There is fable surrounding the creation of chess of which investors would do well to take heed, says Sam Sicilia, chief investment officer of Hostplus.
The ruler of Persia – the Shāh – was a fan of games, but disliked the element of luck. In search of a game of pure strategy, he held a contest. At this event, a peasant brought a game that simulated battles between two opposing armies on a field of 64 squares. The game was won when the piece representing the opposing Shāh was killed by being put in Shāh māt.
Impressed with the game, the ruler allowed the peasant to name his prize. The peasant asked the Shāh to be paid over 64 days in rice. On the first day he wanted one grain of rice to be put on the first of the 64 squares, and the next day for two grains to be put on the second square, on the third day four grains of rice to be put on the third square, and so on and so forth, with the number of the grains of rice doubling with every subsequent square.
The Shāh was delighted at what he thought was a bargain, until one of his advisors informed him there was not enough rice in the world to pay the man by the time the 64th square was reached. (Reports vary to whether the peasant was executed or raised to the kings courts for his wiles.)
“If you think about that analogy, we are somewhere in the middle of the chessboard today,” Sicilia says, in reference to Moore’s Law which states that the power of computing will double every 18 months.
“The move from position 32 to position 33 is doubling all the technology that we have today. From 32 to 64 is where you get all your grains – that didn’t happen in the first 32 squares.
“We are already struggling with what we have, but that’s the speed at which it can happen. In those factors – Moore’s law, technological advances, demographics – you would be foolhardy as an investor to bet against those forces. The world has yet to see that in its full force and that’s going to happen fast.”
Not all share Sicilia’s view. Broadly speaking, in the current investment environment, investors fall into two camps.
There are those who are longing for the ‘good old days’ to come back, meaning reverting back to same world order that existed a decade ago, with the same interest rates, the same monetary policy from central banks and the same inflation targets.
Then there is another group who say maybe this is the new normal, maybe low interest rates will be on a scale of decades, not months or years.
“I subscribe to the latter which is the ‘this is the new normal’ there is no going back to the way it was before, ever,” Sicilia says.
“You can pick up the economics textbook right now and you can pick up the finance text but there are no chapters on what we are discussing, so let’s acknowledge that we are in uncharted waters as far as planet Earth is concerned.
“We have a lot of risks on the horizon…and the advancement in technology is exponential, and so the speed at which it arrives is exponential. And that is a scary thought.”
“[But] at the end of the day you have to put a dollar in markets, no matter what thinking you have; no matter what reading you did or didn’t do, you still need to put a bet, take your member dollar and stick it into something that hopefully generates something more than the dollar you put in.”
Invest in unproven ideas
In the past, investors could afford to be choosy about investments. Put another way, there was plentiful investment opportunities and as such no need to go up the risk curve unnecessarily, particularly when there was stable cash flow-producing companies and investable assets with a long history of generating returns, revenues and profitability.
“But in a world of rapid change you are now being forced to look at things that are yet to generate a dollar – they are an idea. And [if] you wait for them to generate a dollar, that opportunity has gone,” Sicilia says.
He adds how investments are looked at in the future cannot be the Excel spreadsheet approach of the past, because these businesses (by the nature of exponential change) are unproven ideas “sitting on people’s necks in their heads”, and yet that is the future of technology.
“It’s a much more difficult environment to invest in, unless you’re prepared to depart from what you’ve grown up with as an investor. Those who are holding onto that old methodology, I’m afraid are going to be Darwin-ed out.”
A lack of fragmentation
The rise of technology in the form of instant global communication has already introduced a new set of risks with which companies and investors have yet to fully adapt.
In the ‘good old days’ when you wanted to protest against something you would make a cardboard poster with a stick and sit on the steps of that company hoping that the drivers that go by toot their horn at you, and that was about as far as it got, Sicilia says.
“Now you can publicly shame, you can bring your case to the masses,” he says, holding up his mobile phone.
“All of us run our own newspapers. The media has lost control of the single thing it had, which was the power to communicate; now everybody has that power.”
“Social media allows people to simply say when we’ve had enough. And we’re seeing that now politically around the world with the Trump phenomena and related phenomena around the world, maybe Brexit is one of them.”
“We’ve had enough and we are no longer a sole voice.”
He adds we will never get the Great Depression again, because people will simply say, “I won’t do this” and unite to force the political economy to change.
“Somebody will rise up and say, “I will provide everybody with a four-day working week on full pay”. There will be distortions in society.”
Demographics reason for tilt to emerging markets
Technology’s exponential increase is not the only macro-trend of which Sicilia is mindful. He also identifies demographics as an extremely powerful force.
“The only way to change demographics is to wipe out a population, otherwise as time progresses they get older, they become more affluent and they want stuff. They want more protein to begin with and start eating meat, and then they want more Gucci bags and then eventually they will want services rather than manufacturing in their economy.
