Strategic equity allocation considerations for insurance companies in 2024

Research shows that captive managers should make strategic equity allocation stocks the cornerstone of their company’s equity portfolios, says Carl Terzer of CapVisor.

In the realm of insurance company equity investment portfolios, the allocation to large cap stocks serves as a cornerstone and often takes precedence as the primary allocation to risk assets. This strategic positioning is well-founded, considering the undeniable advantages of US large cap stocks from perspectives of both return and risk.

“Optimising asset class combinations can yield superior long-term investment results.” Carl Terzer, CapVisor

To delve into the rationale behind this allocation strategy, we conducted a thorough analysis of return and risk across various US stock capitalisation categories, namely large, small and mid cap. Our analysis, spanning the past decade up to December 31, 2023, employs exchange-traded funds (ETFs) as investable proxies for these capitalisation buckets:

• SPY for large cap
• IJH for small cap
• IWM for mid cap

These ETFs are style-agnostic, passive instruments mirroring the S&P 500 index, Russell 2000 Small Cap index, and S&P MidCap 400 Index, respectively.

Return analysis

Over the specified period, large cap stocks demonstrated significant outperformance when compared to both mid and small cap stocks, as illustrated in Figure 1.

Figure 1: Ten-year performance of large, small and mid cap stocks 

Risk analysis

To ensure a fair comparison of risk characteristics, we standardised the assessment using the S&P 500 index as the common benchmark for risk statistics. The resulting heat map, shown in Figure 2, emphasises that large cap not only exhibits superior nominal returns, as shown in Figure 1, but also offers superior risk-adjusted returns.

Figure 2: Ten-year returns of large, small and mid cap stocks

Diversification

While some argue for the inclusion of small and mid cap stocks to enhance diversification and mitigate overall equity market risk, our analysis indicates that over strategic time horizons (five or 10+ years), mid caps show a 96 percent correlation to large cap stocks, and small caps exhibit a 91 percent correlation. Asset allocators typically consider 80 percent correlation or less as the threshold for an asset class to be a meaningful diversifier.

Attempting to capitalise on diversification benefits over shorter time frames requires accurate and consistent calls on which capitalisation segment will outperform—a challenging task.

A look ahead

Looking beyond the historical performance, we used regression analysis, aligned with long-term capital market assumptions, to project future returns for large cap stocks. While past performance informs expectations, it is crucial to recognise that markets do not always repeat themselves, and reversion-to-mean is an eventual reality (Figure 3).

Figure 3: Starting price to earnings ratio of the S&P 500 is a strong predictor of the next 10-year return

Multiple sources of Wall Street research suggest that large caps are poised to maintain their dominance, particularly from a risk-adjusted perspective. Strategic adjustments to insurance company portfolios may be warranted, with an emphasis on viewing risk and return across asset classes.

Optimising asset class combinations can yield superior long-term investment results. As a sample consideration, we introduced a Europe, Australasia and the Far East allocation, highlighting the potential need for diversification beyond US stocks.

Carl Terzer is the founder and principal of CapVisor Associates in Gainesville, Georgia. He can be contacted at: carl.terzer@capvisorassociates.com