PRESENTER: Hello and welcome to this Akademia learning unit on smoothed multi-asset funds. To discuss the topic, I’m joined down the line by Paul Fidell, Senior Business Development Manager at the Prudential, and by Michael Watt, Investment Director at the M&G Treasury and Investment Office. And before I bring our panellists in, let’s start by having a look at today’s learning outcomes. They are the potential reasons for using a smoothed version of a multi-asset fund, the role of asset allocation in helping to provide consistent returns to investors, and how an adviser should consider client suitability and attitude to risk when recommending multi-asset funds. Well, Paul, why use a smoothed fund in the first place?

PAUL FIDELL: That’s a good question, Mark. I think fundamentally you have to consider what it is that a smoothed fund does for a client. So what all smoothed funds are trying to do essentially is to deliver the returns of a multi-asset portfolio but to do so in a way that the client isn’t experiencing all the short-term market volatility and the impact of that on their investment, and also on their behaviours, you know, clients who get spooked by short-term drops in markets and decide to make inappropriate investment decisions. So it’s an attempt to deliver the returns, but to do so in a smoother way.

PRESENTER: And, Michael, how important is the investment engine that underlies the multi-asset fund, because every decade or so there’s a really big shift in the markets and over the years some pretty big multi-asset providers have got caught out by that?

MICHAEL WATT: It’s fundamental. The smoothing that Paul will talk about doesn’t work without a well-diversified fund that invests across public and private markets. So really the whole solution starts with the underlying fund that’s key to how it’s going to deliver.

PRESENTER: Thank you. I will come back to the investment piece in a bit more detail a little later on in the show, but, Paul, we’re talking about smoothed funds, how many different types of smoothed fund are there out there, is this about smoothing capital, income, bit of both?

PAUL FIDELL: Yes generally they’re set up to smoothed total returns, but there are some subtle nuances in terms of the way that different providers approach the same problem. And essentially we’re all trying to do exactly the same thing, which is deliver the returns but to do so in a smoother way for the customer. The marked differences I guess between the three major providers that are in the market space, two fairly similar, ourselves and Aviva would be the other one, who use a combination of an expected growth rate, which is a rate at which we expect the fund to return based on long-term forward looking projections, and then we have a mechanism for bringing it back into line with actual asset value if that differs by too much from that projection rate. The third way of doing it is the way that LV approach it, which is to use an averaging. So they’ll take the actual performance of a fund and average it over a period of time. So you get a much smoother ride in terms of the journey, you don’t get the peaks and troughs.

So different ways of playing the same problem, but essentially smoothing is about a mechanism that is put on top of an underlying fund to dampen down that volatility, but the key, and I think Michael’s alluded to this already, is that you can’t take a poorly performing fund, add smoothing to it and turn it into something better than it actually is. You need a strong underpin and then you have a mechanism which dampens down that short-term volatility through the mechanism.

PRESENTER: And, Michael, we mentioned expected future return there, how easy is it to predict the future return from an asset class in the round, because at the very least equities are known for being pretty volatile?

MICHAEL WATT: Yes and there’s a huge amount of work goes into us producing our own capital market assumptions, the long-term investment strategy team, and really it starts with how the economics flows into what we’re doing. We’re looking to understand long-term growth expectations, long-term inflation expectations, long-term monetary policy, because that really feeds into or informs the building blocks approach we have to our capital market assumptions. So it’s government bond yield with those component parts, to which you add an equity or a credit risk premium. So there’s a huge amount of work goes into this. It is a long-term return expectation within a certain level of probability, looking out over a 15-year period. It’s not an exact science, clearly, but if you look at the performance of the fund over longer-term periods, it’s encouraging to see that the smoothed return is fairly representative of what the expected growth rates have delivered over that period.

PRESENTER: So would it be too simplistic to say it’s easier to make long-term predictions on asset class returns than it is to make short-term predictions?

MICHAEL WATT: Very much so, because you can have a long-term return expectation. Over the shorter term assets will run ahead or behind of our equilibrium return expectation. So it’s a central view of where we would expect assets to go in the long term and that’s really the anchor that’s central to our setting of the strategic asset allocation.

PRESENTER: And, Paul, we talked a little bit about the different types of smoothed fund, but what do investors and what do advisers need to consider when thinking about recommending a smoothed fund to a client?

