Captive portfolios
Making your money work
Deciding how to deploy capital in the markets is not easy. Captives have to look at their own unique asset and liability profiles to determine their optimal investment strategies. Captive International reports.
Every captive has reserves of capital on its balance sheet which it needs to be able to access to pay any claims that may arise. Managing that capital efficiently, so that it is available when needed, but productive when it is not, is a significant challenge at the best of times.
In markets that are characterised by low interest rates and dramatic swings in investor sentiment, as 2020 has experienced, the challenge is even greater.
Every captive has its own unique set of exposures that will determine the appropriate investment strategy. In Cayman two of the biggest groups of captive owners are US auto dealers and healthcare companies, which sit at opposite ends of the spectrum in terms of risk appetite and investment priorities.
Auto dealers use captives to sell warranties on car sales, which tend to have a duration of less than five years and are generally profitable. Captives engaged in this business therefore tend to be well capitalised and have a relatively high degree of flexibility in how they invest surplus capital. Such captives may allocate a relatively large proportion of their assets invested in equities.
Healthcare companies by contrast have longer-dated liabilities and much less predictable claims profiles, making such captives typically more conservative, with a much higher proportion of their assets invested in bonds.
Hugh Barit, chairman and chief executive officer at Performa, says: “For captives the focus of investing is very much on capital preservation. We often remind clients that they are first and foremost insurance companies, not investment companies, and while achieving attractive returns is important, their first priority has to be to ensure they have the funds to meet their liabilities and collateral obligations.”
Few captives have the expertise in-house to manage their own investment portfolios. Instead, most turn to specialist investment advisors such as Performa or Oppenheimer to manage their assets for them.
“Their first priority has to be to ensure they have the funds to meet their liabilities.”
Hugh Barit, Performa
Expertise
Performa is an investment advisor with more than 25 years of experience in asset allocation for captives. It manages investment-grade fixed income portfolios for its clients directly, while hiring like-minded third party managers to manage the high yield credit and equity allocations for their clients. The fees paid to Performa are the same regardless of whether the assets are managed in-house or by an outside manager, ensuring its interests are aligned with those of its clients.
Oppenheimer invests in separately managed accounts, with asset managers that have clear and identifiable investment styles, such as growth or value investing. It looks for managers with a proven track record, and also buys individual stocks and credits, managing them on behalf of its clients.
Most portfolios owned by captives and other insurance companies are dominated by bonds. While they offer lower returns, on average, than equities, they have lower risk and are highly liquid. Bond investing has become increasingly challenging in recent years, however: fixed income returns are positively correlated with interest rates, which have proved to be stubbornly low.
This has pushed investors down the credit curve, away from the safest paper such as sovereign bonds, towards lower-rated paper that offers higher returns.
Barit says: “In this zero rate environment, with regard to fixed income, it is all about the search for yield. You have to look beyond US Treasuries, especially at corporate credit.
“Many companies look more attractive than the US government right now, given public debt levels, but having an experienced credit team to analyse the companies is vital.”
Barit argues that an allocation to high yield credit, managed in a conservative way, is an essential component of a captive’s balanced portfolio.
“It offers interest rate diversification in a fixed income portfolio, providing yields of 4 to 5 percent, which is attractive relative to what can be achieved in the investment grade market,” he says.
Jack Meskunas, executive director of investments and captive insurance asset management advisor at Oppenheimer & Co, agrees. “There is no value in US Treasuries, or in most other sovereigns, given the level of public debt,” he says.
“But there is value in some high yield municipal bonds and corporate credits, especially in sectors that will benefit from government spending, such as infrastructure, energy and financials.”
For even larger returns, however, investors turn to the equity markets. Equities have experienced some extreme bouts of volatility in 2020, notably in Q1 when the emergence of COVID-19 spooked investors, leading to a selloff across most asset classes. Before the COVID-19 shutdowns the S&P peaked on February 19 at 3,386. The low point came just over a month later, on March 23 at 2,232, a pullback of around 35 percent.
This period of just over a month perfectly exemplifies the risk of investing in mutual funds or exchange-traded funds (ETFs) that closely track the equity market. Although equities can deliver strong returns, they can also turn quickly, leading to severe losses that are anathema to captives, which prioritise capital preservation.
Barit advises his clients to approach the equity markets with caution. “You have to take a three-to-five-year view when it comes to investing in equities,” he says.
“How much capital might be needed to meet the captive’s short-term liabilities and expenses?
“That money should be set aside in safe and liquid investments such as bonds. Whatever balance remains can potentially be invested in riskier assets such as equities.”
“There is value in some high yield municipal bonds and corporate credits, especially in sectors that will benefit from government spending.”
