On concentration risk, assessing alternatives and wealth’s heroes and villains
In our regular video series, we interview the wealth sector’s key decision-makers to discover how they think about life, both within the world of investment and beyond it; what brought them into the business and what keeps them here; and what makes them and their companies tick
It is not a given that multi-investors should be including alternative asset classes in their portfolios, believes Alex Funk, chief investment officer at PortfolioMetrix – but if they do, they have to be able to answer two “fundamental” questions.
Talking with Wealthwise editorial director Julian Marr in the above video, he elaborates: “As a multi-asset investor, you have many different asset classes at your disposal – and I would argue you can be quite granular within that. You don’t just have to say, Oh, I have corporate bonds – you have short-dated corporate bonds, you have investment-grade, you have high-yield, you have emerging market debt and so forth.
“So you have to decide which of those asset classes you want to include in your portfolio – and you have to answer two fundamental questions. One is, what is the purpose that asset class serves in the portfolio? And secondly, is it ‘additive’? Is it adding return or diversification or decreasing risk or volatility? And, to do that, your starting point as an investor would be a representative index you can then take a view off.”
What is the purpose an asset class serves in the portfolio - and is it 'additive'? Is it adding return or diversification or decreasing risk or volatility?”
If you cannot model that index consistently through time, warns Funk, however, you cannot properly understand how the associated asset class will behave in a portfolio context during periods of rapid interest rate increases. “Finding an index you can model off is where it becomes quite difficult,” he continues. “There aren’t many indices within the space for, say, trend-following or hedge funds that don’t have other issues, such as survivorship bias.
“Furthermore, they are going to eat into other parts of your portfolio, right? So if you are going to add in something that is lowly correlated to equities, you are going to have to take from you bond portfolio. And do you want to take from your bond portfolio when US treasury yields are at 4.5%? That has to be a question mark, right?”
‘Theatre of investments’
Elsewhere in the conversation, Funk discusses the outlook for the UK’s wealth sector. “My biggest concern is it turning into a product-centric, sausage factory-style industry, where all we are focusing on is doing as much for as many people as possible at the lowest possible price,” he says. “At that point, we will move away from thinking strategically to thinking more transactionally. We will move away from partnerships to focusing more on distribution channels. We will have far less holistic conversations and much more narrow ones.
“The ultimate loser in all of this is then going to be the investor because, at some point, when we compromise on that relationship aspect and have a more product-centric focus, there is bound to be unhappiness. You cannot compete on both a scale and a quality franchise, right? If you want to scale, fees is the other side of that. If you want to have that quality, you need to have a substantial business model to be able to participate. So I am worried about the proliferation of wealth management in that space and that it continually just drives down cost – but at the expense of quality, partnerships and relationships.”
More positively, as Funk is quick to move on to, that also creates opportunities, asking: “So how do we then move the wealth management industry so that we can help more people? Because clearly, there is a need for that – and technology now allows us to do that.
“So instead of seeing technology as a hassle in your business or yet another system you need to learn, it needs to be seen as an enabler – an enabler to the advice process, an enabler to client discussions, an enabler to showing clients what they are invested in and to create that interaction with their portfolio so they stay invested for longer periods of time. Ultimately, let’s bring the theatre of investments to retail investors.”
A full transcript of this episode can be found after this box while you can view the whole video by clicking on the picture above. To jump to a specific question, just click on the relevant timecode:
00.00: Introduction
00.40: What excites you about the current investment outlook? What worries you?
02.39: What do you most look for in an individual investment? What constitute ‘red flags’?
04.14: How have you set up your own decision-making processes to help guard against behavioural biases?
05.37: To what degree should professional investors be thinking beyond so-called ‘traditional’ investments? Towards what?
07.49: What drives your approach to client communications? Should professional investors aim to attract the ‘right’ type of client?
10.04: What was your path into investment – and, if you hadn’t taken it, what do you think you would be doing now?
