When it comes to constructing a catastrophe bond fund it is important to consider market limitations, in terms of size and the availability of diversification. Given the cat bond market is only so large, there is a point at which growth in fund assets can come at the expense of returns, according to Plenum Investments Partner and Senior Portfolio Manager, Dirk Schmelzer.
This means finding the optimal size for a catastrophe bond fund is important, if you want to benefit from portfolio construction related alpha and not simply become another market tracking fund.
Diversification is one of the issues, given the limited size of the catastrophe bond market and the now growing number of fund managers and investors targeting it.
Which means accessing the tranches of risk a manager wants can sometimes be challenging, making patience a key trait for a cat bond portfolio manager.
But there is more to diversification than just adding new risks and regions to the cat bond market, Schmelzer believes.
“While the cat bond market does offer a high level of diversification due to the variety of independent risks available, the heavy focus on US risks, concentrated on few regions, creates a very asymmetrical risk profile which exposes investors to US hurricane risks in particular. Since the offering of diversifying risks in this market is rather slim, a diversification away from hurricane risks is hardly feasible, however, diversification within the US hurricane segment is entirely possible and also advisable,” he explained to us in a recent interview.
The limitations introduced by the size of the catastrophe bond market and available diversification are most apparent in funds with certain risk – return profiles, Schmelzer feels.
“In principle, investments in cat bonds cover a wide range of different risk-return profiles. However, both very conservative and very dynamically oriented risk-return targets inevitably result in a limitation of the investable universe. If, on top of that, the focus is on avoiding risk concentrations and the associated reduction of potential losses in the case of extreme events (tail risk reduction), the investment universe becomes even smaller, since cat bonds with a high degree of overlapping risks are excluded or can only be allocated to a very limited extent,” he said.
Because of this, Schmelzer added, “Such selective cat bond investment strategies can only be implemented by limiting the investment volume.”
This has ramifications for following the strategies defined, more so than in achieving performance targets and Schmelzer said that larger funds may find they have to invest in positions that have a significant correlation with existing cat bond positions in order to remain fully invested at all times.
As we explained recently, the main UCITS catastrophe bond funds between them have more than $8 billion of cat bond assets between them.
But when looking at the largest cat bond funds only, just three strategies account for around $6 billion of UCITS cat bond fund assets.
In a marketplace that only has around $33 billion of available 144A cat bond notes available, that’s quite a high concentration among just a few big players, which can add to challenges for building portfolios.
Larger cat bond funds are in most cases looking to allocate across the entire catastrophe bond market and even here Schmelzer says that Plenum has a view on optimal fund size.
“This bears largely on the question of the liquidity offered to investors in such vehicles. Another important factor is the composition of the fund’s investor base. So the questions cannot be answered in general, however, in our view, such funds should not exceed an investment volume of about 5% of the outstanding cat bond market. In other words, the critical fund volume is approximately USD 1.5 billion,” he explained.
Adding that, when it comes to fund size in a limited marketplace, “The larger the fund, the greater the pressure to invest in all outstanding cat bonds to maintain a high investment rate. As a result, high risk correlations are hard to avoid in this market so heavily focused on US risks, which increases the risk of losses in case of insured events occurring in the US.”
Interestingly, a study published in 2019 by the University of St. Gallen had specifically looked into this issue of ILS fund size and how that can affect performance.
We reported on that study at the time here and the research suggested that, in the analysis, ILS funds with assets under management of more than $680 million resulted in more underperformers than outperformers.
A key quote from that report states, “When growing too large, however, they might suffer from diseconomies of scale because they have to invest a lot of capital in a relatively small market, where highly profitable investment opportunities are scarce.”
This also means that larger cat bond funds can find themselves reliant on access to new issue paper, as well as to the secondary market, making their relationships with brokers all the more important.
“I think it is a mutual dependence,” Schmelzer said. “While the fund manager depends on receiving the appropriate allocations to cover his investment needs, the broker depends on being able to place new issues, and large-scale investors play an important part in this. Large funds are under more placement pressure than smaller ones.”
At Plenum Investments, the strategy is a little different as the manager wants to offer access to the positions it feels offer the best quality to investors and also to portfolio construction, resulting in less pressure because of the size of the market and making it easier to follow a stricter risk – return strategy.
Explaining that strategy and what the size of the market means to it, Schmelzer said, “Since the natural disaster market as such is not efficiently diversified, the question is how to realize efficiency gains. This question is reflected in our ‘Quality Concept’ which focuses on per-event covers (per occurrence), avoids so-called all natural perils covers on a loss-aggregating basis and ensures a high regional and global diversification, with little overlap of the covered risk regions per bond.
“In doing so, we underweight low-yield bonds with little diversification benefit which, in the case of major loss events, default just the same as higher-yielding investment which cover the same peril region. This allows us to increase the average expected loss and hence the absolute risk compensation, without elevating the tail risk.
“To achieve this goal, we rely on strict selection and restriction to a small number of individual positions which have low correlation with each other. As these individual bonds are closer to the risk, they are more susceptible to smaller insured losses. This is particularly true for loss-aggregating transactions exposed to so-called secondary risks. In the selection process, we therefore place special focus on per-event covers and substantially reduce loss-aggregating structures for meteorological risks. In short, we aim for a tail risk behavior similar to that of the overall market, but with a higher return.”
The upshot of this is that Plenum believes that cat bond fund size needs to be carefully monitored and even restricted to deliver the kind of low-volatility, more stable returns from a diversified portfolio that avoids some of the more loss-prone areas of the catastrophe bond market.
What that means is an optimal portfolio size of around US $400 million, the investment manager believes, specifically for a higher-risk reward strategy weighted towards US hurricane risks.
“Maintaining the quality of funds targeting a market-like return requires a significant limitation of the investment capacity to be able to make use of the limited number of suitable positions available in the cat bond market. The limitation of capacity is hence a logical consequence. Anyone who invests in a niche asset class, which cat bonds no doubt are, should limit oneself in terms of the capacity, unless wishing to build a market portfolio which, in our view, would not be efficient. The issue of capacity becomes even more critical if not the entire investment universe is available because of the set investment objectives,” Schmelzer closed by saying.
It’s important to add that manager strategies differ, when it comes to insurance-linked securities (ILS) and some of the larger cat bond funds use transformers to add private reinsurance deals, in more liquid cat bond form to their portfolios, helping them achieve the portfolio construction they are seeking even at larger size.
But for those focused purely on the main 144A catastrophe bond market, size definitely does matter and depending on the strategy the optimal cat bond fund size may be smaller than you think.