Sonal Desai, PH.D., is executive vice president and chief investment officer of Franklin Templeton Fixed Income. In this role, Dr. Desai oversees Franklin's Municipal, Corporate Credit, Floating Rate, Securitized, Multisector, Global (including Emerging Markets), Money Market, and Local Asset Management Fixed Income teams. She reports directly to the president and chief executive officer and is a member of Franklin Resources' Executive Committee, a small group of the company's top leaders responsible for shaping the firm's overall strategy. In addition, she serves on the firm's management and investment committees.
Dr. Desai is also a portfolio manager for a number of strategies, including Core Plus, Strategic Income, Total Return, Low Duration, Global Absolute Return, and Global Fixed Income.
I interviewed Dr. Desai on March 4.
You have an interesting background across academia, at the IMF and as an economist. How did that career path take you to your leadership role at Franklin Templeton?
Every stage of my career has taught me something extremely valuable for my current role. Academia taught me how to research and understand a variety of issues, how to apply analytics in a targeted and effective way, and how to communicate ideas clearly. At the IMF, where I worked on adjustment programs in many emerging market countries around the world, I learned the complexity of policymaking, which is crucial to understand how countries are likely to react in difficult circumstances. Then in investment banking, in a hedge fund and here at Franklin Templeton, I have gained exposure to most aspects of financial markets in a variety of market conditions, from irrationally exuberant ones to the global financial crisis. I have been enormously fortunate and privileged to be able to lead a very strong team and work closely with extremely talented colleagues.
Your management process integrates quantitative and fundamental disciplines. Tell me more about how that process has evolved and how it is implemented by your team.
Since being named CIO of Franklin Templeton Fixed Income, my focus has been on bringing every source of alpha to the table and ensuring those ideas are disseminated and integrated across the entire team. Competition is high and any advantage is fleeting in the investment management industry. What I have focused on is being able to move the platform forward, differentiate ourselves, and most importantly prepare the team for success in the next 20 years and beyond.
Evolving our process became more of an existential question – what do we need to do to succeed in the decades ahead? To understand our evolution, I think it’s also important to note our close proximity to Silicon Valley and the impact that’s had on our investment culture. Being headquartered in San Mateo, we are immersed in an innovation ecosystem. This has made it immediately clear to us how technology breakthroughs and data science are disrupting entire industries and that asset management will be no exception. In today’s world, if you aren’t continually evolving technologically, you risk becoming obsolete. Our CEO, Jenny Johnson, has been an early evangelist of this paradigm. Moreover, our location has given us great access to data science talent and the ability to collaborate with some of the most interesting startups in fintech.
Overall, the group remains strong in the traditional fundamental research and analysis that our brand was built upon. This remains unchanged, but is now complemented with additional macroeconomic and quantitative research and insights – strengths that we’ve always had but were, in my opinion, under-utilized. We therefore implemented an enhanced “active quant” investment process that includes three proprietary models of quantitative analysis. The first model is focused on high-conviction view formulation, where we translate our macroeconomic views into quantifiable and measurable forecasts for sectors and market impact. The second model utilizes a proprietary optimization process that seeks the optimal sector weights to produce the highest risk-adjusted excess return profile. Finally, the third model is for security selection in certain sectors, where we combine our fundamental views with a dynamic tilting factor-based model and quantitative security rankings to help construct portfolios and select individual securities.
We believe we have found the “sweet spot” that balances quantitative science with fundamentals-based active management, and that this will help us navigate challenging investment environments, generate consistent alpha, and ultimately serve our clients better.
You’ve written, “The entire active fundamental versus quant debate is a false dichotomy.” Explain what you mean.
Advocates of the quant approach argue that algorithms and rules-based factors are more effective and reliable, while advocates of the traditional active fundamental approach argue that the insights from experienced economists and credit analysts can never be replaced by machines. I believe this is the wrong debate. At Franklin Templeton Fixed Income, we bring the two approaches together and believe the future of fixed income investing lies in marrying quantitative science with fundamental active management.
Quantitative insights complement fundamental analysis. Quant provides breadth while active fundamental analysis provides depth. Quantitative approaches can identify patterns in enormous amounts of data and cover the entire investable universe, something traditional analysis cannot achieve due to scale; fundamental analysis provides a deep understanding of the complexity of individual issuers, securities, and sentiment that data alone could not achieve.
A case in point was last year’s market that quite a few factor-based equity strategies had trouble navigating. Factors like value and momentum, which historically moved in opposite directions, began moving in unison. Even layering on a sophisticated top-down algorithm wouldn’t have necessarily solved last year’s performance problem. Given the highly complex and dynamic nature of capital markets, we think quantitative methods work best when combined with traditional human insights derived from classical macroeconomics and fundamental security analysis. Successful investing still requires a human touch.
An example outside of the asset management industry where we are seeing the successful marriage of data science and human reasoning and experience is in the field of radiology. There has been a growing national debate about the future of this field, as some academic research published recently found that artificial intelligence could more successfully assess cancerous tissue and detect diseases than trained radiologists. However, what I found most fascinating was that the research discovered that combining trained human radiologists with artificial intelligence proved to be far more successful in detection than either in isolation. As we have found in asset management, the debate should not be “either-or” but rather how we can combine and leverage the strengths of both.
