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Navigating markets, new risks, and policymakers’ behaviour – new initiatives for the modern portfolio manager

Since the 2008 financial crisis, institutional market participants have become much more heterogeneous, while drastic new risks have emerged across most key angles such as markets, regulations and policyholders’ behaviors. In that respect the few initiatives detailed below by Aymeric Kalife, Associate Professor at Paris Dauphine University may enhance customers’ wealth (through lower fees and more tailored solutions) while improving the financial and insurance industry’s efficiency.

Strengthen long term partnership with clients fitting Risk Appetite and constraints within rapidly changing market, regulatory and policyholders’ behavior patterns

Since the 2008 financial crisis, institutional market participants have become much more heterogeneous: some have higher risk tolerance, a longer time horizon, and are willing to take on an illiquidity premium (e.g. by investing in real estates, infrastructure assets); others are intolerant of any large drawdowns and are looking for some downside protection at a reasonable cost. The rapidly changing regulations had also a drastic impact on the asset selection or ALM strategies (e.g. the variety of treatments across asset classes under Solvency 2). Besides, the drastic and persistent decrease in interest rates has significantly increased the differentiation across insurance companies in the management of their liability risk profile and wealth consumption over time.

As a result institutional investing needs to know clients’ risk appetites and liability structures to customise an adequate asset selection, asset allocation, and risk mitigation strategies, whether they seek income or yields or some downside protection at a reasonable cost. In that respect, customers’ investment decisions are strongly influenced not only by their profitability (earnings and value), risk, capital, liquidity targets under various accounting frameworks (IFRS, Solvency 2), but also by the evolving risk profile of their liabilities portfolios, which depend on their design combined with policyholders’ behaviors and longevity.

As a matter of fact, sudden and significant changes in policyholders’ lapse and use (partial withdrawals, election rate) of Variable Annuities and General Accounts since the 2008 crisis had drastic negative impacts on earnings for most insurers, which required a proper identification to activate mitigating actions through customised asset selection or allocation and ALM strategies. Knowing the specific risk appetite and time horizon of insurers was also key to properly fine-tune the design of the managed volatility funds and CPPIs funds and thus to mitigate at least partially the market spikes during February and October-December 2018. Knowing the structure of the liabilities’ cash flows and their embedded policyholders’ optionalities has also been necessary to properly select the hedge assets’ portfolio and set the portfolio rebalancing triggers based on ALM and market volatility criteria.

Different metrics may be used in that respect: liability capital intensity and capital requirements, liabilities’ financial wealth consumption, liquidity stress tests, duration gap, and policyholders’ behaviors’ degree of rationality, stress tests of liabilities’ assumptions. Regular teach-ins would raise clients’ awareness about new investment or protection asset opportunities.

Ultimately, comprehensive products with advice and strategy solutions that fit clients’ needs, time horizon and constraints (e.g. capital requirements, liquidity, policyholders’ behaviours), combined with careful monitoring are required in order to build long term partnerships across rapidly changing regulatory and investment environments while taking into account policyholders’ behaviours.

Enhance research monetisation through customer centric solutions through tailored cash and derivatives solutions that leverage on fundamental research

Institutional investors who refer to a collection of demanding investors with specific portfolio structures and durations or risk types (strongly nonlinear market risks, liquidity, policyholders’ behaviours, longevity) are likely to use “sophisticated” portfolio management metrics or techniques for the asset selection and asset allocation (factor analyses, asset cross correlation and co-integration).

As the fee for institutional investors is based on the value of the client’s account, risk management or ALM techniques and derivatives can be used to protect generated revenues, all the more is given to the rapidly changing gap between asset and liabilities within the persistent low interest rate environments and the market corrections at multiple times throughout the year. There, again, the expertise and experience of the liabilities’ product design including their evolving risk profiles and wealth consumption patterns, combined with the policyholders’ changing behaviour, are key to mitigate the risks in a robust way, using smoothed cash flow matching, or duration methods.

Besides, tailored nonlinear strategies using combinations of cash and derivatives, leveraging on fundamental research (and not only technical indicators) enable to extract alpha from event driven opportunities across indices, sectors, or corporates: macro-economic trends or events, relative value trades between asset classes or peers, M&A activity, changes in sector regulations, credit rating downgrades, sector or corporate earnings or dividends surprises, share buybacks, changes in corporate management.

Grow portfolio managers’ market timing capacity and agility in the current uncertain environment while keeping their long term fundamental investment view

Governments and central banks are running out of fiscal and monetary tools to stimulate growth, which makes business cycles likely to be shorter and more severe. At the same time, clients have shorter time horizons and increased aversion to risk, and they are less likely to accept short-term underperformance in the hope that the manager will perform well in the long run.

Actually, markets are driven by swings in investor sentiment as well as by changes in fundamentals, particularly in the short-to-medium term. The market volatility pattern has drastically changed over the past 10 years, influenced by the increasing synchronicity between markets (equity-rates but also with derivatives markets) and between the asset management industry and the investment banking trading activity. In addition, the ‘reflexivity’ of the markets – the impact that market moves have on investor portfolio preferences, which in turn impact the markets – will continue to amplify market volatility for the foreseeable future.

As a result, market timing becomes key, without losing sight of long-term investment goals and valuation perspectives. Beyond improving their investment outcomes, through active asset allocation and the broadening of their portfolios with additional asset classes, more sophisticated tactical and adaptive asset allocation (rolling optimisation, momentum rotation and target volatility, tail risks analyses) and derivatives momentum or investor sentiment prospective indicators will improve market timing ability and agility. Finally, as institutional investors trade in large blocks, that can significantly affect the price. Liquidity management becomes key to avoid growing over-reactions in asset allocation post non-fundamental sell-offs (e.g. April 2006, August 2011, August 2015, June 2016, February 2018), as experienced by the poor performance of most flexible or managed volatility funds handled by wealth management due to their lagging behind trend-following pattern during volatility spikes, thus missing the upside during the afterwards backup recovery periods.

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