Ed Goard and Michael Vandenbossche of Munder Capital Management, talk about investment strategies, the threat of inflation and what captives need to look for when considering an investment manager.
Managing insurance assets since 1985, Munder delivers tailored investment management services to its insurance clients, with more than $14 billion of assets under management. Here Cayman Captive asks for their views on asset management and the steps captives can take to maximise their investment position.
Let’s get right into the inflation question. Is US inflation a nearterm problem for investors?
Ed Goard: It is our view that inflation is really not a near-term problem. While conventional wisdom might tell you that current monetary and fiscal policy will generate inflation, we believe that the conditions for inflation to occur are simply not in place right now. The first of those issues is unemployment. Unemployment remains stubbornly high, at just under 10 percent right now, despite massive fiscal stimulus over the last year and a half. If you think about it, most of our domestic economy is driven by consumption, so with high unemployment and a still very shaky housing market, consumers right now are more focused on paying down household debt, as opposed to overconsumption.
The second piece of that puzzle is wage growth. And wage growth really doesn’t happen until labour recovers, and with unemployment remaining high, wage growth is quite unlikely.
The third piece of the puzzle is bank lending. Currently, we are in a liquidity trap, where the liquidity that is being provided by the Federal Reserve is really trapped behind unwilling lenders. The banks rightnow are in the mode of repairing their balance sheets, so they are borrowing from the Fed or borrowing from customers at next to zero interest rates and trying to invest in longer-term government guaranteed debt such as treasuries, agency debentures and agency guaranteed mortgage-backed securities. This is great for the banks because it is repairing their balance sheets, but they’re not making new loans to consumers and to businesses, which is necessary to fuel consumption and growth, so you’re not getting the normal effect you would get in a conventional recession.
Finally, looking longer term over the next decade, we have other things going on. For example, the social security pyramid is getting ready to turn upside down along with the retirement pyramid, so if you look at that over the next decade, our current fiscal policy is basically unsustainable. US government debt (federal, state and local) as a percentage of GDP is 114 percent, compared to its 55-year average of 67 percent. Government spending is at 24 percent of GDP, yet taxes are at 16 percent of GDP. We believe that this will result in a combination of higher taxes as well as lower government expenditure, with both of those likely to be contractionary.
Larger themes are re-regulation and tighter credit than we saw in the 1980s, 1990s and early 2000s, and so we don’t believe that growth will be what it was in the early 1990s and 2000s. It’s hard for us to see how you get an inflationary picture out of that.
If low level inflation remains, what will be the best approach to take on the client portfolio?
Goard: With regard to captive insurance clients, they typically aren’t seeking a high-risk or highly volatile portfolio; Munder, for example, believes in building a very well-diversified portfolio that is positioned to deliver solid and consistent risk-adjusted returns. I’ll use a baseball analogy: we position the portfolio such that it will hit a lot of singles, as opposed to swinging for the fences to hit a home run. What this means is that we manage the risk levels very carefully. Currently, our portfolios are overweighted in three different sectors. The first of these is asset-backed securities, in the form of credit card receivables and auto loan receivables. The reasons why we like that sector are twofold. First off, if you look back at the financial crisis, the collateral backing credit card and auto receivable securities actually performed fairly well. Most of the problems came from the mortgage-backed securities sector, so the problems were non-agency defaults, foreclosures and delinquencies that occurred in the housing sector, not necessarily in the auto loans and credit card sector.
"Adding a higher risk security to a low-risk portfolio can actually decrease the risk of the overall portfolio, while potentially increasing overall return. This is due to the low, or even negative, correlations that can occur among certain asset classes."
On top of that, we believe that we know how these types of securities will perform through a bad economic scenario. The bottom third of borrowers who used to be able to gain access to credit no longer can, meaning that the current securities being issued today reflect a higher credit quality borrower. In addition to that, because of all the heat the ratings agencies took during the crisis for incorrectly rating mortgage-backed securities, they also increased the amount of credit enhancement it takes to get a high credit rating on asset-backed securities. So we like this sector for two reasons: one, you have a higher credit quality borrower and two, the credit enhancement you are getting now is even better than what you were getting prior to the financial crisis. That, in our opinion, means assetbacked securities offer good value at the present time.
The next sector is commercial mortgage-backed securities. We have been avoiding the 2006-2007 vintage securities because that is where most of the problems exist. Our focus is on 2005 and earlier vintage loans and securities, which have a large amount of credit enhancement, where the bond holder has a lot of protection from losses or default. We think that due to the crisis, there has been a ‘baby thrown out with the bathwater’ effect, meaning that although the 2006-2007 vintage loans have some problems, the 2005 and earlier loans are performing quite well and offer good relative value.
And finally, we are active in the banking sector. I mentioned earlier that the banks aren’t lending and making new loans, which is probably bad for overall profit growth and bad for equity holders, but with banks taking less risk, they have repaired their balance sheets; thus from a bond holder’s perspective, we think that the banks represent a good investment at this point.
Lastly, you might ask, what if we do see inflation starting to rear its ugly head? While we aren’t presently positioned in any of these, given that we don’t believe inflation will be an issue, some of the sectors that we would explore as a hedge against inflation would be: TIP S (treasury inflation protected securities), floating rate debt and the possibility of convertibles.
