3 November 2016Cayman analysis

The current environment favours active portfolio management

Structurally lower returns are a concern for all market participants. Lower—and even negative—bond yields have forced investors to take more investment risk than may feel comfortable. There is little sign of this changing: despite the unprecedented policy response from Central Banks, in recent years the prevailing trend has been lower economic growth and inflation forecasts, particularly in the developed world. Central bankers have little choice but to stay the course and keep interest rates low.

There are still opportunities for returns, but selectivity is key. There can be unintended consequences even with traditionally lower risk assets. Corporate bonds may carry liquidity risks, for example. We believe it is important to have a disciplined methodology for assessing the risks and rewards of each asset (and sub-asset) class. Diversification and active management matter in an environment where returns are not easily won. Globally diversified bond portfolios can generate good returns, and there is also a place for some equity market exposure to diversify risk.

How do active and passive investment strategies compare in the current market context?
We believe that the current environment favours active portfolio management. In aggregate, markets are unlikely to make significant progress from here, with slow economic growth and relatively high valuations. The opportunities for positive returns, where they exist, are idiosyncratic and specific, and it is important to be able to take tactical portfolio positions in a proactive manner.

“We aim to ensure that our cell portfolios provide an efficient option for all cell captives regardless of size.”

Passive investing has some strengths: it is usually cheaper, for example, and investors can be sure of the type of return they can expect. However, there are a number of inherent problems with a purely passive exposure, although it may have a role in a wider portfolio. Notably, a passive strategy has full exposure to an entire asset class, which can present problems when it comes to controlling risk. It is difficult for passive portfolios to anticipate and react to market changes, such as a decrease in yields.

Investors need to understand the nuances between the two investment approaches to take advantage of each of them where appropriate.

What investment options are available for cell captives?

Low margins and small scale have seen many cell captives gravitate to exchange-traded funds, mutual funds, money market funds or cash deposits. This does not necessarily provide cell captives with the most effective investment solutions.

Cell captives have struggled to find alternative options because they are largely overlooked by investment managers. Many have portfolios of less than $500,000, and have fee constraints. Mutual funds are often the default solution, but these are imperfect, lacking transparency and potentially having hidden costs. Some have fees in excess of 2 percent; this is unsustainable when returns are likely to be lower.

We have developed a series of portfolio strategies designed around the needs of insurers and delivered as segregated investment portfolios. The portfolios in our cell captive solution provide diversification between asset classes and risk-controlled performance, along with higher levels of transparency and liquidity. They translate our evolving macroeconomic outlook into individual portfolios that keep capital preservation and liquidity at their core.

Can you tell us more about this solution?

We found many cell captives were reluctant to take investment risk, in fear of losing capital, while the existing solutions available were neither cost-effective nor efficient. We aim to ensure that our cell portfolios provide an efficient option for all cell captives regardless of size, and also to provide reassurance that investment risk can be properly managed to guard against significant drawdowns.

Our cell captive investment solution was developed in response to a client request—we were approached by an organisation managing 180 cells and were asked to find a solution to address their investment needs.

We ensure that cell captives have all the advantages traditionally enjoyed by larger captives. Our cell portfolios allow captive cells to invest in a segregated portfolio and benefit from full cost and asset transparency. We, as investment managers, actively adjust the portfolio to ensure it only takes the level of risk that is appropriate for that particular client. This allows captive boards to exercise effective governance and to adapt to changing market conditions.

We have set the minimum investment level at the relatively low level of $250,000. This allows smaller cell captives access to a customised portfolio solution at a cost that previously may have been unavailable to them. The cell portfolios provide clients with economies of scale, reducing the aggregate costs of trading and ensuring this is viable for captives of all sizes.

When building these segregated portfolios, we follow the same process that we would undertake with any other client. We ensure effective asset allocation to diversify risk and exercise portfolio construction discipline to mitigate unrewarded risk. Finally, appropriate stock selection gives our clients a good balance between capital preservation, liquidity and reasonable rates of return.

Providing this level of bespoke service can bring with it reporting complexities. We provide a state-of-the-art online reporting system, updated in real time, offering immediate and transparent access to portfolios. It is a powerful web-based investment portfolio reporting and analytics solution. This is particularly useful for group captives, or captives with multiple stakeholders. We also provide both strategic and ad hoc reporting for management on request or at period end.

What do the next 12 months hold for the cell captive industry?

The captive market has proved dynamic and is seeing rapid growth. There are now almost 7,000 licensed captives, spread across more than 80 jurisdictions. Small captives have led the charge.

We believe this trend has momentum and expect it to continue. In particular, we expect to see the formation of a greater number of cell captives where traditionally standalone captives have been used, simply because the regulatory burdens being placed on captives are increasing.

As the market develops, we believe they will increasingly look to institute more robust investment options, and London & Capital will be there to help.

How has London & Capital’s specialist captive investment management division evolved?

Since its inception in 1986, London & Capital’s defining investment philosophy has been to focus on capital preservation and risk management when building its portfolios. From the outset, this has been well aligned with the needs of captive insurers and we established our captive investment management division in 2006.

This division now has around $1.1 billion in assets under management (AUM), approximately one third of the company’s total AUM. It is a significant and important part of our business. We bring our wealth management pedigree and investment skill together to build and service segregated portfolios designed with the needs of captive insurers in mind. Client service was, and remains, the foundation of our offering.

Lisl Lewis is executive director and head of Caribbean at London & Capital, based in Barbados.