Exclusive Q&A with Tom Clarke of William Blair – Part 1

I recently had the opportunity to speak with Tom Clarke, partner and co-portfolio manager of the William Blair Macro Allocation Fund, about macro investing, risk management, and some of the key themes William Blair is seeing in the market today. Here’s what Tom had to say:

Brian Haskin:  Hi Tom. Can you get us started with a quick overview of the Dynamic Allocation Strategies (DAS) team at William Blair?

Tom Clarke:  Sure. The DAS team is a group of portfolio managers—including myself and Brian Singer—and investment analysts with an average tenure together of about 15 to 16 years. The team manages money from a top-down perspective – in other words, on a macro basis.

Tom Clarke William Blair Portfolio Manager

Tom Clarke, Partner and Co-Portfolio Manager of the William Blair Macro Allocation Fund

That means we invest across asset classes such as equity markets, fixed income markets, developing credit markets, and currencies. What we don’t do is pick individual stocks or bonds of individual companies.

We manage a top-down strategy, which is available in several vehicles and with varying risk budgets. Our largest strategy in terms of assets, which has more than a five-year track record, is managed in order to achieve an equity-like return over time, have a relatively low correlation to global equities, an average beta of about 0.3-0.4, and a risk level over time of about 10 percent. Those are the objectives of our flagship top-down strategy, which is called Macro Allocation.

In regards to how we manage money, I’d highlight a couple key features. First, we have a risk budget, and we’re very dynamic in how we use it. In some environments, for example three years ago, we may take a lot of risk; it will be higher than 10%. And in other environments, we’ll hold the risk very low. So it’s variable and it’s a function of whether we identify abundant, fundamentally inspired investment opportunities, or whether those opportunities are scarce.

It’s also a function of whether near-term macro influences or geopolitical risks stand in the way of those opportunities being realized. At times, those may be a headwind, while at other times they might actually provide a tailwind. As a result, we will move risk up and down over time, but over longer periods of time, it will average somewhere between that of bonds and that of stocks—roughly about 10% .

The second interesting feature about the way in which we manage money is that we make a lot of use of active currency, which we manage separately from asset classes and market exposures. For example, we can be long European equity but short the euro itself as we are today. The reason we use currency relatively generously as compared to many of our peers is that we think it is a very viable source of active return over time, but it also has a very low correlation with the market.

As a result, currencies help us achieve our objective of providing macro diversification with equity-like returns, but without the downside when equities decline sharply.

Brian:  Let’s dive a little more into the risk side of the strategy. One way that you were expressing risk measurement is through standard deviation, but are there other risks that you evaluate, such as asset class risk, regional exposure risk, or factor risk?

Tom:  Sure, great question. We do, in general, think in terms of standard deviation. But we have our own proprietary, forward-looking risk models that we use to manage and to measure risk. I refer to these as models because there are two of them. We have one long-term, forward-looking risk model and one shorter-term risk model. The short-term one is derived out of the long-term model. Our longer-term model is developed upon our assumptions about the long-term covariance structure of the markets when they are in Equilibrium.

For the shorter-term model, which we refer to as Outlook, we bend those long-term assumptions out of long-term Equilibrium under the influence of the macro themes and the geopolitical risks that I already mentioned. So those short-term influences on markets and risks are risk factors that change our assumptions of volatilities and our assumptions of correlations in the marketplace. And that causes these macro influences and geopolitical influences to act as either headwinds or tailwinds to our fundamental opportunities. And they do that in large part through our short-term risk model.

More specific to the question of how we look at risk and in what realm, we are primarily concerned with total risk, but we can break it down by asset class, or by country, or by currency, but also by macro theme as well. And that last one is quite important. If we don’t want a lot of exposure to a macro theme we’ve identified, whether that is the commodity super cycle or populism, two macro themes that have been influential, then we need to have a handle on what risk exposure we actually have to those macro themes. So that’s what we can extract as well from the way we model risk.

And a final point, as I mentioned already, we are not constantly targeting a stable level of risk in the portfolio; it’s quite the opposite. At times, we will take a high level of risk when we see the opportunities, while at other times we’ll want to keep risk low.

Brian:  Do you have any risk targets at the asset class level, or at the country level within a particular asset?

Tom:  Yes, of that total portfolio level risk budget that is expected to average around 10% over time, we do internally break that down so there is a sub-risk budget for different dimensions of the portfolio. Those dimensions would be systematic market risk that could be long or short exposure within different asset classes; active market risk, which is more of a relative value structure where you’re long one country and short another, or long one sector and short another; and currency risk. While risk from each of those components varies over time, the risk budget is about one-third each.

Brian:  Obviously you take into account the correlations between those different asset classes, correct?

