Absolute return: a silver bullet for the investment strategy?

Absolute return strategies seem an ideal response to low interest rates, volatile markets and Solvency II, but what are the associated challenges facing investors? Experts discuss in part one of this InsuranceERM/Insurance Asset Risk and Standard Life Investments roundtable

Chris Cundy: What are the main challenges that you are facing in your investment strategies at the moment?

Victoria Gibson: We all know we have been in a low-yield environment, but I am seeing a lot of volatility in bonds, one of the markets traditionally seen as a safe haven.

Gareth Collard: Solvency II is throwing a lot of uncertainty into how we would like to invest and how it is possible to invest - and they are not the same thing. We, like many other life insurers, spend a lot of effort in re-engineering various processes and ways of thinking about the asset-liability portfolio, so that it works on 1 January, which is taking away from some of the more fundamental decisions about how you would like to invest.

Emily Penn: In the annuities business, it is quite challenging to get assets that are compliant with the matching adjustment. With-profits is not quite so affected by Solvency II, although some of the assets we would like to put in those books may require new models to make them work under Solvency II. The communication to with-profits policyholders is also a challenge. Another big impact on our investment portfolio is EMIR and the clearing requirements, which require us to put a lot more liquidity into our portfolio than we would, perhaps, naturally want to.

Diversification of portfolios

Chris Cundy: What are your tactics for dealing with low rates and volatility?

Emily Penn: For our long-term portfolios it is less of an issue as we are buy and hold investors. For our shorter-term portfolios, diversification away from fixed income investments into equity-type investments makes sense. However, because of the capital treatment, we really have to consider them on a protected basis, e.g. using collar strategies, so we are not totally exposed. In addition, we are looking at other diversifying assets, such as absolute return funds, but there are three main challenges here: the Solvency II treatment, getting stakeholders comfortable with the underlying asset and showing we understand the risk.

Within our annuity fund, one of the challenges is that everyone is invested very much under a Solvency I world. There does not seem to have been a pricing shift yet into the Solvency II world. Nobody knows when that is going to happen, so everyone is still trying to chase yield in assets that are just about matching adjustment compliant. But it feels like everyone is on a bit of a knife-edge.

Victoria Gibson: We are not just thinking about diversifying the portfolio, but we are looking at more alternative strategies, introducing hedge fund strategies and things that we think will provide diversification through the cycle. We are not specifically looking to increase yield, but looking for a more stabilised profile of returns through the cycle.

"When you have got zero or negative interest rates, the ability for bonds to provide diversification is clearly limited." Victoria Gibson, QBE

David Leach: The fundamentals of our investment strategy remain fairly stable, as the characteristics of our liabilities have not changed. We seek an illiquidity premium principally through buy-and-maintain strategies, consistent with Solvency II requirements. Investing in alternative assets requires a lot of due diligence and the appropriate level of governance, understanding and transparency.

Chris Cundy: Does the current environment favour absolute return strategies?

Victoria Gibson: The question ties up with the way in which bond markets evolved during and after the crisis. Losses that should have been taken back in 2008 are being taken now. Rather than having the world end, as we thought it was going to, we have had low rates and low returns. It is a 'slow burn'; a 'loss by a thousand cuts'. When you have got zero or negative interest rates, the ability for bonds to provide diversification is clearly limited.

Gareth Collard: Indeed, this is the problem. Spreads really should be 100 bps higher and we should be seeing more than two defaults a year. Instead, we have seen no defaults in the last few years, but we have been buying assets with an artificially depressed return. So we are taking the pain now.

Victoria Gibson: A lot of assets have been reflated ahead of the real economy. It is hard to find cheap assets, so we are indeed looking at different ways of packaging absolute return and hedge fund strategies, and looking for an illiquidity premium. Underneath it all, we know that these strategies are not risk-free. It will be interesting to see how they perform when interest rates move from where they are now.

Craig Turnbull: Solvency II permits more recognition of investment diversification benefits than most Solvency I regimes and, where investors perceive a potential valuation bubble across many major asset classes, the attraction of diversifying into absolute return strategies can be especially compelling.

Investing in uncorrelated assets

Chris Cundy: If diversification is a strategy, how do you ensure your are investing in assets that are not correlated, but still achieve growth?

