11 March 2020Asset management analysis

Captives urged to sit tight amid equity market volatility

On March 9 equity markets suffered some of their worst days of trading since 2008, leaving captives with large equity positions in their investment portfolios facing the prospect of heavy losses.

Captives with the majority of their investments tied up in bonds will be in better shape, but even they will be feeling some pressure. The flight to safe assets has squeezed yields to almost nothing, while in the corporate credit market investment managers will be watching for downgrades that could lead to losses.

The real carnage, however, has been in the equities markets. Concerns about oversupply in the oil market, combined with those around the coronavirus and questions about its impact on the global economy, have caused large scale panic selling. Captives, and other investors, saw the value of their equities positions plunge.

Longer term investors may feel relatively sanguine, believing the market will eventually rebound. But captives that secured letters of credit, using their investment portfolios as collateral, could face margin calls if those portfolios have large equity positions that are now underwater.

Hugh Barit, chairman and CEO of PRP Performa, told Captive International energy and financial institutions look particularly vulnerable, especially some of the smaller regional lenders that have seen their net interest margins collapse.

“When talking to clients we always stress the risks associated with equities,” said Barit. “With equities you need to think on at least a three, if not a five year time horizon. If you have a longer time horizon equities are great but if you are thinking about how the portfolio will look in one year you are better off with a bigger allocation to fixed income. You don’t want to be in a position where you become a forced seller in a distressed market, like we see today, because you need to free up liquidity.”

Barit urges captives to be patient, where possible, to wait for normality to return to the market. “The hope is that clients do not have to realise losses by selling in this market,” he said. “But every captive should use this as an opportunity to reevaluate their asset allocation and perform a stress test on their portfolios to ensure they are positioned appropriately from a risk perspective.”

Selling is not the only activity Barit discourages right now. Captives should also avoid the temptation to pick up what may look like discounted stocks.

“Now is not a buying opportunity, there is too much uncertainty in the market still,” said Barit. “It will most likely be a few months before we would advise that clients take the opportunity to buy more equities.”

While traders that correctly call the bottom of the market will stand to make considerable returns, the chances of getting the call right are low, he said.

“Market timers are wrong 90 percent of the time,” explained Barit. “Our focus is on getting the right strategic asset allocation, with a bit of tactical positioning over the top. We have been underweight equities for a long time, which has actually hurt us in terms of returns. But we have been worried about this kind of correction and for us, and for captives generally, it is all about risk adjusted returns.”

He stressed captives should see their investment portfolios as a way to protect capital, not speculate to generate higher returns.

“For captives, priority one is capital preservation and priority two is liquidity,” said Barit. “If you get both of those right, then you can think about returns.”