PAUL FIDELL: They really need to understand the mechanism. So the two key component parts are that underlying investment fund and how well-diversified it is, whether or not it’s set up to try and achieve a medium to long-term return and do so in a way that itself dampens down the volatility. And then, secondly, the actual mechanism that’s used on top of that, and there are those subtle differences between them. So the first thing is for the adviser to understand those mechanisms and understand how those mechanisms will respond in different conditions. So, for example, with our own PruFund product, the check that we do to see where we are in relation to that expected growth rate that Michael’s referred to, and we see the clients’ value moving forward by that expected growth rate. Then we check it periodically to see how that compares to the actual asset value and if there’s a divergence, that’s the point at which corrective action is taken to bring you either back into line positively or negatively.

How frequently you do that is quite key. If you’re doing that on a daily basis, for example, then there is a possibility that if the market moves against you in the very short term you could get caught out. With our own, we have different versions, one is a monthly one and one is a three-monthly one, so you’ve got that period of time before corrective action needs to take. So there’s that lagging effect if you like. And then with the averaging approach, which is used by the third company in the market, they don’t have a mechanism for moving the price forward other than the average of the previous six months’ worth of prices. So if that’s falling, then the average by definition will also be falling, and vice versa. So, for me, the key is that advisers really understand the different mechanisms and how they will operate in different market conditions and how well they’ll survive things like COVID and the March falls in 2020 that we saw.

PRESENTER: So all of these rules and timetables you have around the smoothing mechanism, Paul, is it a set of rules that you can apply in any market environment at all, there’s an absolute fully transparent game plan on what’s going to happen next, or do you reserve a certain amount of discretionary power to yourselves to move that smoothing mechanism around on the basis that sometimes extraordinary things happen in the markets and short term you need to take extraordinary actions?

PAUL FIDELL: No, it’s very much the former. It’s very much a formulaic transparent approach. These things evolved from traditional with-profits. If we go back 20, 30 years when with-profits was ruling the roost and dominating flows of investor money, those products were fine, except people didn’t really understand how the returns were then translated into bonus rates and how that applied to their individual policies. And then you had these mythical things, you know, market value adjustments that could seemingly randomly be applied. And PruFund originally was developed to create something that did the same sort of job but in a far more transparent and formulaic way. And the formula that was developed 17 years ago when we first launched it is still the same today in that there are pre-set conditions and if those conditions are met then things will happen and there is absolutely no discretion that we can apply around whether or not to do that. So literally if you hit the smoothing limit, let’s say it’s 5% difference between the value and your value that you’re getting from your expected growth rate, we have to move it.

The two things that we have discretion over, one of which is the thing that we’ve referred to already, which is the expected growth rate, the setting of that figure, that is obviously at our discretion and that’s based on all our forward looking views and the asset allocation, and then the second one, which is something that we did for the first time last year in August, 17 years after we’d originally launched PruFund, was what we call a unit price reset, which is when we adjusted the smoothed price to match the unsmoothed price on a specific day and that resulted in all policyholders receiving an increase in their values, bringing them into line. And there were a whole range of reasons why we did that, but that was something that we could apply discretion over. Other than that, everything is formulaic and transparent.

PRESENTER: Paul, you’ve mentioned a couple of times the importance of this distinction between the smoothing mechanism and then the underlying multi-asset fund, is the underlying multi-asset fund beneath PruFund, is that the Prudential With-Profits Fund-

PAUL FIDELL: Essentially, yeah.

PRESENTER: -or something a bit different?

PAUL FIDELL: No, it’s essentially the With-Profits Fund. So it’s that big pool of assets which is somewhere around the 100 billion plus mark now, that Michael has referred to, hugely well-diversified. That is the engine if you like that sits behind all our smoothed vehicles.

PRESENTER: Michael, you mentioned a moment or two ago the importance of inflation as a variable when thinking about long-term returns. Certainly here at the start of 2022 we’re seeing inflation picking up, lots of fears about inflation becoming endemic in the system. How do you think about inflation and what that does to the risk/reward profile of some of these key asset classes?

MICHAEL WATT: Well, the future purchasing power of investments is a really big consideration for advisers. Within the strategic asset allocation process, we do a lot of work on qualitative scenarios. So the team will outline certain scenarios, global trade, Brexit, climate change, and think about how things might play out in portfolio sensitivity. So it comes back to the smoothed journey we want. We want a portfolio that’s robust across a range of different outcomes, not just our baseline. On inflation, you’ve got the US, UK, Euro area running at, what, two to three times central bank targets in 2021, and this year’s going to be about central bank reaction. Now, our base case for long-term inflation is for it to be contained, for structural forces that have previously weakened pricing and wage bargaining power to reassert themselves, but certainly the risk of inflation remaining elevated this year and into the medium term has increased. And our 2021 strategic asset allocation focused very much on real assets, assets that have the potential to do well in an inflationary scenario, but importantly offer good risk and liquidity premium and strong risk-adjusted returns in our base case. And we’re looking at things like property, infrastructure, assets where cashflows are not fixed in nature, where they can be subject to periodic uplifts and act as a good hedge against inflation.

