The Pru’s John Betteridge, steadying the ship in a time of loose anchors

After nearly three decades at the ­Prudential John Betteridge now heads up the ­Portfolio ­Management Group (PMG), which sits at the center of a global spider’s web of assets and ­liabilities. It is a ­role he relishes, and he is a­ble to provide unique insights into the ­benefits of in-house asset management and the pitfalls of well-meaning but potentially damaging ­regulations.

It is not often that you get the chance to ­inter­­­view someone who stands at the helm of an asset allocation group with in excess of 125bn in assets who is also frank and open about their views on everything from the ­merits of active over passive management, to the unattractiveness of asset managers who jump ship, and the limits of shareholder ­engagement. Betteridge is both confident in what he knows and intensely curious about the things he does not. He freely admits he is not an expert in all the asset classes he invests in, but at the same time knows he has a strong team which provides him with the expertise he may personaly lack.
Betteridge is a quick thinker, and most ­answers flow almost immediately as soon as a question is asked. But, when questioned about the ­impact of the ­financial crisis, his usual quick-fire ­response to questions ­stopped. He seemed genuinely saddened as he reflected on the ­irrationality of some the investors for whom he had once had great ­respect. We are now, he believes, in an era of loose ­anchors. Where old valuations ­assumptions can no longer be relied upon, and what certainty we may once ­have had has ­fallen victim to post-crisis ­volatility. We are ­also, he said, in an era where businesses may no longer be able to rely on counter ­cyclical investment from insurance companies as they attempt to re-emerge from economic downturns. Betteridge laments this loss of ­opportunity for both institutional ­investors and growing businesses, and while he ­understands the drivers behind ­regulations like Solvency II, he is also frank about the ­wi­­­der risks they create.
This is what he had to say:

Describe your role at the Prudential
I run the portfolio management group. So, ­effectively, I am the chief investment officer for the UK insurance business Prudential. There is an M&G connection; I am actually emplo­­yed by M&G for regulatory reasons, but I ­manage the assets of Prudential UK’s ­insurance ­business.
The Prudential UK’s insurance business, very simply, is some big with profits funds, some big annuity funds and some unit-linked ­business. I include in unit-linked business the life and pensions assets.
There are three very different product sets, ­with a £125bn under management, mostly in with-profits in terms of a back book.
There is also £33bn in annuity business in there ­­now.
There are different sets of liabilities and they all have to be managed. We do that through various internal and external asset management companies, of which M&G is just one.
We use external managers where we have not got the expertise ourselves in-house to get the exposure we need. If you were to map the ­relationship between the liability side and the asset side, it would look like a spider’s web – with the portfolio management group sitting in the middle, bringing order to the chaos. Ours is the responsibility for the high-level stuff like strategic asset allocation. That is not just a pure asset allocation, or what our view is, but increasingly now it is a capital ­management activity.
Given current capital regulations, and also ­future capital regulations with Solvency II, we need to work out what the optimal asset ­allocations are for conserving capital, earning return on capital and at the same time ­meeting policy holders’ expectations.
It is bloody complicated. Once we have ­decided on that – and we do this with the boards of the various Prudential companies – it is our job to implement it and to take ­tactical positions around that.

When you are setting the strategic asset ­allocation for one of your portfolios, how do you start the process?
It starts by looking at the promises we have made to customers first and foremost. ­Because the promises we make to customers in one product are very different to the ­promises we have made to the customers in another.
In annuity space, for example, we are looking at guaranteed payments for retirement and there is no surrender in that space. So, we can afford to take on fairly illiquid instruments. ­Because we are looking at a constant stream of payments against fairly fixed liabilities, ­mortality and longevity being assumed, then it is natural we invest in bonds and corporate bonds to get the spread.
In the with-profits space there is less of a ­guarantee: we are looking to maximize ­returns over the long term. There is a certain element of guarantee, so we are always ­conscious of the capital as well. In this case we are looking at a well-diversified pot of ­assets.
But increasingly, within all of our allocations, we are looking at the capital requirements we have to match for regulatory purposes.

