Captive investment: what goes down, must go up
While the conventional wisdom is that “what goes up, must come down”, the stock market usually acts in the opposite way. Investors’ comfort level and reactions to stock price movements are frequently at cross-purposes with logic as well. Let’s delve into these hypotheses.
After 34 years of managing money, I have observed that whether you work with institutional investors, captive insurance companies, or individual investors, all decisions are ultimately made by individuals. Additionally, individuals are emotional creatures, and their decisions with respect to investments are not always timely—or even rational.
I made the following observations while discarding old copies of The Wall Street Journal. I came across the headline from the May 20, 2022, issue: “Eight stocks lead the downturn”.
The article noted that former high flyers Apple, Microsoft, Amazon, Alphabet (Google), Meta (Facebook), Tesla, Nvidia, and Netflix were responsible for almost half of the entire S&P 500 index’s 17.2 percent decline in 2022 to that date.
Those companies are so big that they accounted for over 25 percent of the entire value of a 500 stock index, meaning the other 492 stocks accounted for 75 percent. The fall from grace was stunning: Netflix down 70 percent, Meta and Nvidia down 42 percent and the others down between 23 and 36 percent. Yet these were the same companies that helped drive the market to its highs in 2020 and 2021. And these are the same stocks that took the S&P up in 2023. Table 1 shows these high flyers’ performances in 2021, 2022, and 2023.
These are extreme examples of the volatility of mega-cap stocks and how beneficial or detrimental they can be to what many consider to be diversified indices such as the S&P 500.
Consider this example of “rational” and “irrational” behaviour: a person is window-shopping on his walk to work and sees a beautiful coat in the store window priced at $1,000. He rationally decides to think about it before buying. Later that week, there is a sign in the store window “25 percent off everything” so he decides to buy the coat for $750, feeling good about the purchase of a new coat at a discount price.
I would make the argument that many people frequently act irrationally when it comes to investing. I find that a large percentage of investors feel more comfortable buying stocks when they (and the overall market) are making new “highs” and conversely they want to sell—or NOT to buy—when share prices have fallen, the market is down, and stocks are literally “on sale”. Investor Baron Rothschild once said: “The time to buy stocks is when there is blood in the streets.” When things look terrible and everyone is selling, a rational investor should be buying.
While captive insurance companies avoid a lot of this emotional investment decision-making with managed money, there is the ever-present human element which questions the captive’s strategies when the markets pull back. Going back to our hypothetical shopper, it is as if our smart shopper walked by the coat store a few days later, but instead of being discounted, the $1,000 coat was now $1,200 — and his reaction was to run in and buy it at $1,200 before the price went any higher. This kind of buying behaviour has been commonplace in hyper-speculative assets such as cryptocurrencies.
There are several important ways we can remove this basic human nature (as much as possible) from the captive’s investment decisions.
“A steady, seasoned financial advisor can help navigate the roughest of seas in the stock and bond markets over the long term.” Jack Meskunas, Oppenheimer & Co.
Work with seasoned professionals
When working with seasoned professionals — individuals with decades of experience — a captive’s owner/s can take some comfort in knowing that their financial advisor has likely seen it all in the markets. These professionals have lived — and invested — through multiple bull and bear cycles, as well as recessions, rising and falling interest rates and economic booms and busts. A steady hand on the tiller is needed to guide a captive’s portfolio through rough waters and volatile markets.
Know what you own and why you own it
Anyone who has heard our chief strategist John Stoltzfus speak on the markets has heard him remind investors that they need to know what they own and why. While it may seem obvious, it is often difficult to know “why” you own something when it was selected by a financial advisor or money manager.
Utilising money managers is undoubtedly the best strategy for captive asset management, but keep in mind the experience and tenure of the financial advisor overseeing these managers. I call it “managing the managers”, as the financial advisor must be seasoned and able to keep a steady hand over the captive’s portfolio, as well as explain what the captive owns and why to the managers and owners of the captive.
I would make the argument that industry leaders such as the companies in the table above were just as good and successful in 2022 as they were in 2021 or 2023. The only thing that changed was the share price. A good financial advisor would have advised clients to put assets into information technology, semiconductors, etc, in 2022 to take advantage of the metaphorical blood in the streets.
Update your IPS
The Investment Policy Statement (IPS) is the business plan of the captive investment strategy. I have seen great ones, terrible ones and lots in between over the years. Just as a hiker needs a map to navigate, a captive needs an IPS to let the financial advisor and asset managers know the “path” they are willing to take, the risks they can endure, their anticipated needs for cash and if there are constraints with which the portfolio must comply.
The IPS should be a living document that is updated with some frequency and consistency. While the document shouldn’t be changed multiple times a year, it should be reviewed yearly and updated as necessary. I feel every two to three years to align with normal business cycles is appropriate for a deep dive into the IPS, making tweaks that support the current market environment and outlook.
Know when to change horses in the race
One of the most difficult decisions a captive faces is knowing when to “change horses”, meaning when it is time to change the asset manager, or financial advisor overseeing the asset manager. These decisions should not be taken lightly or capriciously, nor should they be made because of a bad quarter or year—specifically if the overall investment climate was difficult, as in 2022.
When a captive underperforms its benchmarks significantly, or experiences volatility or illiquidity in otherwise normal markets, it is time to do a deep dive on your managers and advisors. I have done scores of portfolio reviews, and as with the IPS, I have seen the good, the bad, and the ugly.
I find that many captives do not know what they are actually paying for in their management fees. For example, managers that utilise mutual funds and exchange traded funds generally do not consolidate the fees that exist in the underlying funds. A firm may state it is charging 50 bps for management, only for you to discover after much digging that it is using sub-advisors charging another 45 bps. Add fees for legal, reporting and custody, and all of a sudden you realise the 50-bps management fee is actually 1 to 1.5 percent per year.
While not every stock that goes down must come up, the world’s best companies will “revert to the mean” of their performance. A steady, seasoned financial advisor can help navigate the roughest of seas in the stock and bond markets over the long term as well as work within the confines of the market and the IPS to best allocate a captive’s assets.
Captives can benefit by exercising caution while not turning a blind eye to their portfolios or their advisors and managers. While a long-term investment outlook is important, short and intermediate-term analysis is also vital to keep the captive’s portfolio on track.
Jack Meskunas is executive director–investments, and captive insurance asset management advisor at Oppenheimer & Co. He can be contacted at: firstname.lastname@example.org.