Can you give an example of how you addressed that dichotomy in a decision in your security-selection process?
An example of where our analysts and the models our quants generate challenged each other and relied on one another to come to the best investment decision was in the auto sector last year. Our factor models evaluated all the available data and recommended an overweight to the auto sector and specifically saw positive opportunities in companies like Ford. Our fundamental credit analysts, on the other hand, recommended a full underweight to the sector based on the fact that the auto industry was undergoing a historic transformation driven by electrification, autonomous driving and ride sharing, and that was specifically not favorable to Ford due to idiosyncratic issues the company was facing. These three mega-trends have triggered an explosion of capital spending across the global auto industry. At the same time, the auto industry is marching towards a cyclical slowdown in sales.
Although our factor models correctly measured the potential value of Ford’s bond returns last year, the model had no visibility into the seismic technology shifts impacting the auto industry, nor the cyclicality of revenues that caused Ford’s bond spreads to widen. After some discussion between our quantitative analysts and our auto credit analysts, our portfolio managers decided to underweight the auto sector and remove Ford – the opposite of what our quant model suggested. Around six months later, Ford’s bonds were downgraded to junk status by Moody’s.
Let’s talk about a fundamental risk factor that is getting a lot of attention. With the spread of the coronavirus, we’ve seen a sharp decline in Treasury yields and the potential for a global economic slowdown or even a recession. How should investors integrate that news and those developments into their fixed income allocations?
The scale of the sell-off we’ve seen in risk assets, particularly equity markets, and the flight to safety we’ve seen to traditional risk-free assets such as U.S. Treasury securities probably has as much to do with the stretched valuations we had coming into this year as to the rise of the coronavirus (Covid-19). The underlying economic conditions have not been massively negatively impacted, and one would have to take “Armageddon” as a baseline scenario to validate some of these market movements. Uncertainty is dominating the market and investors have become increasingly intolerant of any uncertainty – a sure recipe for trouble. Risk is a part of investing and in many ways the actions of policymakers around the world have suppressed volatility over the past several years. Its sudden resurgence has come as a shock and the reaction we are seeing from markets is reflective of this.
The surprise 50 basis point “emergency” rate cut on March 3 was aimed to offset the evolving risks to economic activity arising from the coronavirus outbreak and should underpin financial markets’ confidence and have a positive impact on sentiment. However, the “front line” or primary tool to address this situation should not be monetary policy, but rather targeted relief to specific sectors that are impacted – in short a fiscal response. Chairman Powell said it well – that the Fed is not in a position to control the spread of the virus but can ease financial conditions. Given this stance from the Fed and the panic-driven nature of the market, we could see Treasury yields fall even more in the short term, but these yields would need to be validated by a massive deterioration in the underlying economic conditions or an exponential increase in the spread and economic impact of the coronavirus outbreak. The market reaction is far ahead of what we’re seeing from a fundamental perspective, and while we’ve all become amateur epidemiologists, at this stage even medical professionals cannot describe with any degree of certainty how this situation will play out. Profit margins in certain sectors will undoubtedly be impacted, and the probability of some type of fiscal response to support those sectors has increased if underlying data deteriorates.
Even prior to the current market volatility, we were in a defensive posture, already factoring in expectations of heightened levels of uncertainty and remain so. The situation continues to evolve and we recommend investors remain nimble and ready to reallocate fixed income assets to either provide additional defense against volatility or capitalize on opportunities as valuations become more attractive. Investors should also keep in mind that in the event that the coronavirus outbreak causes a more substantial and prolonged disruption to production and supply chains, it will represent a supply shock with potentially significant inflationary consequences that should not be ignored.
We are publishing this interview on International Women’s Day. The investment industry is still largely male-dominated. Do you see that changing?
I do see that changing, but the change will be gradual, and we need to do a lot more to bring more women into the industry. In my view, the first step has to be to encourage young girls to study math and scientific subjects that will put them in a stronger position to build successful careers not just in the investment industry, but also in other industries that require strong technical skills.
What advice would you offer to younger professionals – particularly young women – who aspire to leadership positions such as yours?
I would give them three pieces of advice. First, believe in yourself—if you put in the hard work and have the passion, you can achieve a lot. Don’t let anyone tell you otherwise. Second, take risks and take chances. Whether it is a new assignment, a new job or a change in careers, taking risk is essential to find new opportunities, grow professionally and succeed. And when the opportunity comes, take it and believe you can succeed. Don’t wait till you feel 100% confident that you have ticked all the boxes. Finally, look for the best role models and mentors, whether they are women or men. Choose the best people to look up to, and the best people to counsel you and guide in your career.
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Sonal Desai, PH.D., is executive vice president and chief investment officer of Franklin Templeton Fixed Income. In this role, Dr. Desai oversees Franklin's Municipal, Corporate Credit, Floating Rate, Securitized, Multisector, Global (including Emerging Markets), Money Market, and Local Asset Management Fixed Income teams. She reports directly to the president and chief executive officer and is a member of Franklin Resources' Executive Committee, a small group of the company's top leaders responsible for shaping the firm's overall strategy. In addition, she serves on the firm's management and investment committees.