the harder it is for people outside the moat to compete. But also what you see is the moats naturally sort of shrinking. So there are less and less people inside the moat because you get people who don’t keep up with the technology space.

And so the fact that the alpha generating industry is becoming more concentrated and that the people on the inside of the ring, the ones who are gaining the assets and gaining the… are people with very big technology budgets. We talk about how we’re a technology empowered business. If you look at everything Citadel does, it’s a technology empowered business. If you look at any of the people who are really the ones gaining significant market share, they are big believers in technology. They may or may not be big believers in quant, but they are using technology to enable them to do a lot of things.

So I think that concentration of alpha generation, the concentration of buying power, the concentration of tech spend is part of a natural virtuous circle if you’re inside it and vicious circle if you’re outside it. And I think yeah, we’re in the mid-innings of that and that the large players will continue to take market share and gets harder and harder for a small niche player to generate a consistent source of alpha.

Peter van Dooijeweert:

The interesting thing is sometimes when I think of technology, I think of prices coming down, but some of the biggest guys are doing longer lockups, passing through more and more costs, taking a bigger chunk of the alpha. Is that reasonable?

Luke Ellis:

That gets to an interesting question and something that is certainly philosophical. You might even argue it goes somewhere in the direction of ethical. You don’t have to push your prices up, you don’t have to push your liquidity out. In doing that, what you are doing is tilting the trade-off between the three stakeholders in the industry, the stakeholders being the investors, the end savers being the businesses and being the employees. And there is a question about how you share the hundred of spoils, the hundred of alpha between those three groups. And I have a philosophical view. So there is a factual thing which is that the only people who take actual risk are the end savers. It’s the-

Peter van Dooijeweert:

[inaudible 00:46:11].

Luke Ellis:

Yeah, exactly. It’s the pension of the primary school teacher in Texas or the factory worker in Gronenberg or whatever. I mean, those end savers are the ones who pull a hundred into their pension in the hope that coming out the other end it will be more than a hundred and the more than a hundred will be enough that they can turn the heating on more often, or maybe if you’re in Texas, turn the air conditioning on more often rather than not. They need the investment returns in order to be able to have a reasonable standing of living when they call on those savings.

That’s the people whose money it is that we all invest and I fundamentally believe they ought to get the majority of the returns. And then it’s about splitting it between the company owner and the employees type of thing. There are others who say, look, what you should do is to take the maximum you can possibly take in fees and then decide how you share it between the employee and the company and the sort of whatever the minimum you need to give away. I understand that and from a point of view of getting rich, I think that’s an optimum strategy as long as you have a relatively short window that you think you’re going to do it for, but it is an optimum strategy in some game theory process.

I think we all make more than enough money to live extremely well and I think we have a duty of care to the people whose money we run. And so I think if we take 20 to 35% of the alpha in fees, we can run a very successful business. We can pay everybody very well. That’s good enough. It may not be a personal maximization strategy if the only thing on your personal maximization is bonus this year. But it’s a pretty good long-term strategy and it’s a pretty defendable one. And if you think about more than just yourself, it’s a pretty good optimizing strategy.

Peter van Dooijeweert:

And let’s face it, we don’t see hedge funds unionizing yet to get more compensation. That might be a few years off.

Luke Ellis:

Yeah, well you might argue that that’s what the pass through strategy is. It’s a form of unionization.

Peter van Dooijeweert:

And I guess that does give them a small advantage if you’re passing through technology investment as opposed to charging a management fee because for an investor then you can make the argument that you’re paying for something that you need as opposed to extravagance.

Luke Ellis:

I don’t really think it does. I mean, honestly what it does is to de-risk everything for the company, in this case the owner of the hedge fund. And so the richest people in the finance world now will be people like Ken and Izzy who run big platforms where they take their performance fees with no cost risk at all. And that’s a great… Well done, them, and they’re several orders of magnitude richer than me and so well done, them. But I don’t think it gives them a competitive advantage. It’s definitely been very good for headhunter fees, but I’m not sure that the sort of savings of the headhunter community is something we should try and optimize.

Peter van Dooijeweert:

Yeah, I think that’s right. So one last thing which you touched on a little bit when you talked about macro guys being good in inflation. So diversification is clearly what everyone wants. It’s funny, last year, 50 basis points and bonds, people were waffling, should I keep them, should I not? And now this year, after kind of a terror of a year, they kind of want to get out of bonds, which I think is kind of intriguing because now you get yield. But if you’re going to diversify using a place like Man, you can use trend, we can use hedge funds, and you often say, Man, we are alpha at scale. But if we’re really going to manage the assets of say the pension fund industry and the sovereign wealth funds, how scalable is it in practice? Is it really alpha at scale? At some point, does the alpha go away? How are you thinking about, let’s call it the medium long-term bonds are out, we need diversification and you need alpha scale?

Luke Ellis:

So I’m not sure I buy the bit that bonds are out as a sort of generic thing. I think in my belief of the likely investment world that we’re going to see for the next phase of time, years not months, is that by and hold is out. Buy and hold on anything is out, but there are moments right now buying credit looks like one of the really interesting things to do. You can get some very attractive yields on things that aren’t going bust. And if there’s a big recession, you’re going to make a lot on the duration element and if there isn’t a duration, you’re going to make a lot on the credit spreads. That feels like a pretty decent risk-return today, but it wasn’t six months ago and it may not be in six months time.

I think that, look, our job is to deliver alpha at scale. Last year was eight billion of alpha. We’ll see what the number is this year. On the go, it should be a decent number again this year. That makes a difference to our clients. Can it transform everything? Can we generate enough alpha to offset the lack of global productivity? No. You can only solve the problem you can solve. Can we generate enough alpha to make a difference for our clients? Yes. Are there a number of things we can keep doing through investing to generate more alpha? That means we can help our clients more or help more clients. Yes. And that’s a good enough goal in itself. Luckily, I don’t have to manage the global economy.

Peter van Dooijeweert:

That’s fair enough. Well, we’ll leave it there. Thanks for taking the time to chat with us, Luke.

Luke Ellis:

Always a pleasure.

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