We spoke with Vanguard to discuss the role of passive and active management within insurer portfolios. Highlights from the discussion include benefits in the core insurance general accounts portfolio, use in the surplus portfolio, and below investment grade fixed income investments.
Ilene Kelman, CFA
Regional Director – Insurance General Accounts
Vanguard Institutional Investor Group
SAA: What are the benefits of active management in a core insurance GA portfolio? What role do passive ETFs play in these portfolios?
Vanguard: Active management works well in a core fixed income portfolio. The purpose of the GA portfolio is to pay the liabilities. Portfolios vary based on the type of business the insurer writes, their surplus position, how management feels about risk, their state of domicile, tax situation, etc. In general, we find that most life insurance companies closely match their liabilities. P&C and Health companies, on the other hand, frequently have shorter-term liabilities and a significant surplus position, which gives them more flexibility. Some portfolios are managed for income, others with some component of a total return focus. Tax situations also vary, and tax management is often an integral part of managing the portfolio. So, active management usually makes sense for the overall core portfolio, with the “alpha” measured relative to how well the portfolio is performing to meet the company’s business objectives.
Passive ETFs can play a role in that they’re part of the active management strategy. Vanguard’s NAIC rated fixed income ETFs are passively managed to recognizable indices, either Bloomberg Barclays or S&P. This enables insurance portfolio managers to clearly understand the characteristics of the ETF they are buying and allows managers to employ our fixed-income ETFs as “tools”. For example, they’re frequently used to eliminate cash drag, match a duration, provide liquidity or facilitate a transition.
We also see ETFs used strategically in a few different ways. One way is for a particular allocation, such as tax exempt bonds or mortgage-backed securities, when a firm doesn’t have that expertise. Another use is as a “sidecar” bond portfolio. The idea here is that a company carves out a percentage of the core bond portfolio and builds a portfolio of ETFs to mirror the portfolio allocation. This “sidecar” portfolio can then be used for liquidity or tax management. One final example is for managing the portfolios of small subsidiaries of larger companies. This is a facile way for a parent company to address the operational challenge of managing a small portfolio and achieving adequate diversification. It also acts as an evergreen portfolio, so they don’t have to regularly replace maturing bonds.
There is one caveat, in spite of the high degree of diversification within each ETF, they are still subject to regulatory security limits. However, some state regulators will approve an all ETF portfolio for a small subsidiary of a larger company.
SAA: Why/how should insurers think of active vs. passive for their surplus portfolio? Where does Vanguard’s insurance team see active and passive used in surplus?
Vanguard: A number of our clients use both active and passive in their surplus portfolios. It comes down to a difference in philosophy. We find that insurance companies use active management where they have conviction that they can outperform.
Many insurers use a “core and explore” approach, with passive investments as the “core” part of the portfolio, often broadly diversified domestic or international equity, and then take smaller active or passive positions as the “explore” portion. These “explore” positions can be small or mid-cap, emerging markets, REITs, commodities, dividend tilts, factor strategies, etc. With a lot of recent discussion around Environmental, Social, Governance (ESG) managed portfolios, an insurer can even use a passively managed ESG portfolio as the “core” part of the portfolio with this approach.
SAA: What does the Vanguard insurance team think about active vs. passive for below investment grade fixed income within the insurance portfolio?
Vanguard: It’s an interesting question. There are merits to both approaches. The active versus passive decision here requires a conversation about the role and goals for high yield in the portfolio, strategic versus tactical use, how comfortable an insurance company feels with illiquidity and downturns, their capital position, and overall risk management approach.
Markets can constrict during downturns, and the effects can be greatly magnified in the high yield market. Since high yield bonds are below investment grade, they offer higher yields because they carry higher risks. As a result, they are more vulnerable to market events. For markets to work properly, there need to be a lot of buyers and sellers. In times of market stress, there are usually a lot more sellers than buyers, creating an illiquid environment, and this is particularly true for higher risk assets like high yield.
While the market will constrict for individual bonds, passive ETFs contain a basket of securities. Spreads will widen for the basket, as it will for the underlying bonds, but in prior downturns, trading has still occurred in these passive high yield ETFs. Unlike individual bonds, ETFs trade on the stock exchange and there are a lot more market participants to facilitate trading. It’s also worth noting that the indices these ETFs follow contain only a small subset of the high yield bond universe. The bonds in this subset are rated and are offered in larger size than most bonds that are not included in the index. This may also contribute to the higher liquidity in the passive ETF.
If liquidity isn’t a concern, active high yield may be a good option. For one thing, an active manager may find value in bonds that aren’t included in the index. In prior downturns, we’ve noticed that changes to indices often occur after the underlying companies and bonds have had problems, been downgraded, and fallen in price. An active manager can make independent decisions in these situations and potentially capitalize on dislocations in the market. So, while an active high yield strategy may contain less liquid bonds, the manager has more freedom to take advantage of opportunities and a broader universe of securities to choose from.
Source: Strategic Asset Alliance, Vanguard Institutional Investor Group
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