11.49: What is the biggest investment mistake you are prepared to admit to – and what did you learn from it?
12.59: Outside of work, what is the strangest thing you have ever seen or done?
13.40: What are your best and worst-case scenarios for the future of wealth in the UK?
15.31: Two ‘Choice Words’ recommendations, please – one a book; one a free choice?
Transcript of ‘Choice Words’ Episode 6:
Alex Funk, with Julian Marr
JM: Well, hello and a very warm welcome to another in our series of ‘Choice Words’ videos where we get to hear from key decision-makers in the wonderful world of fund selection and fund research and find out what makes them tick. I am Julian Marr, editorial director of Wealthwise Media, and today I am delighted to be talking to the chief investment officer of PortfolioMetrix, Alex Funk. Alex, how are you?
AF: Great to be here. Thanks, Julian.
JM: It is a pleasure to have you. One thing I learned from the first batch of these recordings is my intros went on way too long so let’s move away, nice and easily, from that and onto the first question! What excites you about the current investment outlook. What gives you pause for thought or worries you?
AF: Maybe if we start with the worrying, that will lead us to the excitement, to some extent. It is not a great worry – more something to be mindful of – but we are seeing concentration becoming quite a theme within portfolios, right? And it’s not just at an asset class level, but within asset classes as well. When we are seeing portfolio returns being driven by a smaller and smaller subset of asset classes and sectors – and I don’t need to spell out in which direction I’m going with this! – that concerns me.
That is because it allows large levels of volatility to enter the portfolio – and that is when investors’ behavioural biases get triggered to some extent. When we have large relative volatility or big movements away because of these concentration risks, behavioural biases can sneak in – and then you have investors making the wrong decisions at exactly the wrong time. So Covid is such a good example of exactly when you should be buying equities, at a time when everyone is flocking to cash, to some extent.
So that worries me a little bit – but the world today is very different, right? If we go back to the start of 2022, which I think was the last time we had severe volatility in both equities and bonds – you know, starting yields were much lower. I mean, I had to go and double-check this but the US 10-year treasury was roughly 1.5% going into 2022, right? Now you can buy it at 4.5% so, as a multi-asset investor, I have much more differentiated sources of return for my portfolio than I did a few years ago.
And that is the bit that excites me – yields are much higher, there are more sources of return and it is broadening out beyond the ‘Mag Seven’ stocks. This year is an excellent example of exactly how that can happen – if we look at the equal-weighted S&P, if we look at smallcaps, if we look at midcaps relative to the US tech sectors. So I think, in the face of volatility, there is always opportunity – but just be cognisant of how you bring that together in a portfolio.
Beware crystal ball-gazers
JM: Ah – build from a low to a high! We like that. Moving from the general to the specific, what do you most look for in an individual investment? And what do you consider a red flag? AF: I want to hone in on the ‘red flag’ component first because I think that is quite important. The whole asset management industry is designed to sell you a story, right? They will come in and pitch you an idea: their ability to forecast a macro outcome or what Trump’s policies will look like – tariffs, not tariffs – or what Labour winning the election would mean for UK equities.
This idea of crystal ball-gazing, to some extent – identifying a theme before it is a theme – for me, is an absolute red flag, right? These things are very difficult to predict in themselves – but, to predict the directionality of the market off that prediction, is hard too. You need to be right twice – and you need to do that consistently in order to actually generate some excess returns for investors.
So if that is a red flag, what do we like in managers? We like managers who are focused on the risks of the asset class. So focused on the risk of equities, say – the fundamental risks of that: the industry that that company operates in, its strengths, its weaknesses, its opportunities – and giving us exposure to that asset class risk. Rather than how the spat between China and the US works out; or when – or if or at all – the Fed continues to cut rates, right? Because those risks I can diversify away – what I can’t diversify away is a Republican government’s policy decisions over the next six months.
