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My previous two articles set the scene by comparing market risk appetite in the UK, Germany and France. We then looked at asset optimisation within an insurance regulatory framework and the other constraints on asset allocation – liquidity in particular.
This final article aims to challenge pre-set ideas and I hope that it challenges you to think again about some investment strategies that you may have previously dismissed, taken for granted, or not yet thought about.
As per before, I'll focus on the insurers' capital base ("Own Funds") so that liability constraints can, at this stage, be disregarded. Of course, it is important to remember that the value of any investments can go down as well as up and you may not get back the original amount invested.
Equities
These have fallen from grace because of their erratic returns and high capital requirements, making it fair to say that you need to be able to afford to hold equities. We've covered how diversification benefits lessen the cost, however the cost can also be reduced by hedging out foreign exchange (FX) risk. Although FX risk is an integral part of equity markets, hedging out this risk potentially alters the risk reward profile with unintended consequences.
An alternative is to use derivatives to manage both the drawdown risk and the capital requirement. A tried and tested approach to managing this risk is to run a hedging programme that involves rolling a 12-month collar on 25% of the portfolio every quarter. A variant to this that I find appealing is one whereby one-year put protection is bought every month on one-twelfth of the portfolio, the cost of which is offset by writing a one-month call option on the whole of the portfolio. This can generate a positive net premium and has the potential to perform well compared to the more vanilla approach.
Convertibles
Why do these not get more attention? The risk characteristics could almost have been made for an insurance company's balance sheet. A convertible bond offers the upside of an equity with the downside of a corporate bond. Our own strategy operates in the 'balanced area' as shown in the diagram below. The strategy acquires assets that are close to the 'at the money' point, at which the fund will pick up more of the upside of equities than the down side. The portfolio manager will sell if the assets become bond-like on the downside or equity like on the upside.
Risk profile diagram
The convertible bond investible universe has surprising breadth and depth to it. With a relatively marginal added complexity around their regulatory treatment, I think they warrant a closer look.
'Vanilla' multi-asset investment strategies
If broadening your investment portfolios by investing in equities is part of your strategy then you obviously need to look at multi-asset investment strategies. I mean those funds that only invest in traditional asset classes. This route will allow your asset manager to seek additional returns through bets between asset classes as well as within asset classes. I'd also look at the new breed of, low cost, volatility targeted funds to give the investment committee greater certainty around the risk budget allocated to this asset class, whilst keeping an eye on fund charges.
Views amongst insurers can be polarized around active versus passive management and whether the added net of fees return of active management is rewarded relative to the added volatility. Factor investing is emerging as a favoured alternative to passive management by many insurers and it is how we look to provide active management returns within our own low cost, volatility targeted multi-asset funds.
The diversified growth fund (DGF) space is an option and in many respects, interest here has diverted attention away from simpler multi-asset solutions. DGFs are a good choice but can be tricky. Their sophistication and unconstrained nature can be too challenging for many Investment Committees. Determining their capital requirements under the standard formulae can also, incorrectly in my view, serve as a deterrent.
Long/short strategies
Here I'm thinking of market neutral strategies, and all the benefits these bring in terms of diversification. Unfortunately, for all their attractiveness, the standard formulae aren't kind to these strategies. This is because the regulations require the short positions to hedge the long positions with minimal basis risk. It's the basis risk though that provides the performance over time. There needs to be risk capital to cover this basis risk but the regulations don't allow you to prescribe say a 75% hedge effectiveness to the short positions. Instead, the rules require you to totally disregard the hedging provided by the short positions unless you look to develop a Partial Internal Model that captures the risk profile. From an analytical perspective, the data of our own Global Equity Market Neutral fund lends itself to a very compelling analysis in this respect.
Absolute return bond funds
Last but not least, these strategies fit comfortably within the balance sheet because they are an extension of strategies in the familiar world of rates and credit. Their goal is to provide a cash plus return with an eye on downside risk. This offers a more conservative way to grow an insurer's balance sheet. These funds invest in the cross-over space where there can be forced buyers and sellers in the market. The opportunities here can justify the additional capital requirements of sub-investment grade debt. It should be noted though that these funds can also invest in currency pairs which are less capital efficient and where an insurer might wish to exclude these trades from their strategy.
To conclude
It's interesting that when looking at the principles that drive insurers' investment decisions, it is possible to find corners of the investment universe where I'd expect to find more investment activity by insurers (particularly non-life insurers) but where I feel they are conspicuous by their absence. Hopefully I've left you with food for thought. If you would like to hear about BMO Global Asset Management's offerings in these asset classes in more detail, I'd be delighted to speak to you.
Important information
For professional investors only.
Past performance is not a guide to future performance. Values may fall as well as rise and investors may get back less than the full amount invested.
Views and opinions expressed by individual authors do not necessarily represent those of BMO Global Asset Management.
The information, opinions estimates or forecasts contained in this document were obtained from sources reasonably believed to be reliable and are subject to change at any time.
© 2018 BMO Global Asset Management. All rights reserved. BMO Global Asset Management is a trading name of F&C Management Limited, which is authorised and regulated by the Financial Conduct Authority. CM16526 (04/18). UK.
Dick Rae, Director, Insurance Solutions
