Successful investment programmes, regardless of the type of investor, typically have a number of common characteristics. It is possible to achieve good results without them, of course. But consistent long-term results, whatever the specific investment objective, are most consistently realised when certain core principles are followed...
Successful investment programmes, regardless of the type of investor, typically have a number of common characteristics. It is possible to achieve good results without them, of course. But consistent long-term results, whatever the specific investment objective, are most consistently realised when certain core principles are followed.
These principles are even more important for insurance company portfolios, where the impacts of uncertain capital market returns are compounded by the potential need to fund claims resulting from events in an equally, if not more, uncertain world.
Many investors are no doubt familiar with these principles, however newer pools may benefit from this discussion. Those with more experience may also find a refresher valuable to contemplate whether any changes or updates should be considered.
Where to begin?
The starting point is a clear understanding of the portfolio objectives. For insurance companies, this means providing ongoing funding for the potential liabilities the portfolio may have to support. The financial strength of the company and a strong premium flow are relevant, but the portfolio must be able to withstand on its own resources any demands from adverse claims. While shareholder capital may provide a back-stop, this is certainly an option whose exercise is not desired by any of the involved parties.
Once the degree to which the portfolio’s funding level supports the anticipated liabilities has been determined, an appropriate asset allocation target can be established. To the extent a meaningful surplus exists, and subject to regulatory and beneficiary constraints, a more aggressive posture for the portfolio may be considered. The fundamental principles of risk and return indicate that increased returns are achievable, but only by accepting the potential for greater volatility.
In situations where the degree of funding is lower, a more conservative portfolio is required to minimise the probability that adverse market conditions may endanger the portfolio’s ability to satisfy claims.
In this circumstance, taking on additional risk is obviously not appropriate. The end result of this process is the determination of the optimal asset-liability match that meets each pool’s funding needs.
The targeted allocation as well as other information, such as any relevant portfolio constraints, specific asset and security restrictions, and asset quality and rating requirements, should all be documented to provide clarity for the asset managers as well as for boards, finance/investment committee members, and shareholders. This is most efficiently done through creating an Investment Policy Statement (IPS).
The IPS can also serve a valuable role in delineating the roles and responsibilities of the various parties charged with managing and overseeing the portfolio if this degree of specificity is desired.
An IPS need not be a lengthy document, however, so long as the key criteria relevant to the portfolio allocation, acceptable securities, and other constraints, ratings and quality requirements are noted.
A key consideration is the degree to which the IPS provides flexibility to allow the portfolio to adjust to shorter term market conditions. This can be done in a number of ways. Possible adjustments that may add value or reduce volatility would include altering the mix between the major asset classes for balanced portfolios with a blend of bonds and stocks. For fixed income-only portfolios, altering the allocations to different security types (for example, an increased or reduced emphasis on corporate issues versus treasury or agency securities) may be considered. The duration of the holdings can also be adjusted so long as it remains appropriate to the duration of the portfolio’s liabilities, thus maintaining the asset-liability match that is the core consideration for insurance portfolios.
More sophisticated techniques based on specific market expectations may include altering the structure of the portfolio’s fixed income assets along the yield curve to benefit from, or insulate against, anticipated shifts in interest rates for different maturities. For example, if shorter rates are expected to rise, shifting some holdings out somewhat longer to reduce exposure to the short end of the curve, while shortening as needed at the longer end to maintain the overall duration, may be an appropriate strategy. Each pool’s managers should be consulted as to their market outlook and recommendations for adjustments such as these.
Rate headaches
This year poses some particularly thorny challenges for investors, and highlights the potential benefits of a flexible approach that allows portfolios to adjust for shorter term trends. Adjustments should be limited and tempered, of course, so that portfolios retain their long-term focus, but even minor shifts can potentially add value and reduce volatility.
We are seeing a divergence in global interest rate trends, with rates in the US expected to move to a more normalised level, while various foreign central banks are focusing on providing greater liquidity through their own versions of quantitative easing. Beyond the first-derivative implications of changes in the federal funds rate on fixed income portfolios, these changes will also impact currency exchange rates. Higher US rates would be expected to support a stronger dollar, which could create headwinds for large US multinational companies with a high degree of foreign sales as their exports become more expensive.
Beyond the impact on revenues, earnings could also be reduced through translating foreign earnings back into stronger US dollars. So, while US companies may see lower revenues and weaker earnings, moves to greater liquidity overseas may provide support for international equities, as they benefit from weaker currencies and lower interest rates. This has implications for what the appropriate mix between US and international stocks should be for investors who participate in both of those asset classes.
Another consideration is that higher US rates could attract foreign capital seeking higher yields versus those available in Europe or Asia. These capital flows will help to hold US yields down due to increased demand, and will also support a stronger dollar. To the extent that dollar strength helps keep inflation under check, the Federal Reserve’s timeframe for higher rates may be affected, creating additional uncertainty about when the much-anticipated increase in the fed funds rate may occur.
Uncertainty is a constant in the capital markets, but as we move through 2015, with the potential for greater volatility than normal, the need for a disciplined and consistent investment approach is crucial. The guidance of a well-written IPS that provides a clear roadmap for the management of the portfolio under different market conditions, accompanied by realistic expectations and the ability to stay focused on longer term objectives despite shorter term swings, will serve investors well.