JM: A question has just occurred so please forgive me for throwing this in – in both your answers so far, you have touched on behavioural biases and human nature so what have you built into your own decision-making processes to help guard against the behavioural biases we have as human beings?
AF: By thinking about portfolio construction in a sort of ‘loss aversion’ mindset – you know, because the pain we feel from losses versus their equivalent gain is much more – actually, I met an the adviser today, who said he thinks it’s about seven times more. Don’t ask me how he got to that number but I thought that was really interesting!
So how do we construct a portfolio where the reality meets expectation? Take asset classes and predicting their returns going forward. If you were to ask me, Alex, do you think the S&P goes to 7,000 points this year? Well, your guess is probably as good as mine. But if you say, Consistently the volatility is probably 10% on average – that’s modellable, right?
So if you think about your asset allocation in risk terms, rather than return expectations – return will be a function of being in the market, ultimately – now we can model. When we can start telling clients, This is how portfolios behave during certain periods in time, we are setting expectations. And, when reality is within expectation, we are just squashing the opportunity for those behavioural biases to sneak in. So we spend a lot of time speaking to advisers and speaking to investors about these sort of concepts.
Two questions for any asset class
JM: Good answer – thank you for that. Now, to what degree should professional investors be thinking beyond the ‘traditional’ asset classes – bonds, equities, cash – and towards so-called alternatives? And are there any particular areas of alternatives you would be looking at?
AF: It is a perfect question leading on from what we have just discussed. So, as a multi-asset investor, you have many different asset classes at your disposal – and I would argue you can be quite granular within that. You don’t just have to say, Oh, I have corporate bonds – you have short-dated corporate bonds, you have investment-grade, you have high-yield, you have emerging market debt and so on and so forth.
So, as an investor, you have to decide which of those asset classes you want to include in your portfolio – and you have to answer two fundamental questions. One is, what is the purpose that asset class serves in the portfolio? And secondly, is it additive? Is it adding return or diversification or decreasing risk or volatility? And, to do that, you need to have a representative index – your starting point as an investor would be the index and then you take a view off that index, whether it be active, whether it be passive, whatever that might be.
But if you cannot model that index consistently through time, you cannot understand how that asset class will behave during rapid interest rate increases, say, or during periods of inflation shocks – it is kind of hard to understand how that’s going to behave in a portfolio context.
So when it comes to the world of alternatives, if you want to include an alternative asset class, understand its purpose in the portfolio – if it is additive in terms of risk and return – and then find an index you can model off. That is where it becomes quite difficult, though – because there aren’t many indices within the space for, say, trend-following or hedge funds that don’t have any other issues, alongside survivorship bias and all these sorts of aspects as well.
Secondly, they are going to eat into other parts of your portfolio, right? So if you’re going to add in something that is lowly correlated to equities, you are going to have to take from the bond portfolio. And do you want to take from the bond portfolio at 4.5% US treasury yields? Question mark, right?
So just understand why you want to include alternatives in the portfolio. I think there is space for them – for the asset classes that have a long track record that we can model and we can understand how they going to behave – and then take it from the parts of the portfolio where it is going to be additive ultimately.
Embrace your avatar
JM: Thank you for that. Moving on to client communications – obviously, as a journalist, I am biassed but I do think it is so important. What drives the PortfolioMetrix approach – or indeed your own approach – to client comms? And, in particular, how do you bring clients along on the journey so they don’t jump off a couple of stops too early and therefore miss all the good stuff?
AF: It is such an important thing – and it is something we have been discussing so much as a business. I think the entire investment management industry is filled with way too much complexity and lots of jargon and this is not helping clients, by the way – this is not helping alleviate any of their concerns around investments. So you have got to take a step back and say, But why?
