Q: How has the Prudential Real Assets Fund evolved?
The Prudential Real Assets Fund was launched in 2010 and currently has about $100 million in assets. The management team and the investment process has been the same since the inception, however we’ve expanded investment exposure to a wider class of assets including exposure to Master Limited Partnerships, a dedicated global infrastructure fund, and some short duration fixed income funds.
Q: How is your fund different from its peers?
We have concentrated on the real asset space to achieve our investment goals whereas some of our peers are venturing into the more traditional asset classes like stocks and bonds. Among those who stick purely to real assets, we tend to be more diversified compared to some of our peers who are more focused on inflation linked U.S. bonds and real estate. Our portfolio comprises of real estate investment trusts both international and domestic, commodities, natural resources, equities, gold-related investments, infrastructure, Master Limited Partnerships, TIPS and some exposure to short-term credit. Also, most peer funds tend to be more strategic in their investment process, whereas we have a significant tactical component to our process. The fund’s investment objective is to provide exposure to the real asset space with an attractive risk-adjusted return relative to the benchmark over time. We do have a good track record versus the peer group, and have delivered 82% of the volatility of the benchmark. We are dedicated real asset investors and don’t venture into the traditional asset classes. As a result, we offer a choice to investors who want to diversify from stocks and bonds. Moreover, we also provide active management through tactical asset allocation as well as security selection.
Q: What core principles guide your investment philosophy?
One of our core beliefs is that investors exhibit behavioral biases, such as herding and overconfidence bias, that can create pricing overshoot. And we think that provides opportunities in the marketplace. We believe that markets are certainly less than fully efficient and we see markets swing from overshoot to undershoot and see periods of low to extremely high volatility. We think quantitative techniques can be utilized to identify those time periods where markets are in overshoot phase. We think the marketplace appetite for risk has a significant impact on the risk-adjusted returns of asset classes and that is one of the reasons why we have started with the risk regime-based methodology in this portfolio. Our belief is that we can add value by dynamically adjusting between asset classes. We do have a strategic approach at the front end of our process but employ tactical asset allocation to achieve our objectives as well and we think that seasoned investment judgment provides another dimension of expertise that complements the models. The models are not necessarily going to recognize when you are in an environment where there is a sovereign debt crisis or credit crisis - so that is the type of research that we are doing on the macro-fundamental or the investment strategy side.
Q: What is your investment process?
Our investment process is driven by the quantitative models that we have developed, and the qualitative investment strategy research that we do in order to make some of the more judgment oriented calls. I would describe it as a three-stage process. In the first stage we use a proprietary measure of risk appetite to determine what type of regime we are in. We’ve got three types of regimes defined – low, medium, and high risk appetite regimes. Our measure of risk appetite is constructed to detect long term investment regimes. That is, we tend to stay in a regime not just for days or weeks but for months and years. We look at the risk, return, and correlation profiles in each of those regimes. For example, in the low risk appetite regime correlations tend to be higher among asset classes so we get less diversification among risky assets. In that type of environment we hold more defensive type asset classes like TIPS and gold, whereas in high risk appetite regime we focus on the asset classes that are more leveraged to beta. This is the first stage of the process. We have constructed strategic portfolios that are mapped to each of these different risk regimes. From there we use another suite of quantitative models that rank each of assets categories we invest in according to momentum, volatility and correlation. Essentially that’s more of a tactical quantitative overlay that would modify the strategic portfolios by up to 500 to 700 basis points over or under relative to the weights of the strategic benchmark. The third and final part is the investment discretion. We develop macro views and determine how we think this will impact the relative performance of asset classes and make further adjustments to arrive at our final weights. We run the models monthly and revisit our desired weights monthly, or as needed if there are changes to our views or market events lead us to believe the structure of the data may have changed. We note that even in similar inflation periods relative performance can vary dramatically based on changes in risk appetite. For example, the post-tech bubble period, from June 2004 to December 2006, was a time when our reading on risk appetite was normal and inflation was low. In that period, the average yearly gain for TIPS was 3.8%; however real estate soared 25% and commodities returned 14% per annum during the same period. So you tend to get large performance differential even in periods where inflation is low to moderate and stable. In contrast, during the financial crisis, January 2008 to March 2009, a time period during which investor risk appetite was depressed by our measure, we saw that gold rose 30% and TIPS rose 2.4%, but real estate was down 50% and commodities futures were down 10.4%, on an average annualized basis. To summarize, we calculate current risk appetite and then determine the blend of strategic portfolios that correspond to the current risk appetite measure. We blend the regimes so that it does not lead to abrupt portfolio shifts. For example, before our measure would move fully from low risk appetite to medium risk appetite, we would transition partially to a measure that was 70% low/30% medium and so on. We adjust the weights based on changes in momentum, volatility and correlation, and finally we implement our macro-fundamental overlay and this results in a set of final portfolio weights and a position relative to the fund benchmark.