Are you having to forward guess the impact of regulations and also calculate the ­probable risk and return of your ­investments?
Yes, and I guess how the industry has ­changed since I came in to it is the capital dimension is now much more important now than it used to be.
In the collective space, it is purely to be ­consistent with the objectives we set ­ourselves, and the objectives we set ourselves in the ­prospectus for the funds. That is really ­matching a risk rating.
Here you can do ­relatively simple, or ­sophisticated, efficient ­frontier-type models, depending on the ­objectives you set out, and precisely the ­wording you put in each ­particular fund.
But in the insurance space, it is all about ­capital to a degree that was never the case when I came in to the industry.

Are these changes for the better?
The insurance industry as a ­consequence will, as a whole, be a much safer proposition for customers.
But, and I choose my words carefully here, I think it always has been a safe proposition. Perhaps not in totality: there have been ­instances where individual firms have not ­perhaps served their customers well.
I think the intention of the regulation is to ­ensure everybody in future is sufficiently well ­capitalised and in the event of a financial ­crises, like the one we have just gone through, then everyone will survive and policy holders‘ expectations will be fulfilled. But the ­insurance industry did extraordinarily well during the financial crisis. It was a ­banking phenomena, not really an insurance ­phenomena, with the notable exception of AIG which was a hedge fund on top of a ­bloody great insurance ­company, with a big stock lending operation.
One of the problems about Solvency II, and one of my hobbyhorses, is the pro-cyclicality of the capital regime.
The regulators have talked about their desire to create an ­anti-cyclical capital regime. But, ­unfortunately, Solvency II is not going to be that. This is ­because it says you must always have enough capital to withstand a one in two hundred ­year event, which is pretty ­demanding in itself.
But even if a severe market or liability event occurs, you still have to have enough capital to withstand another one.
That is going require the industry as a whole to hold more capital. And whereas in the past the insurance industry has always been an ­anti-cyclical provider of capital to the ­corporate sector at the bottom, we will not be able to ­afford to do that in the future.
If markets fall we will always have enough ­capital to withstand that fall, but we will ­always be asking ourselves, what if markets fall further?
So, we will not be able to be as contrarian as we were in the past, if we follow the ­regulations to the letter. And exactly the same is ­happening in the banking industry.
I always thought there would be a great ­regulatory backlash after 2008, but it is ­turning out to be more severe than I thought. Exactly the same will be true for the banking industry; there will be pro-cyclical biases in the capital regime for banks as well.
It is unfortunate that some parts of the ­capital markets which clearly have to be got going again, like the securitisation market, are ­clearly going to be disadvantaged by the ­regulatory environment.
This will mean recovery will take longer. You cannot have it both ways.
Unfortunately the other dimension of the new regulatory environment is the belief that the more quantitative modeling you do, the more you are able to understand and mitigate risks. The last crisis demonstrated this was patently not true. We have been through an ­extraordinary event, and we have to calibrate everything to a one in two hundred year event under Solvency II. It is actually quite difficult to do that. In my working lifetime, which is over 25 years, that was ­quite a big one, and ­generally speaking I think we came out of it pretty well.

You do not put much store in economic ­forecasting. Why is that and how does that impact your modeling?
Economic forecasters have generally had a pretty bad record. It is very difficult to forecast underlying economic variables to the degree of precision that some people think you can ­forecast these things. Even if you get your forecasts right, markets do not always ­respond in the way you think they should do.
What we like to do is assess market valuation against long term valuation anchors that we have established.
And we look at significant ­valuations from these anchors using ­consensus economic forecasts as a basis for those ­valuation ­anchors.
We then look for ­rapid ­episodic movements in those asset ­prices as evidence of over-or ­under-valuation.
Then we look to exploit those periods of over- and under-valuations, and have a lot of ­patience. We think because we have relatively long-term liabilities, in the annuity space ­particularly, we have a fairly high tolerance for volatility.
Participants in markets should have a fairly high tolerance for volatility in the short term, and therefore we can afford to sit there and be wrong – for a while anyway.

