Liquid alternative allocations to grow, cat bonds & ILS will benefit

Institutional investors are set to increase their allocations to investment strategies which fall into the ‘liquid alternatives’ classification, which typically means a UCITS or 40 Act strategy investment fund, neatly fitting the mold of some catastrophe bond and ILS funds.

Liquid alternatives have been becoming increasingly popular for some investors that struggle with the typically more illiquid alternative asset classes. The guaranteed liquidity of a UCITS or 40 Act strategy enables large pension funds and other investors that require guaranteed liquidity availability to access alternative asset classes that they otherwise might not have been able to.

As a result asset and hedge fund managers have been launching UCITS and 40 Act funds to meet this growing demand from investors large and small for access to alternative asset returns with an ability to move in and out at regular liquidity opportunities.

Sound familiar? The catastrophe bond and insurance-linked securities (ILS) sector has a number of UCITS strategy funds available to investors, with a number of these becoming extremely popular in the last couple of years.

Good examples are the GAM Star Cat Bond strategy, the Schroder’s GAIA Cat Bond Fund, both UCITS, and of course not forgetting the Stone Ridge Asset Management U.S. market mutual funds, all of which have been very successful at raising capital from investors relatively rapidly. There are others, at least nine UCITS cat bond or ILS funds at the last count and Pioneer following Stone Ridge with a 40 Act mutual fund launch.

These funds, and future liquid ILS or reinsurance linked investment strategies, stand to benefit from any increase in interest in liquid alternatives as they don’t just offer liquidity and alternative returns, they are also among the least correlated of assets to macro financial movements.

A recent survey of institutional investors by J.P. Morgan found that interest is rising in these liquid alternatives. Almost 27% of survey respondents invested in a liquid alternative in 2014 compared to just 15% in 2013, but more interesting is the expectation of continued allocations to this space.

The more retail-oriented of the institutions that responded to the survey are typically the most attracted to liquid alternatives. With many investors still focused on a need for liquidity J.P. Morgan said more launches of these funds are likely.

Almost one-third of respondents to the survey said that they expected to allocate capital to a liquid alternatives strategy in 2015. At the same time the 27% who said they already did allocate indicated that they would increase those allocations over the next year or at the least keep them constant.

The biggest allocators to liquid alternatives are banks, investment consultants and registered investment advisers (RIA’s), many of whom will be ultimately allocating on the behalf of retail investors.

Additionally, fund-of-funds managers are increasingly expected to launch strategies based on liquid alternatives, which could also benefit UCITS catastrophe bond and ILS funds as they could become part of the FoF’s selection.

40 Act funds, so mutual funds offering daily liquidity, are one are expected to see strong growth of assets through 2015, according to J.P. Morgan. We’d imagine UCITS will see similar as attraction to alternatives continues to grow.

Any increase in general investor interest in a class of funds that ILS and catastrophe bonds neatly fit into tends to result in increasing demand for the insurance-linked asset class. Given the additional qualities of investments in ILS, low correlation and low volatility over the longer term, they stand well positioned to increase their profile with investors.

Additionally, J.P. Morgan’s report suggests that investors are set to increase allocations to so-called ‘smart beta’ and other alternative strategies which do not have such frequent liquidity. That bodes well for the insurance-linked securities (ILS) space as well, especially considering so many ILS manager funds are moving towards more illiquid, privately transacted ILS deals and collateralized reinsurance.

One reason J.P. Morgan cites for the increasing interest in alternatives generally is that increased market volatility in late 2014 and overall hedge fund underperformance, which tends to increase the desire to find alternatives or smart beta assets.

Artemis wrote about this recently here, when we discussed the fact that as asset class correlations rise the attraction to low correlated assets grows. Given the low correlation and low volatility (over time) of ILS and catastrophe bonds the asset class looks set to benefit from current investor sentiment.

J.P. Morgan’s survey found that only 15% of respondents currently allocate to alternatives or smart beta, but that some investors, particularly fund of funds, are set to allocate more or make new allocations in 2015.

For 2015 J.P. Morgan found that it is Asian respondents to the survey that are most likely to make their first allocations to alternatives or smart beta in 2015, an interesting fact as investors in Asia can tend towards a more conservative approach. However the market environment may be pushing once conservative investors to rethink their opinions of alternative asset classes, again a positive for ILS and cat bonds.

Another interesting fact for the ILS market is that investors are becoming increasingly comfortable allocating to new and start-up hedge fund managers. In fact some large institutions now see the value in getting in early and have capital set aside to allocate to start-up funds.

That could be a very important factor for the ILS market, where new business models and strategies look set to increasingly emerge. Track records may become less important as a whole, however it will be increasingly vital to be able to succinctly and intelligently explain your strategy or ‘secret sauce’ as a new ILS fund manager if you’re to attract this type of capital.

Finally, and another positive for the ILS and insurance-linked investment market, investors are reportedly looking more favourable at hedge fund strategies which have longer lock-in periods now. These strategies can see investors locked in for more than a year in some cases, something that any investment managers looking to longer-tailed classes of reinsurance business as an opportunity will appreciate.

If institutional investors become increasingly comfortable with being locked into hedge fund strategies for more than a year, it could make launching ILS funds targeting longer-tailed risks easier in future.

Of course, as much as this is all positive news for the ILS and catastrophe bond investments space, as ever the problem may be supply rather than investor demand. There aren’t enough catastrophe bond issuances to enable every ILS manager to launch a UCITS cat bond fund, the market just isn’t big enough yet.

Could the ILS and reinsurance market respond to increased demand by transforming more risks into liquid, securitised form? Possibly, but even at the now much cheaper risk transformation costs that would still be expensive.

However, what is certain is that a greater focus from investors on liquid and other alternatives, as well as new manager start-ups or strategies and longer lock-in periods, should all result in greater education and awareness of the insurance-linked securities (ILS) and catastrophe bond asset class.

Greater awareness goes a long way to ensuring ongoing market growth.

Also read:

– As asset class correlations rise, attraction to ILS & cat bonds increases.

– Swisscanto favouring ILS investments over government bonds.

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

– Swiss pensions look to ILS as alternative asset, but regulation hinders.

– On the non-correlation, or otherwise, of catastrophe bonds. And drooling.

– Correlation between insurance-linked securities returns and S&P500 returns declines.

– 2012 demonstrates catastrophe bonds lack of correlation to wider capital markets.

– Understanding the true nature of insurance-linked securities correlation.