The universe of insurance-linked securities funds is about to get another interesting investment opportunity as ILS Advisers, an investment consultancy based in Hong Kong focusing on ILS as an asset class, begins marketing the first ILS Index Fund. The ILS Index Fund will be the first investment vehicle of its kind, allowing investors to take a passive approach to investing across the asset class as a whole.
ILS Advisers successfully launched the Eurekahedge ILS Advisers Index in March 2012, an index which tracks 29 constituent funds and is the first to allow a comparison between different insurance-linked securities fund managers in the ILS, reinsurance-linked and catastrophe bond investment space. The experience of launching this index has shown ILS Advisers that some investors would benefit from a vehicle which allowed them to invest across the asset class and diversify themselves across investment managers.
The performance of the Eurekahedge ILS Advisers Index shows that the strategy has value. Since its inception in December 2005 through October 2012, the index returned over 7% per annum, with a volatility of less than 2.5% and a Sharpe Ratio of more than 2. Soon after its launch ILS Advisers began to receive questions from interested investors asking how they could achieve this sort of return and the diversification an ILS index tracker would offer, whether they could invest directly in the index, or an ILS fund-of-funds.
The ILS Index Fund will track the Eurekahedge ILS Advisers Index, but it’s not as simple as some might think. While it is possible to physically replicate the existing pure cat bond indices, by investing across a balanced portfolio of cat bonds to match the index allocations, it is more difficult if one wants to include private transactions. The only feasible way to really track the index is by investing directly in the constituent funds of the index. This is exactly what the ILS Advisers ILS Index Fund does.
We spoke with Stefan Kräuchi, Co-Founder of ILS Advisers, to better understand the technicalities behind this innovative investment fund. He told us that the index is by definition, constructed using a strictly defined universe and a transparent formula and clear rules for calculating the weight for each constituent. In order to translate this into something tangible that can become an index tracker, or akin to an ILS fund of funds, you need to consider that not all constituents of an index are investable at all times, for example some funds may be closed off to new investors. An investable index, on the other hand, requires this by definition and this is where the complexities and technicalities lie that ILS Advisers have had to overcome.
Stefan Kräuchi said; “We felt there was a strong need especially from smaller institutional investor to diversify their ILS investments across different managers and funds.”
Kräuchi quickly realised that they needed a solution which would allow them to track the index by investing directly in a subset of the constituent funds of the index. Whatever this solution was it had to ensure that any deviation from the performance of the index was limited and controlled and limited so that the return of the index fund would match the real index experience.
Given the nature of ILS investments and the quite unique risk and return characteristics of an ILS fund, Kräuchi knew that the fund would not work if a standard approach to index investing was followed. An investment in ILS will typically provide stable premium income while there are no major loss events and this results in the kind of smooth upward return profile that we’re so familiar with across the various ILS and catastrophe bond indices. Of course losses do happen though, and major catastrophe and insurance loss events can dramatically impact the otherwise stable return profile. This means that ILS investments can have a return profile quite dissimilar to other asset classes and the distribution of returns can be heavily skewed towards the tail which makes other methodologies for tracking indices unsuitable for ILS.
So with a number of complex issues to address in order to successfully create a methodology which would allow it to launch the first ILS Index Fund, ILS Advisers teamed up with the Zurich based ETH Group spin-off, swissQuant Group. ILS Advisers wanted the index fund to be as true a representation of the Index as possible and for it to give investors a truly passive way to access the ILS markets returns. To enable this goal the quant specialist uses realistic models from insurance mathematics and statistics to closely replicate the true nature of ILS return distributions, which are heavily-tailed and skewed. swissQuant uses its statistical models to allow it to match the shape of the ILS markets return and that of the Index as closely as possible while maintaining a true similarity to the Index constituent funds, so offering a truly passive approach which allows them to control risk while maintaining the upside of the index within the ILS Index Fund.
This new fund could prove to be extremely popular in the marketplace as it offers the first opportunity for investors to achieve a return across the breadth of the ILS asset class and across the performance of ILS investment managers. This means that diversification within the portfolio is not just per manager but also across managers, which does mean constituent fund selection is important to manage to ensure no concentrations of risks arise.
Stefan Kräuchi commented; “When big disasters strike, the advantage of a diversified approach becomes very evident: While the worst affected funds had negative numbers in the double-digit range as a result of the Fukushima catastrophe in March 2011, the Eurekahedge ILS Advisers Index lost less than 4%. Given the performance patterns of the asset class, limiting your downside is crucial.”
An index tracking ILS fund is akin to a fund-of-funds, something that has not yet been done in the space, and there is a definite subset of investors for whom this could be extremely attractive. Investors such as Japanese pension funds, who have significant capital and a great deal of interest in the ILS space but historically have found the returns higher than their targets could find a more stable way to invest across the market with this strategy.
ILS Advisers are not rushing the launch of this fund, there is an education process for investors as this is a totally new strategy. Stefan Kräuchi told us that they would aim to launch the fund at the earliest in Q1 2013. It’s clear that there is a lot of work to do in setting up an index tracking ILS fund but we suspect that this fund will prove very popular as it adds a totally new opportunity within the ILS space. You could even envisage other ILS investment managers making small allocations to the ILS Index Fund as a way to maintain a base level of cross-market exposure and return before augmenting that with their own investments.
No doubt we will bring you more details as the ILS Advisers Index Fund moves towards launch.