Jack Meskunas, Oppenheimer & Co
Equity approach
Barit says Performa’s clients with letter of credit obligations have recently had a tactical underweight to equities.
“This is not so much a view on the market, but the fact is there has been a lot of uncertainty around the pandemic and the US election and many of our clients’ collateral positions cannot sustain significant equity market volatility,” he says.
Meskunas says he is bullish on equities for 2021. “We have vaccines against the coronavirus being approved which start being rolled out by the end of 2020, and a safe vaccine is the key to long-term economic recovery,” he says.
“Interest rates will start increasing sooner than people think. They are not going to be high in absolute terms, but any increases will be supportive of credit. I do not expect a double-dip recession in 2021.”
Captive managers do, however, have to decide how closely correlated to the overall market they want to be, notes Meskunas.
“After a drop such as we saw in March they should be asking what their asset managers did to protect them. Inevitably there will be more volatility ahead at some point, and captives need to invest in a way that protects them when that happens.”
Captives that do have surplus capital available above what is needed to cover their liabilities will be attracted to the returns on offer in the equity markets over longer time horizons. Having decided to invest in equities, however, there are additional decisions to make about what kind of stocks to invest in.
Meskunas says: “Clients have largely abandoned value stocks—such as financials and energy—in favour of growth this year and that has generally been a good move for them, but since the US election there has been a real opportunity to get back into value stocks.
“The Dow was down for the year until October but by the end of November it was up 5 percent. You need a blend of value and growth; there are tremendous opportunities in sector rotation at the moment.”
With many captives feeling ill-equipped to make such macro calls about whether to invest in value or growth, some are attracted to the idea of investing in professional fund managers, which should be better equipped to make such decisions.
“After an extremely challenging year, investors will be looking ahead to 2021 with cautious optimism.”
Fund managers
“Some captives will invest in a mutual fund, or a suite of mutual funds, but that is a desperately inefficient way to invest because of the management fees. Mutual funds also have a habit of doing the wrong thing, of buying in the highs and selling in the lows,” Meskunas says. Instead, he believes, captives should consider investing in hedge funds.
This is not an easy decision to make, admits Meskunas. “The biggest issue with hedge funds is liquidity,” he explains.
“A captive thinking about hedge funds needs to know how often it can get its money back, because some offer annual redemptions, some offer it quarterly and some offer it monthly. The risk for a captive is that it will not be able to get its money out when it needs it.”
Meskunas estimates that a captive needs around $10 million in assets before it can even think about hedge funds—at that level it can invest 10 percent of its portfolio into hedge funds while satisfying normal minimum investment thresholds. This number does vary, however, depending on the nature of the risks the captive is exposed to.
For very large captives with long tail risks, or those that are very well capitalised or have a lot of other liquid assets such as cash or money market funds, an allocation to hedge funds can make sense, says Meskunas.
“Hedge funds have been much maligned in recent years because of their high fees and relatively poor performance but there are good managers out there if you look at track records,” says Meskunas.
“I invest in a hedge fund that invests in global equities with a growth focus and it is up 47 percent this year,” he adds.
“Even at the bottom of the market it had not lost any money, it has not had a single day in the red this year, because it was hedged using put options on the S&P 500 and a short book.
“Any captive invested in that hedge fund has not lost a night’s sleep—or a penny of their capital—this year.”
Meskunas believes captives need to look beyond how they have invested in the past and come up with new ideas and fresh thinking to ensure they are maximising returns in their investment portfolios.
“They need to look for managers with specialist styles,” he advises. “A good manager is vital. It is not enough to identify the right sector because there is huge variation between companies within a sector. A good manager is better placed to know where the opportunities are than most people working at a captive will be.”
He urges investors to review their portfolios regularly with fresh eyes, and not to fall into the trap of being needlessly loyal to investments that have been favourites in the past.
Meskunas says: “It is important to know what you own and why. You need to consider this regularly, there is no point in buying and holding blindly, what looked like good value yesterday may not look like good value tomorrow. The investment outlook can change quickly, as the pandemic proved.”
At the same time, captives should be realistic about the returns that are achievable in the current environment, says Barit. “An 8 to 10 percent return is unrealistic without assuming a significant amount of risk in the portfolio,” he warns.
After an extremely challenging year, investors will be looking ahead to 2021 with cautious optimism. Barit predicts returns in 2021 will remain modest, especially in fixed income.
“Once a COVID-19 vaccine becomes readily available, which probably won’t be until at least the second quarter, economic growth should begin to get back on track,” he says.
“Until then, governments will have to continue providing monetary and fiscal stimulus. Investors need to continue to focus on risk management and keep their return expectations in check.”