Emily Penn: I think the not-correlated debate is quite challenging when we have to hold capital against a 1-in-200-year event. In this context, everything is correlated.

Gareth Collard: Even the bond market!

Emily Penn: In an economic view you may think you are gaining diversification, but from a capital view it could be quite hard to justify that. To make it work from a return on capital perspective, we often end up with capital-protected versions of what we would really want to do.

"We would like to consider absolute return funds in our asset universe, but to make them work we need to develop internal modelling capabilities." Emily Penn, LV=

Gareth Collard: This is because of the predominance of regulatory capital, rather than your own economic capital view.

Emily Penn: Yes. We have an economic capital metric, which we would ideally like to manage our business by, but we are still constrained by regulatory capital.

Victoria Gibson: Having a validated economic capital model as the basis for the regulatory capital model sounds very neat, but it is resource-intensive. People struggle to understand it and, sometimes, it does not align with what you intuitively feel are the risks of an investment.

Resource intensive work

Bruce Porteous: Finding diverse strategies that generate return and which are genuinely diversified in the tails is resource-intensive, because it requires a rigorous process. But is that not the real value-add to insurers of an effective absolute return fund provided by an external asset manager?

Emily Penn: We would like to consider absolute return funds in our asset universe, but to make them work we need to develop internal modelling capabilities. However, like other insurers, our resources are constrained and the focus is on getting our internal model approved to cover our existing asset portfolio. We can probably justify a small investment or if we can put some capital protection around it. But in terms of actually making a substantial investment, at the moment, it is just not a business priority. It might become a priority in stage two or three of the internal model building process, one or two years down the line.

Gareth Collard: We need to have the expertise to be able to model and understand the risks inherent in absolute return. This would require a big investment at a time when we are making significant investments in similar models for static investment strategies - which are hard enough to model in themselves.

David Leach: The ORSA implications of these investments also need to be considered. Typically there is a lot of freedom in how an absolute return fund invests, and with ORSA being a forward-looking assessment, some judgement would need to be made about the mix of those investments going forward, what might go wrong and what the implications could be.

Gareth Collard: There are a lot of questions that are very difficult for us to answer without investing a lot of time and effort just to see whether it could work for us. I do think it is very difficult for companies at the moment, particularly for companies that are not huge, to dedicate that amount of resource to this. I could see people investigating it after 1 January.

"Perhaps we are not as brave as we could be in having our own economic view, and considering the future and our decisions in that light. Nevertheless, we have to be pragmatic." Gareth Collard, Just Retirement

Looking backwards and forwards

Emily Penn: Track record is one of the challenges that we have come across. We have looked at this type of investment for our portfolios, but when we wanted to build the models for it, they had a two or three-year history. This was not sufficient for us to be able to justify that they had a lower volatility than a normal fund-type investment.

Gareth Collard: The past itself can be a very confusing guide to the future, because we are in a time when the central banks are doing unprecedented things. How much value is history?

Chris Cundy: What is that implication of that? Do you worry about taking a risk on something new?

Gareth Collard: Perhaps we are not as brave as we could be in having our own economic view, and considering the future and our decisions in that light. Nevertheless, we have to be pragmatic; it is all well and good us thinking that some absolute return funds make a great deal of sense, but if it does not work in the regulatory world, or if we have to invest such a huge amount of time to get to that point, you have to question the extra return and stability. There is a temptation to go for the easy life and do something that is sub-optimal, but less problematic.

David Leach: It is important to understand the risks and rewards of new opportunities in the context of risk appetite. New opportunities can bring risks that an organisation might be less familiar with. It might make sense to use third parties who bring specialist expertise, although the right level of experience is needed in-house to provide the necessary oversight.

Emily Penn: One of the other challenges is the time horizon of a lot of these funds. They might have a three or five-year objective, which as long-term investors makes total sense to us. But we cannot get away from the fact that many of our stakeholders still focus on what happens over one year. Also, for a with-profits fund, every year you are benchmarked against similar with-profits funds. You are never going to lose your job for following what everyone else does.

Part 2 of this roundtable, discussing the modelling of absolute return funds, expected returns and Solvency II reporting, can be read here.

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