Q: Why do you use the risk appetite measure? How do you come up with a measure of risk appetite?
We start with the concept of a risk premium but we call it a measure of risk appetite because we think it is more intuitive to explain. Generally, the risk premium is low when investors are greedy and high when investors are fearful. This measure comes out of our U.S. tactical asset allocation model which has been used by QMA for a very long period. Embedded within this model is an equity risk premium, a required return that investors demand to invest in stocks over bonds. This used to be a fixed number within the model, but in the wake of the financial crisis we decided to make it an adaptive risk premium. That is, the size of that premium would vary depending on the environment and investors’ attitudes toward risk. We did not want to make it a subjective element but an objective measure so we incorporated a process whereby the model evaluated its own performance over the past 12 months. If the model was outperforming relative to its 60/40 benchmark (meaning 60% equities and 40% bonds), we would assume that the level of the risk premium embedded in the model was correct. If the model was wrong for whatever reason, say it was underperforming the 60/40 benchmark over the past 12 months, we assumed it was because the size of the equity risk premium was wrong and the model would make adjustments. For example, if the model were too bullish over the past 12 months, it would increase the size of the equity risk premium and, if it were too bearish it would reduce the size of the equity risk premium going forward. Once we recalibrated the model, we had a time series of the equity risk premium that varied over time. We reasoned that this may contain information that was applicable to the performance of asset classes more broadly. After segmenting that time series into three investment regimes we found that the structure of return, risk, and correlation differed substantially in each of the three regimes and that provided a basis for making active investment calls.
Q: Can you briefly describe your organizational structure?
QMA has nearly 40 investment professionals and manages about $115 billion. Roy Henriksson is our Chief Investment Officer with 29 years investment experience. We offer both systematic equity and asset allocation products. The dedicated asset allocation team is 11 members but we leverage the resources of the entire firm. We have a general research group of nine individuals that support all of the teams and three traders. The strength of the firm is our intellectual capital. Of the approximately 40 investment professionals, 17 have PhDs and nearly all have advanced degrees and/or respected industry designations. Prudential Investment Management, QMA’s parent, is set up as a collection of investment boutiques. We believe that this boutique structure is a key factor that drives talent management and thus investment performance.
Q: What is your decision making process?
The front end of the process is systematic as we have already discussed. We have an investment committee that meets formally once a week and that votes formally once a month on our broader asset allocation portfolios. However, I do make the final decision being the lead portfolio manager on this fund and I work closely with Rory Cummings, who works on QMA's asset allocation team, and Joel Kallman, a fellow portfolio manager on the Fund. The investment team which is the asset allocation team comprises of Edward Keon, Jr., Joel Kallman, Rory Cummings, Marcus Perl, and Ted Lockwood. We vote formally on a team portfolio relative to a benchmark and that sort of determines how much risk we want to take in portfolios and then basically our team of three is responsible for using that as part of our tactical judgmental decision making process that we apply to develop the final real asset suites.
Q: What other factors involve your research process?
We are using the two sets of quantitative models that I talked about before - the risk appetite measure and regime strategy, then the MVC overlay, combined with a macro-fundamental view. How do we come up with our views on the macroeconomic landscape? The team generates the views through active discussion and debate by leveraging a variety of resources. We subscribe to a variety of independent research services and meet with Wall Street strategists and economists. The underlying sub-advisors of the portfolio are sector experts so they provide intelligence regarding the fundamental trends in areas like infrastructure and natural resources or in the fixed income markets. So we are often inviting them to come in and talk to us not only about how their investor strategies are performing, but also about what they see happening in their markets.
Q: How do you construct your portfolio?
The investment philosophy is based on various risk regimes which drives our models and defines the portfolio construction process. Our additional research is investment strategy based and we monitor markets to identify the key drivers in any particular situation. We use a blended benchmark that is one-third real estate, one-third Treasury Inflation-Protected Securities (TIPS) and one-third commodity futures. Specifically, we use a combination of the Barclays TIPS Index, Bloomberg Commodity Index and MSCI World Real Estate Index. Our portfolio exposures have evolved significantly over time. At one point in 2011, we were 40% TIPS. Within the past few months, our exposure to inflation linked securities was down to 19.2% and we’ve increased that exposure a little recently. Just to give you historical perspective, at the launch of the fund, we were about 16.5% in gold-related investments. As of today, we have no exposure to gold.