Behavioral finance is key to what you do. How do you apply this?
I think it is something which is very difficult to build into a model. I come back to my ­previous comments on ­episodic periods in the markets, namely that if you are seeing ­rapid market movements, and if you are ­seeing the ­justification for ­those rapid market ­movements following certain rules, that is evidence of classic behavioral economic type behavior. A good example is when people start saying that ‚this time things are ­different‘. It is one of the factors we build into an ­assessment of over- and under-valuation.
I would point out that the success of this – and it has been quite successful in the past – depends on those ­valuation anchors being the right ones.
In the first eight years of this century, and the last five or six of the last, you could be fairly ­sure that the valuation anchors were the right ones, and they were pretty stable. As a ­consequence, this sort of approach was very successful at generating additional ­returns.
Going forward, with structural change and the ’new normal‘, we are in what we call a ­loose anchors phase. You can be less certain of ­those valuation anchors.

What are the valuation anchors you are ­attempting to hold onto?
Its equilibrium yield effectively, or ­equilibrium rate of return built up from a fairly basic ­economic theory. So, short-term interest ­rates, term-premium, inflation-risk premium, ­leading to an equilibrium long-term bond yield and an equity risk premium.
It is ­different for different markets and ­different stages of ­development. It is also ­different for different degrees of ­diversification, particularly in ­equity markets and for ­property risk ­premium.
And then for each asset class, this results in an equilibrium long-term rate of ­return that you expect asset classes to be ­exhibiting at any one point in time.
Then it is simply a matter of assessing the ­pricing of different markets, using consensus expectations of the future economic ­environment to build-in what the pricing ­actually is, and looking for big deviations. ­Either an over-or under-valuation relative to those equilibrium. Then attempting to take ­advantage of it.

What is your view of short term-ism in the mar­­­­ket?
I do not think it is healthy. The reason it is ­there is the focus by the fund buying ­community – and the whole fund management industry as a consequence – on short term ­performance numbers. In equity space, and to a certain ­extent in bond space, because ­performance is instantly measurable, that tends to happen. But in other parts of the ­capital markets, in credit markets, it is less short term, because most purchasers of credit instruments are buy-and-hold.
This is also true in the ­commercial property markets. There is not the same focus on short term performance numbers, because ­everyone knows those numbers are less reliable.
It is interesting to see the different pressures on the different parts of the of the capital ­markets, so I would not say that all the capital markets are equally short term-ist.
Equity space is instantly measurable, even if it is not meaningful.
At the other end of the space, in property, ­performance is allegedly ­measureable, but everyone knows it is not meaningful.

What is your view on mark-to-market ­accounting? What has that done to the way that ­investors are allocating their capital?
It depend on the liquidity of your liabilities. In insurance space, in annuity funds where there is no opportunity for an annuitant to cash it in, there is huge illiquidity in those markets.
Under old capital regulation we were able to use the yield on the assets to discount the ­liabilities. There was a clear linkage between the assets and the liabilities – as it should be.
Under the new regulation, under mark-to- ­market ­accounting and market consistency we have to discount those liabilities. Not by the yield on the assets, but by swaps, short term ­interest rates.
Because that is supposed to be the risk-free ­interest rate, which is a ­liquid instrument, and you should be able to ­liquidate your ­assets at that particular rate ­irrespective of what is going on at any stage of the cycle. Which is ­ridiculous!
One of the things which wound me up during the crisis was there was a lot of focus by ­regulators on mark-to-market valuations of our fixed-income interests, and particularly whether they were correct. Yet there were banks in that environment which were, in ­certain parts of their book, ­effectively carrying leverage loan exposure at book when the ­market price was 60 and their liabilities were extremely liquid. There seems to be a ­disconnect in the ­interpretation of how ­accounting rules ­impact various parts of the financial sector, and it is not always an ­entirely consistent application of the ­rules.

Did the crisis impact your investment ­philosophy?
To anyone who lived through that and was ­involved in financial markets, it must have changed the way they operate. I was ­astonished at times by the degree to which people, whom I thought were fairly ­rational sensible ­investors, were panicked ­into doing irrational things.

Do you use much external advice?
We do not really rely on external advice on ­asset allocation specifically. We rely on people’s opinions on different ­asset classes, and we ­make a fair amount of use of the ­different ­investment banks, ­particularly in the capital management space. We use a lot of ­derivatives and they can be used to do all sorts of things to your portfolio in terms of protection and enhancement. There are a lot of very skilled people out there whom we use.

