A third way: capital-aware active management
A capital-aware active management approach should incorporate both the active management strategy and the regulatory capital efficiency of the bonds. What could this process look like?
The insurance investor could, for example, apply the algorithmic return-on-capital optimisation process to the bonds selected by the active approach. For each asset, the investor replaces the expected returns derived from Solvency II fundamental spread assumptions with the fund manager’s expected return. This combines the active strategy with a capital-driven active investment strategy.
The robustness of this approach would depend on the risk sophistication of the capital formula. The investor can constrain the optimisation to mitigate against these concerns. But this does not address the basic issue.
The fact remains that an optimisation algorithm can only solve for the relatively simple capital formula. It does not incorporate other forms of risk. As a result, it may still deliver a portfolio that is not attractive or sensible from a more holistic risk perspective. The process is still being driven to ‘game’ the regulatory formula as much as possible. Is this the ‘optimal’ approach?
Refining the capital-aware active management process
An alternative starting point is to screen out the most capital-inefficient assets first. The active manager can then use this narrower universe to construct the portfolio in their usual way. This is a less demanding use of the regulatory formula.
The portfolio construction process does not depend on the formula providing an accurate risk measure for all assets. However, it does allow for the fact that regulatory capital is costly. Some assets, including ones that are attractive from an investment perspective, may be capital-inefficient.
This approach screens out assets that are best avoided by a capital-sensitive insurance asset-owner. We summarise these different processes in Diagram 1.
Diagram 1: Alternative investment processes: quantitative optimisation versus capital-aware active management
Source: Aberdeen Standard Investments, April 2020
We can illustrate this revised capital-aware active management strategy for a portfolio measured against the BAML Sterling Corp. Index used above. This index included 1,004 different bonds from 391 issuers, as at 30 September 2019. Of those 391 issuers, the active fixed income process identified 195 as active ‘buys’, with a total of 530 bonds outstanding between them. Screening out 25% of the bonds that were least capital efficient, left 397 bonds.
Chart 3 highlights the bonds that are both active ‘buys’ and the most capital efficient, as well as showing those screened out during this two-stage process.
As noted above, an equal-weighted allocation to all bonds in the index resulted in a matching-adjustment benefit of 7.7% and an SCR of 11.2%. An equal-weighted portfolio of these 397 capital-efficient bonds increased the matching-adjustment benefit to 8.8%, with a reduced SCR of 10.1%.
So, capital-aware active management has materially improved the return to risk-capital ratio. Of course, a purely quantitative approach can also offer this level of improvement or more, at least in the short term. But this would not incorporate the skill of the active investor in assessing the fundamental risk and return characteristics of investments. It would not include any forward-looking assessment of bond ratings.
In practice, an insurer using a quant approach must hope that the regulatory capital process is good at identifying cheap assets. Yet we know this is not the case.
In this paper, we have made the case for incorporating an active approach based on a judgement of the fundamentals of investment. We believe that investors can add value by incorporating forward-looking assessments of business models, industry dynamics and a company’s management.
However, there are quantitative approaches to active management too, not just to risk capital management. Could insurance investors use a purely quantitative approach that combines active investment views with risk capital management, avoiding the need for judgement?
In practice, even quantitative approaches involve judgement. Investors must judge which quantitative models to employ. In addition, asset returns are not normally distributed, with negative outcomes occurring more often than expected under the assumption of normally-distributed returns. This is particularly true for the credit portfolios that dominate insurance portfolios.
These statistical properties, including higher moments such as skew and kurtosis, are hard to capture in an optimisation process. When they are included, they can result in portfolios that are not intuitively sensible in our experience.
Investors also require judgement when placing constraints on the optimisation process, such as setting limits on individual issuers. Today, integrating ESG analysis into the investment process is as good as mandatory. Yet there are no widely agreed sets of measures for ESG factors. Here too, investors must use their judgement.
We developed the example above in the specific context of Solvency II and credit risk. But the ideas, logic and principles behind it are more general. Insurance investors can adopt this approach to any case where our two basic premises apply – an active investment process and a sophisticated, detailed, risk-sensitive regulatory solvency capital regime.
Could the underlying principles of this paper be applied outside the world of regulatory constraints? Looking beyond solvency capital, investors can apply the same thinking to build a carbon-aware active management process. All they would require is some measure, or ranking, of carbon footprint. These too could be integrated into an active investment process. In Strategic Asset Allocation: ESG’s New Frontier, our Multi-Asset Research team set out how investors can adapt their strategy to address our changing climate in a disciplined way that avoids compromising expected returns. The principles set out in this paper allow investors to apply the same thinking to their underlying investments.
To be clear, there is a place for a robust quantitative framework in the investment process. These frameworks allow both portfolio managers and insurers to understand the art of the possible: the highest achievable expected return for each level of a portfolio’s incurred capital charge. They provide a valid solution where taking an active view is not possible or relevant. They can highlight the scope to enhance risk capital management of an existing, well-constructed asset portfolio.
However, these quantitative tools, and the metrics they embed, are not sufficient to deliver a genuinely optimal portfolio for an insurance investor.
To provide the greatest value, they need to be combined with fundamental analysis based on expert judgement – a capital-aware active approach.
1 In the context of Solvency II Matching Adjustment, this metric has particular importance since it determines how much the liability valuation can be reduced as a result of taking credit risk in the asset portfolio.
2 For this rather pathological example, the asset strategy would create £100 of capital through a reduction in liability valuation and require £70 to support it. In other words, this asset portfolio requires less risk capital to support it than it creates.