Return is harder to find than ever, forcing insurers to delve even deeper into alternative assets, such as infrastructure debt, according to investment managers in the conclusion of Best’s Review’s annual roundtable.
- Jeff Roberts
- January 2020
CONSTRUCTING OPPORTUNITIES: Asset managers and their clients are investing in private assets, such as infrastructure debt, private equity and securitized assets.
- Big Risk: The downgrade risk of BBB investment-grade assets could have far-reaching capital implications.
- More Outsourcing: The trend of outsourcing to external asset managers continues to grow as insurers delve deeper into complex alternative assets.
- AI Investing: Insurers are discussing and even experimenting with artificial intelligence-driven investment strategies.
The risks seem to keep growing.
Low interest rates. The potential downgrade of BBB assets. Even the risk of overreaction.
So where are the opportunities?
“There's a lot of levers that still can be pulled,” said John Simone, managing director and head of the Insurance Solutions Group for Voya Investment Management.
They mostly fit under the umbrella of private assets, such as infrastructure debt, private equity and securitized assets.
Simone was among the experts participating on a Best's Review roundtable, discussing the search for yield while remaining aware that the end of the economic and credit cycles looms closer each day.
This year's panelists—Simone; Alton Cogert, president and CEO of Strategic Asset Alliance; and Jeb Doggett, managing director with Deloitte Consulting and a founding partner of Casey Quirk—discussed overall investment trends for insurers, the potential downgrade of BBB credit and the rise of artificial intelligence in investing.
Which market risk most concerns you entering 2020?
Simone: The big risk is the potential downgrade risk of BBB rated debt. That will cause a capital impact to insurance companies. It doesn't necessarily mean they'll lose money, but it can provide some level of capital impact with the amount of BBB credit that's out there. Do we feel there's an impending BBB crisis? No. But that is something that we think about.
Equity volatility is also something that raises a level of concern. Insurance companies typically don't own a lot of public equity. They favor private equity because it's less volatile the way its values are struck. But that is something people need to be cognizant of.
Cogert: You have all the macro risks [credit risk, liquidity risk and equity risk]. From an individual company standpoint, I would say the risk is one of overreaction. “Such and such is happening, and we have to move in this direction with the portfolio…” Do what's best for the company's business, irrespective of some of the noise that's going on short term.
What asset classes do you expect increased allocations in through 2020?
In general, insurance companies have made significant investments in data scientists and AI capabilities, primarily to drive their core insurance business. Some of those capabilities are now being redirected to augment their investment capabilities. But it’s still early days.
Simone: One of the obvious things that we've seen is a trend toward private assets. And that takes the shape of investment-grade private assets, meaning private placements or infrastructure debt; of investment-grade private credit; and below investment-grade private credit. Obviously we're extremely cautious there because a lot of money has flown into that market from not only insurance investors, but more so from traditional institutional investors.
There's a lot of [business development companies] that are forced to own middle market loans, and they're causing spread compression. We therefore believe investors need to be careful in making sure they are getting paid for the risk they are taking. But there's definitely opportunities within that market that we're being very selective around. Also investment-grade commercial mortgage lending is still something that has a very strong bid for folks who want longer duration core-type assets or even medium-term duration core assets, just given the quality of those assets. The case is the same with what we call core-plus or light transitional assets in the commercial mortgage lending space. We've seen spreads come down, but they're still attractive relative to public corporate credit. That's a theme that will continue into the new year.
We've also seen a tremendous amount of securitized [loans] going into collateralized loan obligations, both very high quality CLOs—and that's a function of folks using Federal Home Loan Bank borrowing lines to invest in floating rate CLO paper. We actually feel that investing in CLOs definitely makes sense, but also we feel that in order to weather various cycles, you really need to be more diversified in securitized. So we're seeing a lot more people interested in conversations about more diversified securitized mandates. We're going to continue to see that trend. It's also a great diversifier from just being in long corporate credit.
For instance, if you're investing in asset-backed securities, you're betting on the U.S. consumer, whose balance sheet is actually less levered than corporate balance sheets. Whereas if you're just investing in CLOs, you're really still along that corporate balance sheet, and we think you should be more diversified. So that's a big trend that's going to continue, especially given some of the structural advantages of investing in securitized [assets] and also the improvements in structure coming out of the lessons learned from the 2007 financial crisis. It's not the same securitized market of yesteryear.
And frankly, there's also private credit, private debt that's higher octane, whether it's private equity secondaries or mezzanine. Investing in say infrastructure, that's something that we're really focused on ourselves because we feel renewables specifically are more recession-proof and also generate attractive double digit-type returns. So that direct infrastructure mezzanine space as well as private equity are areas that we're focusing on.
