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The Art of Predicting Returns….Or Is It A Science?

 Paul Fidell, Senior Business Development Manager at Prudential, says we shouldn’t try to fool ourselves


Prudential Paul FidellOften we believe that we are better than we actually are at something.  In my head I am a great golfer but, in practice, I am never going to the win the British Open!  And so it is with the forecasting of investment markets and why “crystal ball gazing” is not really a viable investment process.  So where does that leave us in terms of risk management and making investment recommendations?  Should we be focusing more on certainty and predictability in our investments to help deliver against the client’s attitude to risk and capacity for loss as well as their longer term needs and expectations?

Predictability itself can be defined in a number of ways.  It can be the consistent repetition of something that makes it possible to know in advance what will happen, or it can be the quality of something being likely to happen, such as behaviour or an event.  But, how do we measure “predictability” and what statistics are out there that can help inform our decision making process?  In his famous “Uncertainty Principle”, Heisenberg states that there is a fundamental limit to what is knowable about a quantum system.  The more precisely the observer knows a particle’s position, the less they can know about its momentum, and vice versa.  Perhaps the same is true of investments, maybe we can only tell part of the story from looking at statistics?

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And, if there is one thing the financial services industry truly excels at, it is the production of statistics.  There is a seemingly endless array of ratios and figures that can be used to both compare different investments and supposedly help make investment selections, including:

  • Alpha
  • Beta
  • Volatility
  • Sharpe
  • Maximum Drawdown

The key point is that none of these ratios should be used in isolation, both from each other, or in the absence of more qualitative information relating to the investment being considered.  This is important for two reasons.  Firstly, many of the ratios are actually inter related, so an understanding is required of how one figure might be influenced by another.  Secondly, statistics can never replace an understanding of how different investment classes can perform in different market conditions.  Hence the need for a qualitative perspective on things.

All of which can lead us to a well-managed multi-asset approach where the characteristics of different asset classes can be combined to deliver greater certainty and predictability.


The Pru Fund Range

The PruFund range of funds is designed to deliver some of this predictability, and spread investment risk, by investing in a range of different assets and making use of a unique smoothing process.  This process aims to smooth the peaks and troughs of direct investment and provide less volatile and more stable returns over the medium to long-term in line with each funds objective and allowable equity parameters.  There are various versions of PruFund available offering different levels of risk and potential return.

To provide predictability going forward, Prudential announces the Expected Growth Rates (EGRs) that apply to the funds every quarter.  The EGR which applies to each fund is the annualised rate which will be applied daily to increase the unit price of that fund.  The EGRs take into account the expected long-term investment returns on the assets of each fund. 

The longer term track record for the original PruFund Growth Fund demonstrates how closely linked the actual returns are, when compared to the EGRs:

From

To

EGR

25/11/2004

25/02/2006

6.60%

26/02/2006

25/05/2009

6.85%

26/05/2009

25/11/2009

6.70%

26/11/2009

25/11/2012

6.60%

26/11/2012

Present

6.20%

Annualised return 25/11/2004 to 30/06/2014*

6.66%

* Source: FE Analytics. Total return, bid to bid of PruFund Growth Fund from UK ABI Insurance Universe

Remember our definitions of predictability?  The EGR can be likened to the consistent repetition of something that makes it possible to know in advance what will happen, whilst the skills and expertise of the PMG in managing the underlying assets can be likened to the quality of something being likely to happen, such as behaviour or an event.  Good outcomes generally come from having good foundations in place.


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