PRESENTER: Paul, coming back to smoothed funds, you were talking there about the importance of understanding the mechanism and the mechanics around that, but what about dos and don’ts for advisers when it comes to potentially recommending a smoothed fund to a client?

PAUL FIDELL: Well I think there’s a couple of things, one of which is around risk profiling, which is obviously a crucially important thing for many advisers and their clients, which is aligning an investment solution at an appropriate level of risk to their customers’ attitude to that risk. And often they’ll run through a questionnaire and arrive at an answer. When you’re looking at a smoothed fund, that’s quite a difficult thing to do, because essentially you’re no longer just looking at a multi-asset fund now and the behaviour of those assets, you have by definition got a mechanism that’s been put around it to manipulate in the short term that volatility. And volatility is essentially how customers feel about risk.

So one thing is to try and look at a smoothed fund in terms of its risk profile. It’s not just about the underlying assets, it should be about the impact that smoothing has on that risk profile, but that’s a very difficult thing to put into numbers terms. The other one is to not view these as short-term tactical vehicles. A lot of funds get compared on a fairly short timeframe in terms of how they’ve reacted to market and how the performance has gone up or down, and generally smoothed funds are set up with a medium to long timeframe and essentially that’s the timeframe over which their performance should be judged. So the two things, for me, for advisers to think about would be (a) the risk profiling aspect of it and how that aligns to their customers’ feelings about risk and, secondly, the performance and when do you judge these.

And we saw this ourselves in the aftermath of March 2020 when everybody came out and suddenly it was, you know, you’re doing all the wrong things, the performance is awful, you must have made some incorrect asset allocation decisions, and here we are two years later and the smoothing has done its job, has pulled those returns through, albeit on a lagged basis. And now if we look at it today on a five year timeframe, for example, including March 2020, we have significant outperformance against what you might call a representative benchmark index. So judge them in the right timeframe, medium to long term.

PRESENTER: And would it, Paul, be a mistake to think of smoothing as in some way offering a degree of downside protection, because I guess if you’re talking to a client about attitude to risk, you’ve also got to assess their capacity for loss as well?

PAUL FIDELL: Yes, absolutely, and it would not be true to say that smoothed funds can’t fall in value, they can, and there can be some fairly significant falls. Now, even in the worst-case scenario, and if we take those two examples of March 2020 and then October 2008, the global financial crisis, where you saw 25, 30, 35% falls in typical equity markets over a very short period of time, smoothed funds that were available at that time, so in 2008 and 2020, didn’t fall as far as the market did. So there was a degree of putting the brakes on, providing some downside protection. The difference of course is that the fall happened essentially in what looked like a single day, because it was the smoothing mechanism kicking in and making that correction in one movement as opposed to over a period of time. So you can get this slightly misleading perception that they’re incredibly risky because the price has fallen by 10% in a single day, the reality is what that’s reflecting is maybe weeks or months of falling market conditions, it’s just crystallised in one moment in time.

So yes they do provide a degree of downside protection. They have a mechanism which can essentially kick in in those sort of situations to provide you with that small buffer, but ultimately they are multi-asset funds and ultimately they’re there to deliver whatever the returns are. And if those returns are falling and negative, then that’s what you will ultimately get from it, but in our case certainly, we like to look back and see that actually it has delivered very healthy and positive returns.

PRESENTER: So, Michael, given the importance of what’s going on in the markets to what you can provide to clients, can you talk us through your approach to asset allocation, why it’s so core to what you do?

MICHAEL WATT: Well, it starts with the capital market assumptions I mentioned earlier, that’s the anchor for where we expect returns to sit over the long term and that provides inputs to, and we talk a lot about GeneSIS, we have our own in-house economic scenario generator or stochastic modelling tool, and along with correlation and volatility assumptions that allows us to model the full range of assets, public and private, and to come to our efficient portfolio. The chart here you can see shows how diversified the portfolio is, but importantly how dynamic it is and how it’s evolved over time. You can see equities in red, real estate in green, alternatives, which to us is private equity, infrastructure and hedge funds or diversifying strategies, and in yellow, that’s the alternatives in yellow and in blue fixed income. The lighter the shade the more domestic, so the lighter shade of red is UK equities and you can see back in 2012 a deliberate reduction in US, UK equities, diversifying more overseas over time with a big focus on the Asia growth story. We’ve introduced separate allocations to China and India. So we’re very much focused on capacity and where we believe economic activity is going to be; likewise in fixed income, you can see the reduction over time to UK and Europe, diversifying more into Asia in 2005 and private credit around 2016.