Cogert: All other things being equal—and they never are equal—I would focus on the quantity and quality of cash flow and/or income that an individual investment will provide, and of course how it fits into the portfolio on a correlated and uncorrelated basis. The kind of assets that throw off cash and then income. Those become more and more attractive in a low rate environment.
What asset classes do you expect investors to avoid through 2020?
One of the obvious things that we’ve seen is a trend toward private assets. And that takes the shape of investment-grade private assets, meaning private placements or infrastructure debt of investment-grade private credit and below investment-grade private credit.
Voya Investment Management
Simone: We always advise folks that if the strategy can't be explained in the time it takes to go up a couple of floors in an elevator, then you may want to stay away from it. You really need to understand the source of return in any particular strategy.
The one area that we caution folks about is going blindly into any asset class based on yield or structure. An example would be stay away from ideas that look capital efficient but really shouldn't be. For instance, a lot of strategies have been packed into structured notes and equity. Collateralized fund obligations are an example. We caution that the strategy might have a very attractive capital profile, but have you underwritten to the underlying risk of the assets being wrapped in that structure? Make sure you know what that return is because if you lose that capital structuring advantage, you might owe something that has a lot higher charge than you originally thought. So be cautious of structure, of what's the source of return.
Another area where you need to be cautious is middle-market lending, as an example. We look at everything in a relative value way. There's so much money poured into areas of the infrastructure market, areas of the middle market, where they're really not getting paid for the risk that they're taking. So know what you're getting into. And partner with somebody who really knows the underwriting and ideally who has some skin in the game.
Cogert: Investments where there are high fees involved. If you're in a low-return environment—every year when we do our asset allocation analysis, it seems expected returns on asset classes keep going down. It's crazy. For example, long-term projections on U.S. large cap stocks: In the next seven to 10 years, expected return is about 5%, which is about 2% to 3% more than you get on investment-grade fixed income, which of course has a lot less volatility than the stock market.
Compare that to investing in some of those alternative asset classes, which promise the moon and sometimes don't give it to you—asset classes like hedge funds that typically will charge 2 and 20—a 2% fee plus 20% over a hurdle rate.
I don't get it. In that type of environment, you could be taking a third or more of your expected return and paying it to an investment manager irrespective of how the investment performs. It boggles the mind. Why would you do that? There's always better, more cost-effective investments.
Are insurers continuing the trend of outsourcing more of their assets to external asset managers, especially for alternative assets?
Cogert: All the numbers we see indicate it just continues to slowly increase over time. Financial markets have gotten more and more complex over time. And that's only going to continue. That puts a strain—from a competitive standpoint—on the investment departments of the internally managed companies.
It's almost always cheaper to pay folks as employees than going out and hiring an active investment manager because the external manager has its own profit goals. But the problem is one of expertise, availability and knowledge of the market. The big investment managers know the market really, really well. How can internal management compete with that? And if you're not in a money-center city, how do you get the best people?
The increased complexity in the markets means that different asset classes arise. That expertise, a lot of times, is not internal to your staff, and you then have to go with some kind of external mandate.
Doggett: The largest firms have very little to zero assets that are outsourced. It is the medium and small firms that outsource. But it's not a huge bonanza. It's slow and more in the alternative, higher-yielding assets and capabilities they don't consider their core competency, like emerging market debt and privates.
About half of the firms we speak to either have a third-party asset management business or are considering building one. The idea is that the needs of pensions and the foundations and endowments are aligned with the insurers' core competencies in private fixed income and real estate.
If insurers can provide those capabilities to third-party investors for a fee, they can reduce the effective cost of running the general account. Or if they can build a meaningful asset-management business, they can build enterprise value and drive cash flow in excess of what they earn on investments.
Do artificial intelligence-driven investment strategies have a role in industry investment practices and are they growing?
Simone: From our perspective, we're using robotics within various processes to reduce costs associated with managing money, which in essence translates into better outcomes for our clients.
We have a lot of robotic initiatives going on at Voya to speed up processes. To the best of my knowledge, we don't use AI in managing equities at this particular point. But that is something that we're definitely thinking about.
Doggett: In general, insurance companies have made significant investments in data scientists and AI capabilities, primarily to drive their core insurance business.
Some of those capabilities are now being redirected to augment their investment capabilities. But it's still early days. Relative to some of the independent asset managers, insurers have made a fairly significant commitment. The exception would be the independent quantitative firms. They are in a different league.