How often does the PMG meet up and ­discuss the rebalancing of portfolios?
Strategically we have to do it every 12 months, but if markets are moving around or ­regulations are changing, then we will do it more ­often with the different boards.
As you can ­imagine, we did that quite a bit ­during the ­crisis. Tactically, we are looking at market ­behavior on a constant basis. We do not have any fixed timetable for a tactical ­meetings. The only way it can work is with a constant process of ­re-evaluation.

Where do you stand on the active versus ­passive debate?
I am not a great fan of passive investment. If you look at the way the FTSE100 has changed over the last 20 years, it is a completely ­different investment in terms of its ­fundamental economic characteristics, not least its overseas exposure. Look at the ­number of overseas domiciled companies now embodied in that index – it was not like that 20 years ago. It may or may not be ­desirable for you to have that index, but you should not think you are getting exactly the same ­exposure.

You are in charge of allocating assets, both to internal managers at M&G and external ­managers. What do you look for in a good fund manager?
A sound theoretical philosophy as to how the manager thinks they can add value.
Also, the ability to articulate that philosophy, and, most importantly, a systematic means of delivering that process.
A lot of people say they do one thing and then go and do something ­completely ­different.
We deliberately make use of our internal ­managers quite a lot.
That is essentially because we think we can have influence over those mangers in a way we could not when using lots of external ­managers.

How much management is outsourced?
It depends on the product. In the with-profits space and for annuities, for example, it is ­virtually entirely internal.
In fact, with annuities it is entirely internal – because the benchmark is corporate bonds, and in M&G we have one of the best fixed-
­income teams around.
In with profits, because we have a reasonable exposure to alternatives, we have some ­external managers.
In the unit-linked space we use external ­managers quite a lot, and in collectives. One of the things we have done in the ­dynamic portfolios is to outsource some of that ­external manager selection process to OBSR.

When a manager underperforms, what is your process for dealing with that?
For internal managers, we do a due-diligence process on those managers every year.
Bad performance can be the result of bad ­decisions, bad luck, bad process or bad ­people. And we are trying to identify which of those things it is. That is not always easy because good ­people can make bad decisions, and we all have bad luck, but what we are looking for is to weed out bad process.
That is the advantage of having internal ­managers: if we can identify bad process, then we are in a very strong position with ­those managers to influence them to do ­something about it.
With an external ­manager, we would have no influence.

When you choose managers are you looking for process over personality?
Process is key. And also that it is team-based, because it is important to be able to bounce ideas off other people in capital markets.
We manage a huge amount of money across many different asset classes, and frankly I am not an expert in all of them.
You are always ­learning something. If you are taking all the decisions on your own, instead of pooling knowledge, then you are missing a trick.

You have been with Prudential for nearly 30 years. When you see managers switching ­between firms, does that impact your ­decision on ­whether to appoint them?
Yes it does, to be honest. We are looking for stability.
Everyone has ­different motivationsbut I think it is the ­passion for the job that matters.
Great fund managers, people like Tom Dobell and Neil Woodford, have all been in those ­positions for a long time, and frankly it shows.

What motivates you in your job?
Frankly I think this is the most interesting job that I could have in London.
Because there are £125bn in assets, lots of ­different liability issues, and we have just ­been through a crisis and recovery which ­have left markets pretty volatile.
We are also going through the ­greatest ­regulatory change in the insurance industry that I can remember.
Also, Prudential has a global franchise and has a big involvement in Asia, which is very exciting.
And here I am sat in the middle of it; it is just incredibly interesting.

Investors came in for a lot of ­criticism during and after the financial crisis for not engaging more with the companies they owned, ­especially the big banks. How much ­responsibility should you be taking?
We will comply with the stewardship code, but I think it is difficult, to be honest.
The fact was that before the financial crisis,society ­generally, and the financial ­sector ­particularly, became collectively ­deluded.
Society thought property prices were only ever going to go up, and the financial sector thought it could make a lot of money lending in to that process.
Very few people had the insight to stand against that.
I do not think improved ­processes for ­corporate governance, and an improved ­relationship between shareholders and ­corporates would have avoided the crisis.
The crisis led to a belief that more process was ­all that was required, but you could argue the more ­process you have, the more ­likelihood there is of you coming to mistaken beliefs in the first place.
I do not think it is going to generate a ­meaningful improvement in the way ­decisions are taken.