So it’s a long-term approach, but it’s worth mentioning as well that when we’re reviewing the strategic asset allocation, at least on an annual basis, we also look at the here and now, and that’s really important. We’re looking to see, do we see imbalances where our valuation’s at, and 2018 is a good example. Towards the end of 2018 we made a big reduction in equity exposure, valuations looked stretched. We saw a big sell-off in the markets and by January 2019 we felt that valuations looked attractive again. So we implemented an interim strategic asset allocation to increase risk again and that worked out well. And then in 2019 we felt that the cycle looked extended, valuations again were back to looking on the rich side, we felt the global economy looked vulnerable to an exogenous shock and we reduced risk. We didn’t expect a global pandemic, but what it did mean was that when we saw that sharp selloff in the market, something that we perceived to be a deliberate shutdown of economic activity, it wasn’t triggered by an overheating economy or a policy mistake, so when we saw the magnitude of the monetary and fiscal stimulus that was being put in place, we were confident to implement that strategic asset allocation and buy into the weakness. So it’s almost like navigating the cycle as well, whilst it is a long-term approach.

PRESENTER: And Michael, is it getting harder to find diversification in a multi-asset portfolio, there’s so much QE out there, it’s been inflating the values of equities, inflating the value of bonds, is it a tougher job to do now than it was 10, 15 years ago?

MICHAEL WATT: It is getting challenging. I think when we look at the markets just now, if we assume continued vaccine rollout in developed markets with emerging markets lagging, we could see robust year-on-year economic growth this year, although slowing from 2021 levels. But it would be fair to say from where we are right now looking at valuations that there could certainly be headwinds in fixed income over the short to medium term, particularly in developed markets where bond yields are low, credit spreads are tight. We’ve actually reduced our duration to lessen the impact of rising interest rates and other meaningful allocation into higher yielding areas, Asian and emerging market debt, including Africa, and a number of these emerging market central banks have actually tightened last year with real yields becoming even more attractive. And I think in equities space, yes, you need to take a sector view across different regions as well, there are areas that are looking rich, but we’re still seeing opportunities. We’ve seen a recovery in valuations and profit margins but may still have scope for top line growth as the recovery evolves. So there are opportunities, but yes there are areas of the market that are looking quite richly priced.

PRESENTER: And, Paul, you talked about the long-term nature of a smoothed fund for an investor, but is this a product for the accumulation phase of somebody’s investment life or the decumulation phase?

PAUL FIDELL: I think it can work in both to be fair. The one thing I wouldn’t ever say is that this is some sort of universal panacea, the answer to everybody’s investment problem, because it’s not. It suits a particular type of client who is, as I said earlier, looking for the sort of returns commensurate with investing in a multi-asset product but without that short-term market volatility that makes them feel uncomfortable, so that can work in both an accumulation space or a decumulation space. It’s particularly attractive in the decumulation space because by definition somebody is extracting money from a portfolio on a regular basis. And this is where you get the so-called sequence of return risk or negative pound-cost averaging, lots of different phrases which essentially mean the same thing, which is, if I’m disinvesting and I need a fixed amount, then if the value, the price of my investment is falling at that point I’m having to sell more of it to meet my withdrawal.

So anything that stabilises the price is going to intuitively work quite well in that sort of situation, providing of course it’s still providing that overall return sufficient to meet the withdrawals, for example. So we’ve seen a great deal of success with advisers using our smoothed fund in conjunction with decumulation strategies for that exact reason where you are, it’s that smoothing effect, that dampening down the volatility which helps with the sequence of return risk, but ultimately it can be used in either decumulation or accumulation.

PRESENTER: And what’s the cost of smoothing, is there no cost at all or fundamentally are you paying a small insurance policy to get, not guaranteed returns but certainly smoothed returns in your investment portfolio?

PAUL FIDELL: The cost of the fund in terms of the annual management charge that we have for running the funds, that covers both the cost of smoothing but also all of the work that Michael and the team do within Treasury and Investment Office, so all the asset allocation work, all of that analysis, all of that long-term forward projection, so on and so forth. Ultimately, over that medium to long term, smoothing should be neutral. Essentially what you should get back is the return of the underlying asset pool. So it’s difficult to say that there is a 15 or 20 bps or whatever charge specifically for smoothing. What you do have to consider, however, is that in a mechanism like ours where there can be periods where there is a difference between the smoothed price, which is what the customer is receiving, and the unsmoothed price.

