Catastrophe bond ‘appraisal ratio’ highlights portfolio benefits

by Artemis on February 19, 2015

While some areas of the mainstream media and certain financial experts continue to describe catastrophe bond investors as yield hungry, this simplistic view ignores the benefits the insurance-linked asset class can bring to a portfolio.

Case in point, the appraisal ratio (AR). A measure that can be used to determine the performance quality of a fund’s investment portfolio, which looks at a new investment and calculates how the expected risk, return and diversification benefits will complement an existing portfolio.

In the latter stages of last year Dr. Peter Hecht, Vice President of Evanston Capital Management, published a white paper discussing the underutilised, yet important appraisal ratio methodology, using catastrophe bond investments as an example.

Dr. Hecht declares that; “Only the Appraisal Ratio, defined as the expected alpha-to-alpha volatility ratio, correctly accounts for an individual investment’s return attributes.”

With this in mind, Dr. Hecht’s white paper states that catastrophe bonds are extremely beneficial to an investment portfolio’s risk/return profile, as they have a higher AR than many other investments, like emerging market equities and bank loans. Dr. Hecht also feels that this portfolio theory approach to evaluating investments is too often overlooked.

“As a former finance professor, I am always taken aback by how many investors are ignoring basic modern portfolio theory when evaluating the performance of hedge funds and other investments within their portfolios,” Hecht commented. “There is also a tendency to focus too much on an individual investment’s Sharpe Ratio, expected return and correlation properties and not enough on beta-adjusting returns and risk-adjusting alphas.”

When discussing an investment’s AR it’s necessary to mention the Sharpe ratio (SR), a formula that is used to determine whether a portfolio’s returns are down to solid investment decisions or excess risk.

The higher a fund’s AR then the greater its SR will be and, in turn, the greater a fund’s SR is the better its risk-adjusted return has been.

Sophisticated investors look at individual investments in the context of the overall portfolio, so for investors allocating capital to the ILS or catastrophe bond asset class, how they contribute to the overall portfolio return is key.

The paper provides a practical example, comparing the Swiss Re Cat Bond Index, the Credit Suisse Leveraged Loan Index (Bank Loans), and the MSCI Emerging Markets Equity Index (“EM”) as potential “new” investments for a portfolio. For the purpose of the research the “existing” portfolio is allocated to the MSCI World Equity Index and Barclays Global Aggregate Bond Index in a 60/40 split.

Comparing catastrophe bonds with other asset classes, on a portfolio theory basis

Comparing catastrophe bonds with other asset classes, on a portfolio theory basis - Source: Evanston Capital Management

The paper looks at which of these “new” asset class investments would have the most beneficial impact when added to the existing portfolio. As you can see from the numbers above, catastrophe bonds have the highest Sharpe Ratio, the lowest Beta versus the existing portfolio, the highest Alpha and the highest Appraisal Ratio by a large margin.

The paper explains:

It is interesting to note that EM equities have the highest annualized return but the lowest AR, while catastrophe bonds have a somewhat lower return but the highest AR. Why is this? We know that in the traditional “balanced” 60/40 portfolio, the vast majority of risk comes from the equity component. EM equities are a high-beta form of equity, and therefore most of the risk of an emerging markets equity allocation is common to the existing risk of the 60/40 portfolio. This is why EM equities have a beta of 1.92. In this example, only a small portion, 1.56%, of EM’s annual return is a unique alpha component, and that alpha component is also volatile, producing a low AR.

By contrast, catastrophe bonds have very little risk in common with the 60/40 portfolio, which is consistent with the 0.08 measured beta. Most of the catastrophe bonds’ return is from unique alpha sources (6.91%) with lower volatility, producing a substantially higher AR. As a result, catastrophe bonds are the most impactful addition to the existing 60/40 portfolio.

So it’s apparent from this example that catastrophe bonds are a viable and solid option for investors wishing to add some diversification to their portfolios. This further highlights the low-correlation feature of ILS and cat bonds, as well as their ability to provide a stable return over time.

Further to added diversification to a portfolio the cat bond asset class also displays far less volatility than other benchmarks, as discussed recently by Artemis. This adds much-needed stability for an investor, particularly at a time when the market is enduring certain pressures.

Another benefit to investors catastrophe bonds offer is that they display an extremely low-level of correlation with the wider financial markets, something that was highlighted recently by there being no impact to the cat bond asset class from the recent oil price declines, or the recent movements of the Swiss franc.

Artemis discussed qualities the cat bond asset class brings to an investor’s portfolio in June of last year, drawing on research from Preqin, a provider of information and analysis for the alternative asset management marketplace.

“Investors are looking for hedge funds to do more than produce high returns; in fact, it is their ability to produce risk-adjusted absolute returns which are uncorrelated to equity markets that appeals to these institutions,” stated Amy Bensted, Head of Hedge Funds Products at Preqin.

Similarly, the research showed that like hedge funds, catastrophe bonds and reinsurance linked investment players are happy with a lower return, ‘particularly if the asset class provides the benefits to their overall portfolio that they seek.’

Given the clear benefits that catastrophe bonds offer to large investment portfolios it is no surprise that interest in the asset class remains high despite the returns having declined over the last couple of years. An asset class that can provide such a complementary boost to a diversified investment portfolio stands to continue attracting investors even when its yields are lower.

In fact, even when other asset class yields increase an allocation to catastrophe bonds or ILS will remain a very attractive option for large institutional investors. This is why saying that the reason the ILS asset class is growing is due to investors that are hungry for yield is too simplistic. Even in a higher-yielding world catastrophe bonds and ILS will remain a good addition to a diversified portfolio for savvy investors.

Also read:

Swisscanto favouring ILS investments over government bonds.

Cat bond market averages 8.33% annual growth since 2002: Swiss Re.

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