In a similar fashion, the ebb and flow of the tides within the investment management industry can offer opportunities to maximize external investment.
Just as in the medical provider universe, there is a clear trend of consolidation occurring within the investment management industry. The rising tides within this industry include low interest rates, high investment valuations, and the continuing impact of the pandemic on the economy and the markets.
Consolidation has brought an important inflection point in which medical professional liability (MPL) insurers need to decide whether their investment portfolios are equipped to effectively navigate these rising waves. Putting that issue in the appropriate context involves a discussion of the changes occurring within the investment management industry, how MPL insurers can engage in due diligence to capitalize on these changes, and strategies to optimize investment
portfolios in the current market environment.
The reason for consolidation
Between roughly 1993 and 2007, the active investment management industry enjoyed a golden age as technology, low interest rates, and rising stock prices facilitated the launching of new firms and products and a significant increase in active managers’ assets under management. Then, the financial crisis not only forced many firms out of business, it also created a cost consciousness that drove a shift away from active toward passive management. That trend has continued to accelerate as active managers increasingly are losing assets to their passively managed counterparts.
The flows into passive products over the last 10 or more years have occurred during a sustained bull market that has experienced only a few instances of short-lived volatility, which were then immediately followed by market rallies. This upward trajectory has created a complacent mindset in regard to passive management that tends to overlook the risks involved in changing market dynamics. Passive management on today’s scale has yet to be tested with a sustained economic downturn and/or bear market. At the same time, the trend in asset flows that heavily favors passive management has succeeded in compressing active management models and made them more difficult to scale.
In response to these trends, asset managers are already seeking to decrease their dependence on more-established equity and fixed-income markets, and focus more on asset classes and market sectors where active management can truly add value. These include convertible bonds, other specialty sector fixed-income, hedged equity, and other alternatives. That’s why the number of money managers specializing in these areas is growing and is likely to continue to increase over the next five years. The firms currently in these spaces have a head start from a track record, personnel, technological, and expertise standpoint, and, therefore, already possess a competitive advantage over firms that are just starting out.
The implications for MPL insurers are profound. Because competition for investor assets is already heating up, as more firms crowd into this space, that competition will become fierce. That means that MPL insurers will not only have a variety of strategies and processes to
choose from but can also benefit from a thorough due diligence process to evaluate and select among the many candidates seeking to manage all or parts of their investment portfolios.
Due diligence: skill versus luck
We believe investment managers with sound investment strategies, outstanding human capital, and consistent investment process position a portfolio for improved investment outcomes. In our view, to successfully evaluate investment managers involves assessing a specific investment
manager’s potential for future success rather than focusing on past performance. That means possessing a thorough understanding of the people and process behind the numbers is a critical part of the evaluation process.
When evaluating past performance, it’s not easy to determine whether that performance stems from luck or skill. In making this determination, MPL insurers must get a handle on the risks that an asset manager assumes when executing a specific strategy and whether the strategy is sustainable over the long term. This process involves evaluating five key factors. Working through these factors in an objective way helps ensure that a company’s internal investment team and/or investment consultant team positions your manager selection process for success.
We believe there are five key factors that facilitate a qualitative understanding of a specific manager’s process and potential value-add to your investment team. Successful asset management teams exhibit these characteristics:
- Evaluating ideas within a proven framework
- Examining ideas with an experienced analyst team
- Demonstrating superior access to key investment personnel
- Relying on an objective process
- Understanding the performance cycle of investment managers
As you conduct your due diligence, we have found that the best way to proceed is with a formal qualitative and quantitative research process with an emphasis on qualitative due diligence. This process helps identify the investment manager who best fits a given mandate. Within the qualitative evaluation, incorporating core factors into your framework such as the types and numbers of professionals employed, risk management/compliance, organizational operations, investment process, investment philosophy, and performance expectations is also additive to the process.
Pre-pandemic, gathering this information usually occurred in onsite visits and face-to-face interviews with a manager’s investment management team, the executive management team, compliance officers and members of the trading teams. This process is quite adaptable to a virtual platform that includes virtual meetings and secure tools for data transfer and analysis.