Why do we write like this? Why do we want to use terms like ‘Sharpe ratios’ and ‘drawdowns’ and ‘optimisation models’? Is it justification of fees? Like, what is it that means you feel compelled, as an expert, to write like that? So everything we do as a business, we put in the retail mindset and think, Maybe it’s not even the adviser who is going to consume this. Clients need to understand this and it has to add benefit to them. So write about the things that matter – and that is not about the latest GDP releases or the inflation prints or the key drivers of that. Write about things that are interesting.
Secondly, in a post-Covid world – I mean, people have such short spans of attention, right? You know, the click-bait, this constant scrolling, all of that – we are struggling to consume this information. So delve into different ways of communication – like this podcast. Fantastic, right? It is a good way to meaningfully communicate with your clients in a way that they can consume on the train or in the car.
Or videos – you know, short, snappy, 60-second videos. What’s happening in the markets? How is the portfolio positioned? And embrace technology – like, we are embracing avatars. There will be avatars of the PortfolioMetrix team and we can get information out much quicker. Under no circumstance would we ever try and tell an investor this is not us, right? It is clearly an avatar of us but it allows us to more efficiently and quickly communicate information in a consumable fashion.
At the coalface
JM: Well, that is one to watch. Sorry, I just have this image of you guys as tall, blue and with tails – but that’s not the ‘avatar’ you have in mind! A more personal question now – what was your path into investment and, in a parallel universe, what would you be doing if you hadn’t gone down that road?
AF: That is a great question. I was lucky enough, while I was studying financial analysis at the University of Stellenbosch, to do my CFA exams as well. So I always knew ‘investmenty finance’ was the pathway but I was never clear which part of the industry I would land up in. So I did lots of different things across finance. I spent some time in an audit firm – which I do not recommend for most! I did lots of work in corporate finance, M&A, equity funding, private banking – and then I went completely left-field.
I joined as a financial adviser in a small wealth management firm in Johannesburg – and it’s only there that you truly understand the purpose a solutions provider fulfils, right? When you are at the coalface, sitting with a client, building up that financial plan, understanding that their greatest risk is shortfall risk – the possibility that they do not achieve their goals.
So risk is so important – how you construct portfolios in order to achieve that risk and, ultimately, the journey they go on through that portfolio to achieve those goals. I think that is truly where my love for investments came in and the way I sort of stumbled into this career. It is hard to imagine being in any other industry at this point but, if I think about the key attributes I love about it – it’s problem-solving and creating solutions, right? So it is quite a boring answer but maybe I would have been a management consultant of some sort!
JM: Well, you had me at ‘University of Stellenbosch’! If I been at university in Stellenbosch’, I would have been just continuously in vineyards!
AF: I mean, winemaking was considered!
Investors’ Achilles’ heel
JM: What a wonderful place to study anyway! OK – so always investment. What was the biggest investment mistake you are prepared to admit to – and did you learn anything from it?
AF: It is probably not a single event so much as a facet, but overconfidence is most people’s Achilles’ heel. And sometimes, when you are so close to an investment idea or a decision, your own behavioural biases quickly overshadow that, right? And it is almost when you sit back and say, What could go wrong? – it is actually at that point when it can go wrong. So there are many times when you are often too close to an investment and I would say that would be some of the biggest mistakes.
What you learn from that is, constructive debate in a team environment is absolutely critical. And that no one person is right all the time. I mean, that is literally why we are in multi-management, right? No one is right all the time! And so taking the opportunity to sound out ideas around the team, using that constructive debate, allowing for challenge – it really is a good way to overcome some of that. But always challenge yourself – when something feels too good, make sure you get a second opinion on that.
JM: The next one is an odd question but I don’t care – it’s my interview! Outside of work, what is the strangest thing you have seen or done?
AF: This is potentially not ‘seen’ or ‘done’ – but it is probably the thing people least expect from me! I mean, you saw me come into the podcast today – I am a fairly large fellow – so no-one would have guessed I was a professional show jumper in South Africa and, for most of my junior career, I competed at a very high level before I joined the professional fund management ranks. So there is a ‘fun fact’ for you on something a bit stranger than fund management!
