By Ken Johnson, CFA, CAIA, FRM, Vice President, A.M. Best.
Headlines reflecting the recent underperformance from the hedge fund industry have caused insurers to rethink their current investment allocations, and whether or not to add allocations to this non-traditional asset class going forward. However, the ongoing low interest rate environment and more recent equity volatility have added a complicating factor to not being exposed to hedge funds in some manner.
Many believe that insurers jumped into the alternatives arena more heavily over the past few years in an effort to boost returns through taking on additional credit and liquidity risk. However, exposure to alternatives, including hedge funds, also represents a prudent portfolio allocation for those companies with the ability to trade off some liquidity while improving overall portfolio diversification. Hedge funds have the potential to add incremental return to the portfolio and the ability to reduce volatility and downside risk.
However, whereas in the past this allocation was primarily a tool for investing “excess” surplus, many hedge fund portfolios are now allocated to back specific lines of business and, therefore, the variability of returns receives heightened exposure each quarter. For example, in Voya Financial Inc.’s (VOYA) recent 1Q16 earnings release, the following segments were all negatively impacted by the performance of alternatives: Retirement, Annuities, Investment Management, and Individual Life. Clearly, VOYA is not alone as many insurers have alternatives, including hedge funds, backing specific lines of business and have suffered the same negative impact. MetLife Inc. and American International Group, Inc. (AIG) specifically stated their desire to substantially reduce exposure to hedge funds, with one reason being the volatility they have added to operating results.
The hedge fund industry saw outflows of $15.1 billion in the first quarter of 2016. This is from an industry whose market is estimated at roughly just short of $3.0 trillion and, therefore, the outflows represent only approximately half of one percent. In addition, 1Q16 marked the first two quarters of consecutive outflows for the industry. As a whole, the industry lost about 1% in 2015 with some managers down double digits.
The road ahead for hedge funds looks rocky as well given the current global economic environment. The United States faces slow growth and, globally, concerns remain around the uncertainty of central bank policies. Even the discussion around a potential Brexit adds heightened uncertainty.
In addition, what seems to have also hurt performance is the traditional issue of too much money and too many managers chasing the same finite opportunities. Also, the proliferation of hedge funds, 10,000+ strong, has made finding skilled managers a more difficult endeavor. Finally, the fee structure of “2 and 20” is having an impact given the low single digit returns for the industry. Many larger institutional investors have been able to whittle those fees down a bit but they still remain outsized given the more recent performance.
A few large public pension plans, which generally allocate close to 9% of their portfolios to alternatives, have already backed away from this market over the past few years. We now see the insurance industry, allocating a more modest 5% or so of alternatives, backing away from hedge funds as well. AIG announced plans earlier this year to reduce its $11 billion portfolio by roughly half. MetLife said in its first-quarter earnings call that it would reduce its roughly $1.8 billion allocation to hedge funds by an estimated $1.2 billion, down to approximately $600 million. Finally, Lincoln National Corporation, with a much smaller portfolio, will be modestly increasing its below industry average alternative portfolio but with more of a focus toward private equity.
As for the use of proceeds from this “run” on insurers’ hedge fund portfolios, although some of it may find a home in other alternatives such as private equity or real estate type exposure, we would expect most to go back to more traditional investments such as investment grade corporate bonds and/or commercial mortgage loans and common stock. Obviously, this only makes more dollars chasing a crowded investment set, potentially further squeezing already tight insurer returns. So while most hedge fund investors in the insurance space are disappointed, and justifiably so, there just aren’t many other attractive alternatives for them to invest in this current low-return environment.
The persistent low interest rate environment has continually challenged companies to find solutions to improve earnings, particularly publicly traded entities. There the industry speaks to a renewed focus on underwriting or managing expenses tighter and away from using the investment portfolio. However, many companies have already used the well-worn lever of
tightening the belt around expenses since the financial crisis of 2008-2009. A. M. Best does not believe there is significant excess in current expense levels that have not been wrung out of the system to date. In addition, the ongoing need to fund rising compliance and technology costs, including cybersecurity measures, makes it more unlikely that attacking expenses is a panacea to investment portfolio shortfalls. With respect to a renewed focus on improving underwriting, the competitive landscape will provide strong headwinds to implementing a successful strategy.
On the bright side for hedge funds, the HFRI Fund Weighted Composite Index was up 1.0% in April, lifting 2016 performance to 0.3%. The HFRI Asset Weighted Composite Index was up 0.2% for the month as well. However, this follows a few years of sub-par returns, particularly against a broader S&P indexed return. Overall the hedge fund industry remains resilient and perhaps today is more flexibe than in the past. This includes, for example, stepping into the void the banks created by backing away from certain types of lending. With this, A. M. Best still believes we may see a further pullback from direct investments in hedge funds over the short-to-medium term as companies try to ride out the volatility on the sidelines.
Top 10 Trends in Insurance for 2016 (March 2016)