At what size should a captive consider professional investment management?
Goard: Generally, a captive should hire an investment manager when its portfolio reaches around $10 million. However, we have seen several captives that were experiencing rapid growth and hired managers at the $5 million point. Portfolio size is a major consideration, but captives should also consider future premium flow and expectations, durations of their liabilities and their overall risk profile.
Typically, what happens when a new captive is formed at around a million dollars in size is that they will invest most often in the money markets. However, as they start to grow and get more premium flow, and once they know how their liabilities are going to react and they get to that $5 million point, they may want to consider a professional investment manager.
Anything smaller than $5 million is very difficult to manage as an individual portfolio because it would be difficult to provide them with the diversification that they would need. Most investment managers have a minimum investment management fee that correlates with their account minimum, which for example at the $10 million level, can still offer them the ability to earn a nice return, even after paying that fee. Below that level, costs can be prohibitive.
What should a captive look for when hiring an investment manager?
Michael Vandenbossche: They should look for a manager that has an experienced investment team with a demonstrated track record within the captive insurance space. Specifically, the manager should have knowledge of collateral requirements and 114 trusts, and how they impact the proper portfolio structure. expertise in this area includes familiarity with the domiciles, and knowing the captive’s managers, attorneys and other service providers within the given domicile. Additionally, the firm should have made a commitment in its infrastructure that services its captive clients, and within those structures should have a deep and knowledgeable compliance department, given the many rules and regulations to which captives are subject.
For most of our captive clients, their background is not on the investment side, so it is important that the investment manager is also a good communicator and can articulate its investment philosophy, strategy and rationale for current positioning. it is important that it can provide market education and knowledge in addition to delivering its management expertise.
What are the costs involved when a captive hires an investment manager?
Goard: A captive should only expect to pay a fixed investment management fee. there will be a custodian fee that the bank will charge, typically within the 2 to 5 basis point range, but unlike with a stockbroker, where transactions are charged on each process, an investment manager is paid on a net basis. So there aren’t really any additional fees. We charge a fee on the overall management of investments, not on a transactional basis. This ensures that we are always working in the best interest of the client. investment management costs will differ by asset class. For example, some managers charge in the vicinity of 20 to 30 basis points for fixed income. In the equity markets, we’ve seen ranges from 60 to 120 basis points, again depending on the specific equity style and vehicle (mutual fund versus separate account). Whatever the fee structure is, it will vary depending on the manager; so it’s important to discuss costs upfront.
How will Solvency II impact the role of the investment manager?
Vandenbossche: Solvency II will only affect investment managers if the captive is deemed to be under-capitalised, at which time, thegoverning monetary authority can restrict its activity. But most of munder’s captive clients are very well capitalised and, in fact, after the financial storm of 2008, we ended up seeing a number of our captive clients sending dividends to their parent company because they were overcapitalised. So we didn’t experience any problems in terms of solvency or the under-capitalisation of our captive clients.
If a captive uses an investment manager for fixed income, for example, at what point in its life cycle should it consider expanding its asset allocation?
Vandenbossche: As a captive matures, several things may begin to occur. For example, they may experience premium growth, perhaps a surplus, their liabilities may become more predictable and their time horizon for investments may become longer. While the actual investable asset size will vary across captives, in our experience, captives greater than $20 million may begin to consider expanding their allocation, especially in cases where a surplus exists. this can develop in many forms, be it expanded fixed income instruments, US equities or even international equities, or alternative vehicles such as conservative hedge funds, in the most advanced cases. While this may seem counterintuitive, adding a higher-risk security to a low-risk portfolio can actually decrease the risk of the overall portfolio, while potentially increasing overall return. This is due to the low, or even negative, correlations that can occur among certain asset classes. Obviously, these choices generally occur outside the assets that are subject to specific trust and other collateral-related investment requirements, but a good manager will plan and execute a structure suitable for their client’s needs.
What are some of the key challenges being faced by your larger, more experienced captive clients?
Vandenbossche: Once a captive reaches a stage where multiple managers and asset classes have been established in the portfolio, the greatest challenge becomes the administration and oversight of the aggregate investment portfolio structure. it becomes increasingly important for the captive plan to establish a formal investment committee, where members meet on a more frequent basis than the typical annual meeting—for example, quarterly. investment committee members focus on monitoring the portfolio to assess and confirm that the overall portfolio structure is doing what they intended, and to investigate and rectify any potential issues that may arise. With increasing frequency, where multiple managers are involved, a captive may choose to hire an outside investment consultant to assist with these more complex plans.
Do you have any concluding thoughts?
Goard: The final point we would make is that it is paramount when developing an investment portfolio for the captive to understand both what the duration of its liabilities are, and its liquidity needs. And this involves working side-by-side with the actuaries to understand their expectations for claims paid and premium flow. then, the investment manager should tailor a portfolio accordingly. in summary, having an experienced investment partner with demonstrated expertise in managing and servicing assets for captive clients is a critical component for success.
Ed Goard is chief investment officer, fixed income and Michael Vandenbossche is a senior portfolio manager at Munder Capital Management. They can be contacted at: firstname.lastname@example.org and email@example.com