Now, sometimes that will be in their favour, sometimes it will be below, and in those situations somebody somewhere is effectively having to support that price, and that is done in our situation, because we’re part of the With-Profits Fund, it’s done through the use of our inherited estate, which is a sort of working capital element if you like of the With-Profits Fund, doesn’t belong to any particular policyholder, but it’s available for their use. And that creates, if you like to use a very crude analogy, very deep pockets that we can use to support the smoothing mechanism, and any profits or losses of that smoothing mechanism are met by that inherited estate. And that puts us in a pretty unusual situation, because the strength of the Prudential With-Profits Fund, the size of it and the scale of that inherited estate allow us to operate this smoothing mechanism very efficiently and very effectively and have done now for many years.

PRESENTER: Michael, you mentioned earlier the size of assets at the Pru. I think the With-Profits Fund now is about £118 billion in size. Are there particular pros and cons or challenges of running a portfolio that’s that big?

MICHAEL WATT: Yes, well, firstly, we have a portfolio management team that are extremely experienced in managing the day-to-day liquidity of the fund, keeping the fund in shape, implementing strategic asset allocations that I’ve alluded to earlier, which can involve shifting significant amount of assets. But I think the size and scale offers more benefits. I think I’ve touched on some of those niche asset classes that we invest in, but what it does is it increases the opportunity set that the fund can invest in and the projects that we can pursue, whether that be seeding new niche opportunities like Asian property that we seeded a long time ago, African debt, Asian fixed income, or even more recently building bespoke solutions with third parties, for example, regional ESG optimised passive solutions. So it opens a lot of doors and I think if you look in the alternative space it allows us to invest in bespoke strategies, €160 million into Italian solar, private funds that offer diversifying strategies, $100 million into Music Royalties Fund and the list goes on. And I think even in property, more recently, forward funding a last mile logistics facility east of Paris pre-let to Amazon for €95 million.

So it shows the size and scale. But I mentioned where fixed income could be a headwind and I touched on how we’d reduced duration, increased allocation to Asia and emerging market and African debt, but private credit is another area where we can capture an origination premium, and it’s worth mentioning Catalyst. Because Catalyst is a £5 billion commitment that will be deployed over the next four to five years, investing in private markets, very much with people and planet central to what the fund is looking to achieve, in addition to profit obviously. So this is looking to invest in some of the solutions to some of the major problems there are in the world, whether it be in biotech companies, Vaccitech for example, their platform underpins the AstraZeneca vaccine, whether it be in gene sequencing with a circular economy mindset, whether that be recycling plastic, recycling of household goods that ends up in landfill. So it’s a huge commitment that you would need a fund of this size to be pursuing opportunities like that.

PRESENTER: Well, Michael, you were looking to the future there of the fund and we’re almost out of time, so I wanted to get a final thought from each of you around what you think the future for smoothed funds is going to be. So, Paul, let’s start with you. What developments can we expect from smoothed products over the next few years?

PAUL FIDELL: Well, as I say, the fund itself has been around for 17 years and over that time the changes have actually been pretty small, which is testament to the guys who built it in the first place in getting it right first time out, but there have been some fairly significant developments in the last 12 months, for example. So in August of last year we launched our PruFund Planet range, which is a specific range of smoothed funds with ESG credentials. That’s not to say that we don’t have ESG as part of our investment process for the main versions of PruFund, but these are specific bespoke versions for customers who are looking for that style of investment. And I think we can probably see things like that occurring as we go forward where we’re looking for variations on the theme, picking up on new opportunities that are available to us and developing a smoothed fund version of it, because it’s a mechanism that’s been proven to work and we’ll use it wherever we possibly can I think.

PRESENTER: Thank you. Michael, a final thought from you.

MICHAEL WATT: Yes, just in terms of outlook for the fund, I’ve mentioned that perhaps headwinds in fixed income, we’re well-positioned for that, in equities I think there’s still room for growth there, but I’ve touched on real assets and property, we continue to see positive sentiment towards sectors like industrials, residential, retail warehouse, we’ve seen double digit returns in 2021, and prime yields are still at a significant premium to what you’d see in developed market fixed income. So cautiously optimistic and I think the fund is extremely well-positioned to do well across a range of potential outcomes.

PRESENTER: We have to leave it there. Michael Watt, Paul Fidell, thank you.