Tom:  Yes, the correlations between markets and asset classes are obviously influential. I would say that in the long term, and stepping back to the idea of Equilibrium, we don’t see any correlations between currencies and the stock and bond markets. Generally, that’s a theoretically robust and empirically sound assumption. But in the short term, they obviously can be correlated. As a result, our short-term risk model takes into account correlations,, which helps to factor in where we might want to take currency exposure when we think it will be positively correlated with market exposure that is also attractive.

Conversely, it might allow us to identify negative correlations that both are worth exploiting, and that’s very good because that tends to diversify the portfolio in the way that we like.

Brian:  With the globally coordinated central bank intervention that we’ve seen over the past few years, market volatility appears to be lower than what it might be under more normal conditions. Do you consider that at all in your portfolio construction and evaluation of risk?

Tom:  We will consider that in our short-term risk model, and it will be reflected in our long-term valuation assumptions as well. Central bank intervention has basically manipulated interest rates, short-term and long-term. This has led to an unbalanced perception of risk in the marketplace, encouraging risk-taking in quite a substantial way.

In addition, this has been going on long enough that some young-ish investors might be aware of little else. This encourages investment decisions that probably would not have been made otherwise, and results in investors buying more equities and other risky assets. At the same time, the interventions haven’t really stimulated inflation expectations. But there is really no playbook for how this will end or unwind. To a large extent, it falls into the realm of what ex-Defense Secretary Donald Rumsfeld once called “a known unknown.” We don’t really have a blueprint.

What that means for our portfolio decisions and our thinking is that some equity markets, which we now think are at fundamental value or a bit above, probably wouldn’t have got there without the help of central banks; not yet, anyway. And it makes us highly reluctant to chase them any higher. Also, bond yields are probably a lot lower than they otherwise would be; negative in some places. And while we do not like bonds at these yields from a long-term, fundamental valuation perspective, we are extremely cautious about being overly bond-bearish when so many bonds are being taken off the market and socked into central bank balance sheets and portfolios.

Brian:  Let’s jump back to the macro themes and talk a little bit about some of the more dominant themes you’re seeing today and how they have worked their way into the portfolio.

Tom:  There are broadly five themes that we think are currently in play. Populism and the commodity super cycle are two that I already mentioned; three more that are a lot less intense now than they were a year ago are Chinese growth, European growth, and capital flow vulnerability in the emerging world. We call those macro themes because Chinese growth and European growth, and the sentiment around it, doesn’t just affect China or Europe; it has a much wider relevance than that. As a result, these are macro themes.

The one theme that is dominant and probably got more dominant with the recent U.S. Presidential election, is populism. But these macro themes cut across the investment landscape and have an influence wider than any one geographical area. And that’s why we don’t incorporate them into our thinking on a market by market or currency by currency basis. But we do build them in as broader risk factors that change the risks and returns of markets across the range of asset classes and currencies.

For example, the dominance of a commodity crisis as a market influence in recent years, which we capture in the commodity super cycle macro theme, is something that depressed the compensation from assets and currencies that belong to commodity-exporting countries. But it also raised their risks and their correlations with each other. And what that does, or what that did, is it undermined what we generally viewed as fundamentally attractive investment opportunities, particularly on the currency side.

So we felt – we still do feel – that the currencies of many commodity exporters are fundamentally attractive on a medium- to long-term basis. But that attractiveness was blunted, or made less compelling, by the risks being higher, the returns being attenuated, and many of those currencies being more highly correlated and less differentiated with each other than they otherwise would be. So the macro theme has stood in the way of valuation opportunities and it’s one of the reasons that we ran a lower risk in the portfolio than we otherwise would have up until a few months ago.

Going back to populism, we call it a macro theme because it has a couple of common elements across the world, even though it manifests in different ways in different areas. I’m thinking of first the Greek debt crisis from a few years ago; Brexit and the rise of radical opposition parties in several European countries, including France, Italy, and Spain; and now President Trump. If we define populism, we can basically call it a movement whereby voters are disenfranchised with the status quo, and with incumbent leaders and their policies. This is a collective reach-out for new unorthodox leaders who are advertising more radical solutions to the situation.  Simply said, populism stands for nothing.  Populism stands against something.

And what’s been something that all these manifestations of populism have in common? First, they’ve almost all been more powerful and more durable than almost anyone has anticipated. But second, they all manifest as policy preferences to push back against globalization—so as a push back against immigration or trade, and the movement of goods, services, capital, and labor between countries. It’s a theme that has basically, from a macro sense, a somewhat negative growth influence because it’s anti-trade, anti-migration.

There are winners and losers from that in a macro sense. That’s why protection is popular in the first place. But from an overall macro perspective, the influence is growth unfriendly. And that’s probably the most meaningful macro theme we’re kind of grappling with right now.

Check back later this week for Part 2 of this interview.