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The Changing Nature of the Investment Business 
Change is not always a good thing. Inertia can be good where it keeps us from making poor decisions. However, inertia is being overcome every day in the investment business. Here are a few examples:
1. Hedge funds continue to grow like wildfire, despite their inherent problems for many insurers. The latest number was $2.5 trillion invested in hedge funds.
2. Private equity continues to grow as well at a pace never before seen. Commitments from investors to private equity funds were over $650 billion in 2006.
3. Credit derivatives now have achieved notional amounts over $20 trillion with $33 trillion expected to be reached by 2008 (by the way, these forecasts from the British Bankers Association have traditionally been exceeded by reality).
We have yet to see a good study of how each of these and other phenomenon are changing the structure of the investment business. However, we can certainly begin to see how these changes to the investment business are changing the practice of investing for insurers.
Hedge funds are increasingly being considered as alternatives by insurers even in the 1-5 billion range (and some smaller companies have been prodded to invest as well).
We have seen instances where individuals relied upon by traditional investment managers for insurance accounts, have gone on to the greener (higher fee) pastures of hedge funds. So, there is indeed a brain drain of some kind occurring.
But, most importantly, hedge funds will cause us all to rethink investment risk and exposure. Our portfolios are not merely a mix of investment exposures (not simply asset classes like UST, MBS, etc.); but a series of interest rate (duration), prepayment (convexity), credit, market value and other risks. All of these risks must then be balanced against expected return, as well as other risks (some the same, others not) on the liability side of the balance sheet. Once again, the importance of DFA, ALM, ERM or whatever initials you like to use.
Private equity funds are growing largely because of two major phenomenon:
1 - Greed: Management of public companies have found it’s better to switch than fight in many instances and reap the rewards of going private than public.
2 - Aribtrage: The cash ‘yield’ expected from equities is greater than the cost of debt. And, when you lever the acquisition at the company level with more leverage at the private equity fund level, the expected return return on investment rises considerably (so does the risk).
Their impact on our portfolios include:
- Taking public companies out of play and causing numerous downgrades of corporate bonds when the issuer was previously investment grade.
- Additional returns on the equities of those companies.
And, where do the Private Equity funds get most of their financing nowadays? Don’t ask their banker. Nearly 3/4 of new financing is done the institutional route via CLO’s and part of the ease of such financing is due to the rapid use of credit derivatives (CDS) to diversify risk for the investors in these CLO’s. Put another way, the rapid rise of the CDS market has meant that investors can now take idiosyncratic credit risk (related to one or a few credits) and diversify sufficiently to reduce most of the credit risk to systemic risk (having to do with the overall credit risk of the economy).
The impact of the credit derivatives market on our portfolios include:
- More efficient pricing of credit risk and, with it, tighter spreads on corporate bonds (though that is not the only reason for spread tightening).
- That means it’s getting more difficult to find securities that compensate us sufficiently for credit risk. The key question here is: "At what point do we say there has been a paradigm shift in corporate bond spreads, due to structural changes in the investment business and at what point is the spread tightening just due to excess liqudity in the market which would be sopped up in a problemmatic environment?" Try running that one by your investment manager and getting a well reasoned, thoroughly researched answer.
We don’t mean to belabor the point, but these are just a few ways these three changes to the investment business are directly impacting the investment process of insurers. There are other areas of the business that are changing and other impacts on our investment process.
However, the key question is this, "How should your company’s investment process (strategic asset allocation, DFA/ALM, risk management, benchmarking, portfolio monitoring, performance measurement, etc.) be reconsidered in light of these changes?"
Your comments and questions are much appreciated.
Thank you.
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