In the search for alternative sources of income, fund selectors at family offices, independent asset managers, and classic institutional investors have been increasingly dealing with alternative investments for years. Markus Hill spoke to Martin Friedrich, Lansdowne Partners Austria GmbH, about cat bonds as an asset class, risk versus return, correlation properties as well as the respective advantages and disadvantages for investors. Besides, in this niche market, they talked of challenges and opportunities for manager selection. Likewise, sources of information on this topic, and current topics of the in-house publication (capital market strategy) were discussed too.
Hill: As a capital market expert and fund of funds manager, you closely observe markets and available investment options. In one of your last publications, you discussed the topic of behavioural finance and then specifically addressed the asset class of cat bonds. Why are cat bonds of particular interest to you and other institutional investors?
Friedrich: As a multi-asset investor, our fund can potentially invest in anything that is tradable at least weekly and complies with the UCITS regulations. In addition, we adhere to the principle to only invest in capital market segments that we understand sufficiently. The criterion for ‘understanding’ is our ability to formulate our own return and risk models. That is the case in the cat bond segment, an asset class which I have been following for a number of years now.
To be more precise in answering your question, our interest in an asset class can be measured primarily by two factors: First, what potential returns do we expect from an investment? Second, how strong is the correlation of these returns with the rest of the portfolio? Theoretically, it is sufficient for an investment if an asset class stands out positively in only one of the two dimensions. In extreme cases, according to portfolio theory, even an investment with negative return expectations could still be appropriate if that class of assets exhibits sufficiently stable and negative correlations.
Insurance-linked securities, or cat bonds for short, are even better than that. They actually offer the best of all possible worlds in a multi-asset context. In the context of today’s market outlook, they offer attractive yields AND low correlation coefficients.
Hill: How do you assess the risk/return ratio?
Friedrich: On the basis of a pure Sharpe ratio analysis – expected return divided by volatility – cat bonds beat practically all other asset classes. However, we need to question whether that ultimately leads to a correct assessment of the true risk, because cat bonds have the unpleasant characteristic of producing really large losses from time to time, and these losses are unfortunately not predictable, as they are triggered by natural disasters. Worst of all are hurricanes – typically those that form over the Atlantic and then hit the coast of the United States. In this way, losses in the double-digit percentage range can occur practically overnight. As an investor in catastrophe bonds, you must be able to live with this risk. In purely mathematical terms, it means that you should not rely solely on volatility as a measure of risk in sizing your position.
Hill: What are the advantages, what are the disadvantages?
Friedrich: I have already touched on the advantages: cat bonds are a high-yielding investment with simultaneously low correlation to traditional asset classes. At the same time, many investors have withdrawn from the asset class after two disappointing years in 2017 and 2018, at an inopportune time as we think. Today, more than ever before, the insurance industry has a need to lay off risks in the capital market. The pandemic is hitting this industry hard and will tear a big hole into balance sheets. Cat bond investors, on the other hand, have escaped with practically no losses, but are indirectly profiting from the losses – many of which are not exactly quantifiable yet – of large insurance groups.
To elaborate, just a week ago we received an example of how this is actually playing out: Google is currently issuing a $237 million cat bond to protect its buildings and server farms in California against earthquake risks. The fact that THIS COMPANY is directly accessing the capital market is an indication for us that their traditional insurers do not have sufficient capacity on their balance sheets to offer this certainly attractive customer satisfactory conditions. It is a signal that the insurance market is in a “hard phase”. This is a good time for investors, as they can influence the conditions of catastrophe bonds in their favour!
As a drawback, I would mention that even today’s spreads of 6-9%, which are attractive from a historical perspective, cannot protect against sudden, unforeseeable catastrophes. Against this background, an investment in catastrophe bonds always remains partly a poker game, even if you have a relatively good hand in today’s market environment. Whenever such losses occur, the newspapers will be full of reports on them; which can quickly create a difficult situation for a fund selector who then has to see his boss and take responsibility for a big hole in the portfolio.
Hill: How do you identify suitable asset managers in this segment?
Friedrich: Basically, we proceed as we do with all such decisions. We observe the market and compile lists of all available providers. In the case of catastrophe bonds, this is relatively simple. It is a genuine niche market, with a manageable number of providers. In fact, I think we are in contact with all the funds we could invest with today. Thereafter, it depends on how much each respective approach convinces us. As always, the quality of the team is in focus, and experience in the insurance industry is really a key issue in this case. In addition, we make sure that the balance between avoidance of risk and ability to meet return targets is tailored to our needs as a multi-asset investor. After all, it makes a big difference whether a specific risk affects you by 100%, or whether you can diversify it away.
Hill: If one would like to delve deeper into the matter – is there any interesting literature on the subject?
Friedrich: To start with, there was a good article published in the New York Times, written in 2007 by best seller author Michael Lewis, entitled “In Nature’s Casino”. It’s an old one, but nevertheless gives you a good idea of how the asset class was created. For up-to-date information on the current weather, the National Hurricane Centre offers extensive information. For German-speaking investors, there is also the website ‘www.catbond.com’, which contains some useful information.
Hill: As Head of Research, you are intensively involved in economic topics. Which topic is currently the focus of your interest?
Friedrich: The truth is, we always have to cover quite a range of topics. But the interest rate outlook always plays a central role, and in turn is derived from a longer-term analysis of the economic situation. That is why I am currently working on a summary of the inflation outlook. A lot depends on getting it right, because the very low interest rate environment is by now penetrating almost all asset classes as a price-determining factor. A rise in interest rates would present investors with a completely new situation. If you are wrongly positioned, the effects could well be catastrophic.
Hill: Thanks for the interview.
Martin Friedrich is portfolio manager of the Lansdowne Endowment Fund and Head of Research. He joined Lansdowne Partners Austria in January 2019 from HQ Trust, one of the largest independent multi-family offices in Germany. Mr. Friedrich has been employed there since 2009, most recently as Head of Capital Market Analysis and Co-Chief Investment Officer. He also managed customer portfolios and was responsible for the investment process of LIQID, a Fintech company in Berlin.
Link to Lansdowne Partners Austria GmbH: https://www.lansdownepartners.com/austria