JM: You competed internationally?
AF: So locally in South Africa – but at the highest level.
See tech as an enabler
JM: Yup – that is strange enough. That will do. Thanks for that. One more wealth-oriented question – what are your best and worst-case scenarios for the future of the wealth sector in the UK?
AF: I feel my biggest concern for the sector is it turning into a product-centric, sausage factory-style industry, where all we are focusing on is doing as much for as many people as possible at the lowest possible price – and then we will move away from thinking strategically to thinking more transactionally. We will move away from partnerships to focusing more on distribution channels. We will have far less holistic conversations and much more narrow ones.
Then, I think, the ultimate loser in all of this is going to be the investor because, at some point, when we compromise on that relationship aspect and have a more product-centric focus, there is bound to be unhappiness. You cannot compete on both a scale and a quality franchise, right? If you want to scale, fees is the other side of that. If you want to have that quality, you need to have a substantial business model to be able to participate. So I am worried about the proliferation of wealth management in that space and that it continually just drives down cost – but at the expense of quality, partnerships and relationships.
That therefore creates some excitement as well, though, because it creates opportunity, right? So how do we then move the wealth management industry so that we can help more people? Because clearly, there is a need for that. And technology now allows us to do that.
So instead of seeing technology as a hassle in your business or yet another system you need to learn, it now needs to be seen as an enabler – an enabler to the advice process, an enabler to those client discussions, an enabler to showing investors what they are invested in and to create that interaction with their portfolio so they stay invested for longer periods of time. Ultimately, let’s bring the theatre of investments to retail investors.
Thinking in stories
JM: All good, upbeat stuff. Last question, then – we call this ‘Choice Words’ because of the professional choices you make as a fund selector. What we – that is the royal ‘we’ – are looking for now, though, are personal recommendations. One is a book choice, which does not even have to be investment; the other can be anything, really – podcasts, restaurants, we have had experiences …
AF: Fantastic. So the first one ties in neatly to some of the conversation we have had – and it is something we are actively reading as a business, actually. Building a StoryBrand, by Donald Miller basically says people think in stories, right? If you think about any movie you have watched, there is a hero who has a problem. This problem is typically a villain, the hero meets a guide, provides a solution that ends in success and ultimately gets the girl – and most of us consume thinking in that pattern, right?
So how does that apply to your proposition? How does knowing that help what we do? And, you know, the wealth managers or the advisers we work with – ultimately they are that hero so what is their key villain? It is clear non-core distractions – spending time on compliance, managing their own portfolios, market volatility, more compliance, consumer duty, you name it.
So in comes the guide – the investment solutions managers who can help them resolve some of those issues and it ultimately all ends in a successful business. You know – focus, something they can monetise at retirement, clear from distraction, going from being overwhelmed to in control, going from working ‘in the business’ to ‘on the business’. So that helps us frame mindset. So I really enjoyed that book and I recommend it to anyone if you really want to think about messaging in a way that people actually understand.
The second one is a cheeky plug! But I always encourage everyone I meet in the UK to just go to South Africa – just once, right? It will be the best holiday you have – I am willing to wager on that. Despite all the doom and gloom you probably read in the news – you know, on a probability basis, nothing bad is going to happen, right? You are going to have fantastic food, an enormous cultural experience and, I would argue, the best red wine in the world.
JM: And we are back to Stellenbosch! Don’t worry about that ‘plug’ – we actually had someone on plugging their own podcast. Yes – you know who you are! But absolutely – visiting South Africa has to be done. And that sounds an interesting book too, with the wealth industry trying to work out its own version of blowing up the Death Star or killing the Wicked Witch of the West or whatever it may be! I will look out for that one. Great ‘Choice Word’ choices, Alex – thank you so much for that. It has been a great conversation.
AF: Great to be here. Thank you so much.
JM: And thank you all very much for watching.
Please do look out for further Choice Words episodes as they are published