When conducting your quantitative analysis, we believe there are four key questions to consider:
- 1. How were the performance returns achieved?
- 2. What risks did the manager take?
- 3. What risk and return expectations does the investment mandate have?
- 4. Did the manager adhere to its stated investment style?
These questions can be answered by utilizing a myriad of analyses. Most
commonly used are rolling period analysis, attribution/performance drivers,
discrete period analysis, style analysis, excess return profiling, peer group
comparisons, active share/tracking error analysis, and total risk analysis.
Finally, in our opinion, the best way to establish and maintain conviction in regard to your asset manager selection is to monitor consistency of philosophy and process, performance versus benchmarks and peers, performance versus expectations, and organization and key personnel stability.
Current opportunities
Fixed-income-focused investors, such as insurance companies, have experienced relatively strong market returns over the last year; however, dynamics in the fixed-income market are changing and more recently we have seen performance suffer due mainly to rising interest rates and tightening credit spreads. We do believe selective opportunities persist within certain asset classes. In our opinion, municipal bonds are attractive due to the potential higher future tax rates, the better-than-expected municipal credit profiles, and the potential of further fiscal stimulus for states. Also, the bank loan market could be additive to current fixed-income portfolios given the typically lower duration risk and the potential for adding more yield versus traditional short-term
securities.
Given the unpredictable nature of capital markets and insurance companies’ high priority of reducing enterprise-level risk, we believe diversification among multiple asset classes is likely to generate more consistent returns over the long term. To that end, we also see opportunities within equity allocations, though historically small for insurance companies, in the current market environment. Earning reports since January of this year have come in much better
than expected, strengthening our position on the attractiveness of equities. Specifically, we favor trimming any overweight positions within high-yield bond allocations, and allocating to emerging market equities (EME) and U.S. small cap equities. For EME, we believe a broader trade recovery, higher commodity prices, and the continued rollout of the COVID-19 vaccine may be tailwinds for this asset class. Within U.S. small cap, our view continues to improve due to a strengthening U.S. economy, the Fed’s reinforcement of accommodative monetary policies, additional fiscal spending, and COVID-19 vaccine rollouts.
A final word
However you allocate your portfolio, identifying the money managers within these asset classes can take time but has historically added value and, most importantly, is advisable to fulfill fiduciary responsibility.
Disclaimer:
All investing involves some degree of risk, whether it is associated with market volatility, purchasing power or a specific security, including the possible loss of principal.
Asset allocation cannot eliminate the risk of fluctuating prices and uncertain returns. Investments in fixed-income securities are subject to market, interest rate, credit and other risks. Bond prices fluctuate inversely to changes in interest rates. Therefore, a general rise in interest rates can cause a bond’s price to fall. Credit risk is the risk that an issuer will default on payments of interest and/or principal. This risk is heightened in lower rated bonds. If sold prior to maturity, fixed income securities are subject to market risk. All fixed income investments may be worth less than their original cost upon redemption or maturity.
Income from municipal securities is generally free from federal taxes and state taxes for residents of the issuing state. While the interest income is tax-free, capital gains, if any, will be subject to taxes. Income for some investors may be subject to the federal Alternative Minimum Tax (AMT).
Stocks offer long-term growth potential, but may fluctuate more and provide less current income than other investments.
Investing in foreign securities presents certain risks not associated with domestic investments, such as currency fluctuation, political and economic instability, and different accounting standards. This may result in greater share price volatility. These risks are heightened in emerging markets.
Wells Fargo Advisors did not assist in the preparation of this report, and its accuracy and completeness are not guaranteed. The opinions expressed in this report are those of the author(s) and are not necessarily those of Wells Fargo Advisors or its affiliates. The material has been prepared or is distributed solely for information purposes and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Additional information is available upon request.
Wells Fargo Advisors is a trade name used by Wells Fargo Clearing Services, LLC, Member SIPC, a registered broker-dealer and non-bank affiliate of Wells Fargo & Company.