Our building blocks framework for constructing capital market assumptions for the PruFund range of funds.
We construct our capital market views and assumptions for all asset classes and geographies over a medium to long term investment horizon. This breadth of scope is combined with a depth of analysis to build a holistic framework that can be used for formulating asset allocation decisions. This allows us to capture the key drivers and interactions of asset classes and geographies whilst also considering the additional dimension of term structure and multiple future scenarios.
- We use a range of diverse inputs and modelling in our process, including bespoke in-house modelling of structural factors like demographics trends, economic growth models, globalisation and technological change.
- This is combined with deep-dive analysis of future scenarios – both qualitative using known risk factors, as well as quantitative work using GeneSIS, our in-house Monte Carlo engine.
- We consider each of the structural building block components of asset class returns, including: real cash rates and term premia; inflation; risk premia by asset class and geographical region; and illiquidity premia.
This enables us to build capital market assumptions that provide an anchor for where we expect returns to sit over the medium to long-term.
The philosophy underpinning our long-term capital market assumptions is based on an intuitive principle: investors face a risk-return trade-off when choosing assets, and in particular, they expect to receive higher returns for adding risk to their portfolio. The amount of risk and return will vary depending on the macro-economic backdrop, monetary policy, risk appetite, and a host of other factors. Yet the overall structure of the risk-return trade-off between asset classes is maintained over the long-term.
Over short and medium-term time horizons, the valuation of an asset is an important consideration in determining the risks and returns that we can achieve by investing in that asset. While there might be short-term movements away from longer-term fundamentals, if this anomaly persists over a longer time frame then rational investors will move in and out of asset classes until an equilibrium trade-off between risks and returns is reached.
Our approach acknowledges that market behaviour is uncertain and stochastic and short-term factors can cause asset prices to deviate significantly from their long-term fundamentals, and allows us to assess to what extent such deviations may be expected to persist. Ultimately, it allows us to build a term structure of returns that informs our expected growth rates.
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Scenario analysis – living in an uncertain world
Finally, a key tenet of our capital markets framework is how we model and account for inherent future uncertainty. While there is only one realised past, we must consider many potential futures. As such, a significant proportion of our time is spent calibrating and analysing qualitative as well as quantitative scenarios.
The qualitative scenarios focus on key themes that we expect to drive capital markets over the near term, which have, most recently, focused on optimistic and pessimistic technology scenarios, fiscal risks, and scenarios that would lead to geopolitical escalation e.g. the recent Middle East crisis. This allows us to create robust portfolios for clients, which are highly diversified by geography and asset type, across a range of scenarios.
Rather than relying on any single area to generate significant returns, we use the sum of many parts to create attractive risk-adjusted returns from a highly diversified mix of assets that we believe are well positioned for future growth.
GeneSIS
We model the impact of these quantitative scenarios using GeneSIS, our proprietary Monte Carlo scenario generator, which also enables us to capture dependency and volatility structures and build a term structure approach to risk premia and volatility.
We use our unique in-house, stochastic modelling tool, GeneSIS, to map out a broad range of future scenarios, to help us anticipate the impact of changes to interest rates, inflation and global events.
The process enables us to build:
- A complete term structure for each of our asset class building blocks.
- A number of scenarios which show the range of possibilities around the central estimate for each building block component, and capture the interrelationship across asset classes.
- This, in turn, allows us to build a clear picture of the forward looking distribution of the PruFund expected growth rate.
This content has been prepared by the Life Investment Office (LIO) for information purposes only and does not contain or constitute investment advice.
