In Part I of this series, we asked several key questions you should be asking now about your insurer’s investment portfolio. In Part II, we conclude with key questions that go beyond the greatest investment challenge faced by insurers in thirty years (low rates for longer):
Should the change be strategic or tactical?
Let’s assume you have decided on a course of action in order to improve your company’s portfolio despite ‘lower rates for longer’. You know what you want to do, but should you make this change strategically or tactically?
Using a strategic viewpoint, your change will be based upon a long term view. It will be discussed carefully amongst senior management and the Board, and will typically require Board/Investment Committee approval. You will be able to execute this change carefully, over time, monitoring progress to putting the change into place. This is the typical scenario for most, if not all, of the investment decisions made by insurers.
However, if this change is a tactical one, you will want to set specific parameters around which you will (and will not) execute the change. Many of these parameters may have to do with more changeable variables, like financial market conditions, interest rates, spreads, etc. You will want to execute this tactical change only when it looks to be advantageous and you will want to exit this change when things appear disadvantageous. Alas, a tactical change requires a very active approach that requires active management – something that most insurers do not employ internally. More importantly, without setting specific ‘triggers’ for exiting the position or delegating this to the external manager, many insurers will find it difficult to successfully exit (let alone enter) a tactical trade. This is primarily because most insurers’ investment processes are geared to making strategic not tactical changes.
Do we have the right investment manager to execute the strategy?
Gertrude Stein said, “A rose is a rose is a rose.” However “a fixed income manager is NOT a fixed income manager is NOT a fixed income manager.” Different managers take different biases into their approach to the fixed income market. Thus, even for a change in strategy that is limited to investment grade bonds, it will be important that your investment manager can successfully handle that change.
For example, let’s say your strategic change is to deemphasize corporate bonds and emphasize structured securities. I can tell you from experience that I would feel very comfortable with several managers for this change, but would be more than uncomfortable for others.
Know what your manager can do really well and not so well, before asking them to be part of the change in strategy.
Do we have the right benchmarks?
First, if you are using the Barclay’s Aggregate Index, immediately make the change to a more customized benchmark that is more yield oriented than the heavily government/agency weighted, low yielding Aggregate Index.
Next, realize that whatever benchmark you choose it must be directly related to your company’s preferred asset allocation. Thus, it must reflect this change in strategy. If not, you are asking for the investment manager to beat a meaningless benchmark.
And, ask your manager to prepare a performance attribution analysis that compares actual to benchmark performance and answers the ‘whys’ behind performance. For example, was it interest rate decisions, yield curve shifts, sector or security decisions that really drove performance?
Finally, always remember that an investment manager’s primary goal is to get your business and his/her subsequent goal is to keep your business. Everything else feeds into those goals. Thus, he/she will always want to stay close to the benchmark construction. And that means understanding how your benchmark is impacting manager behavior, may be the most important part of managing your investment manager.
Do the current investment strategies dovetail with the Board’s/senior management’s risk appetite?
When all is said and done, no investment strategy is worthwhile if it does not dovetail with your company’s risk appetite.
Take a look at long term ‘drawdown’ studies to see how bad your ‘preferred’ asset allocation has performed in the past. If the Board and senior management are in concordance with those expectations on the downside, you have the beginnings of an agreement on risk appetite.
Obviously, many of these questions apply to your company’s investment process, even if you do not make a change in strategy (and even ‘no change’ is a decision that must be analyzed as carefully as any proposed change). A careful, step-by-step approach to understanding how your company will meet its greatest investment challenges is a must in these uncertain times.