“Take China. Since they are decreasing their manufacturing, conventional wisdom is that it is becoming more consumer-led. And those consumers will place demands for goods and services and as an investor that gives you a clue, if you like, as to where to invest and you should be able to capitalise from that.”
This shift in China also means other countries, such as Cambodia and Vietnam, are picking up manufacturing and progressing on the industrialisation journey.
Because of these type of demographic forces, Hostplus made the call five years ago to tilt towards emerging markets in its international equities portfolio. Currently the $20 billion super fund has $5.3 billion invested in international equities, with 20.5 per cent of the total portfolio in developed markets and 7 per cent allocated to emerging markets.
However, Sicilia says the decision to tilt has yet to play out.
“Emerging markets is a place that’s begging as a cohort to get their day in the sun. So are we going to make any more investments to emerging markets? At this stage we have four emerging market managers sitting there, doing their little slice of emerging markets and so, opportunistically, as cash comes into the fund, if that happens to be a good place to invest then we will have no difficulty in doing so.”
Credit replaces bonds
The fund’s demographics around its membership are also a consideration.
“It is one thing this fund has going for that isn’t readily available to other funds is its demographics. Our young demographic means lots of money comes into the fund and not a lot of money leaves, [therefore we have a] high tolerance for illiquidity, and more unlisted assets provide downside protection in market volatility so we don’t need bonds.”
This is fortunate for the super fund, as bonds look set to continue to give low yields. As such, Hostplus has decided instead to focus on credit and have separated it out from alternatives into its own asset class.
“We don’t think we will be relying on bonds for downside protection going forward, so you need to look elsewhere for it,” Sicilia says.
“But the world still has to function in terms of capital flows and how money is lent and transferred between one entity and another, and the credit mechanism is a good way of doing that. So corporate credit and the like we think will be an ongoing feature of the portfolio.”
At the moment, the allocation to credit is about 6 per cent of the fund, which is a reasonable slice in itself and comparable to the 7 per cent for emerging markets.
“Why are we going to focus on credit? Again, it’s an unlisted investment and we have a high tolerance for illiquidity,” Sicilia says.
“It is a diversified investment from other real assets, property, infrastructure et cetera – not fully diversified but largely uncorrelated. Thirdly, it provides downside protection to volatility of markets, which is a good thing, and fourthly it affords us yield in an environment where yield is scarce.”
“Needless to say because it’s an unlisted asset and you need a tolerance for illiquidity not everybody can fish from that pond. So we are happy to say it is a good candidate going forward.”
Again, reading the wider macro-trends, Sicilia thinks there is more going on with negative interest rates than is first apparent, particularly concerning their effect on currency.
Broadly speaking, no country really wants a strong local currency; because it makes exports more expensive, imports cheaper and inbound tourism more expensive.
However, the relative movement between currencies has been low, as central banks have been maintaining a gentleman’s agreement not to get into an outright currency war.
“So what happens next? That’s the real question. Do central banks just give up on currency? And the reality is that this probably [is] another thing in play and that is negative interest rates.”
“You’d think negative interest rates are to penalise people for storing money in a bank, so that they would go out and stick it into the market environment, to invest it.”
However, that investment and increased consumption has not been happening, arguably because the penalties are not high enough at the current rates of between zero and negative 1 per cent.
“If the rates were negative 5 or negative 10 per cent and every time you deposited money into a bank lost 5 per cent or 10 per cent of it straight away, you might not do it.
“But that doesn’t mean you are going to invest, you’re probably just going to stick it under the bed. I was thinking about that and it occurred to me that if you’re a multinational company operating in Europe or in Japan and you get revenue, would you deposit it into a local bank?
“You don’t have a mattress to stick it under and it’s pretty risky with those volumes [of] cash to stick it into the in the back office.
“So what do you with the money? Do you repatriate it back home rather than lose 5 per cent or 10 per cent? Probably. And what does that mean? You’ve got to sell the local currency to convert it into your foreign currency. And when you sell it puts downward pressure on the local currency.”
Sicilia speculates that maybe negative interest rates are really a ploy by central banks to reduce the value of the local currency because that is the net effect of the decision.
“It will put downward pressure without cutting your own currency. In other words, the gentleman’s agreement by central banks to hold off on currency wars is being circumvented by a negative interest rate policy.
“And so maybe negative interest rates are more beneficial than what they seem to be on the surface.”
If Sicilia’s assessment is accurate, it begs the question why the Australian Reserve Bank has not done something in that in that regard. An answer can possibly be found in their worldview.
“Our Reserve Bank – at the risk of sounding political, though the bank is independent – falls into the ‘we are waiting for the old days to come back’. But they are not coming back.”