Q: How do you define and control risk?
One of the ways that we are managing risk is by providing a diversified portfolio among real asset classes and investing with managers that follow different investment processes. So we think we are offering diversified alpha. I think the risk management is very much tied to the investment process so when we think we are in a low risk appetite regime where correlations among risky asset classes are high, we hold more defensive asset classes. And when we think we are in a more normal environment where we can get more diversification among risky assets we take on more risk. We have been able to reduce risk relative to the benchmark as measured by standard deviation. There are many measures of risk. Volatility is one measure of risk that is explicitly incorporated within our investment process. That is, through the MVC model we are deemphasizing the sectors that are high on the standard deviation basis relative to the others. Maximum drawdown is another measure of risk. In some of our other portfolios, we attempt to explicitly reduce this measure, however, that’s not something that we do in this portfolio. Tracking error is another measure of risk. We are comfortable taking large amounts of tracking error relative to our composite benchmark because that’s how we are going to add value. And in fact we have had very high tracking error relative to that index. That is how we look at some of the various dimensions of risk.
Q: How do macroeconomic backdrop affect your tactical allocation?
The U.S. economy is about to move from a period where in the aftermath of the crisis we have been stuck in this sluggish near 2% growth mode and we think that growth is likely to accelerate in the next few years to 3% to 4% because a lot of the headwinds we have seen since the financial crisis have started to fade. In addition, U.S. consumers are in much better shape financially. We still see pent-up demand in consumer durables like housing and autos; bank lending has been tepid but we are starting to see signs of slow but steady rebound. So we think we are moving into a less constrained credit environment and that we are likely to see some of the cyclical sectors like housing and autos expand because they have been held back by abnormal credit conditions. Moreover, U.S. federal government has narrowed the deficit as a percentage of GDP to below 3% from the historic high of 10% and we think that that is something sustainable and does not present a problem for the economic recovery. And at the same time we are still in an environment where there is an incredible amount of slack both domestically and globally. The Federal Reserve is likely to phase out its unconventional monetary easing in an orderly fashion and in a way that is not likely to disrupt markets too much. So, we think the environment is likely to be a good one where growth globally is not going to be robust but it will be strong enough to fuel continued earnings growth and continued asset appreciation with really no threat of inflation as the central bankers take away the excess liquidity. I do think that the U.S. consumer has restructured and the consumer is in a strong position to spend. We have got some income and wealth distribution problems in this country but I do think that if you look at things in the aggregate financial obligation ratios are best since the early 1980s. As a percentage of personal disposable income; it is reasonably easy for Americans to pay their bills in the aggregate, consumer net worth is climbing and above its historic high in 2007, just before the crisis. We saw a decline in consumer wealth during the crisis but it has reached the prior peak before the crisis and continued to move up. Now, a lot of that is driven by stocks and house prices. But if you look at home affordability, I think home prices are still affordable for the average person. In addition, equity valuations are still reasonable. If we look at equity market valuations, despite the market indexes tripling since the lows during the financial crisis we are still looking at a price-to-earnings ratio of 16 on the S&P 500 Index; now that’s not cheap but that’s not scary either. So in general, our macro-views have emphasized some of the more equity oriented asset classes such as global infrastructure, natural resources, and real estate.
Q: Why should investors buy real assets in a low inflation environment?
One of the reasons that real assets funds have been a tough sell over the past few years is because we haven’t seen inflation. I would point out that you don’t necessarily need a high inflation environment for some of the assets in these portfolios to do well. We saw that during the 2000 to 2010 period the collection of assets that we refer to as real assets did incredibly well and there was hardly any inflation over that time period. Year-to-date our fund is up substantially, more than broader equities index in an environment where reported inflation is low. The real asset space is something all investors should consider in their portfolio even during times when they may not be performing well because we simply can’t predict the future with 100% certainty. And, this is likely to be a hedge for the rest of our portfolio in the event that unanticipated inflation does rear its ugly head and even if it does not it is still a good diversification play for investors when complemented with the traditional asset allocation portfolio.
Q: What lessons have you learned from the financial crisis?
We had the benefit of creating this investment process in the aftermath of the crisis. The experience of the past few decades has shown that you can have very long periods where investors display either a high or low appetite for risk and that this has significant implications for the structure of returns, risk, and correlations in asset markets. This led us to a regime based process which has so far served us and our investors very well.
